|Shares Out. (in M):||153||P/E||0||9.0x|
|Market Cap (in $M):||4,700||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
I think NCR is a currently interesting opportunity in a currently uninteresting market. Before going into some of the NCR story – just a couple of highlights as to why this opportunity exists today and why it is a compelling moment to consider an investment:
1) NCR had run as high as $50 in March and then suffered the ignominy of the dreaded 1-2 combination of a large PE/insider sale at the top combined with back end loaded guidance that they would not waver from until finally capitulating in their 3q earnings call…the type of 1-2 that inspires a visceral reaction with investors and sellsiders who have been humping your stock all year. But as laid out below – the core value seems unaffected by a particularly weak quarter that does not necessarily read through to future years, but the stock has had an emotional reaction. Hence the opportunity.
2) While NCR did bring down guidance (although only $0.20) the memory of a crappy, thin margin hardware company combined with DBD’s (who many associate as a comp) disaster lead people to assume it s a very lumpy and hard to predict business. While not exactly a utility, in fairness to the CFO, he had to bring down numbers only 2x before 2009 and 2014. They can manage through weak orders by controlling costs, which they did in 3q, but that the order weakness into 4q was just too much to overcome. ATMs will be down 30% in 4q - and that does not happen very often. Actually in many ways the business is getting more predictable/recurring as ATM’s and related software keeps shrinking as a %. Almost all of the fcf/earnings now come from software, cloud and other equipment with good secular growth – a story they have been telling. Unfortunately for them, the legacy ATM business (something like 18% of rev) had a really bad year – and really bad 4q (down 30%)…which shakes the “don’t worry about ATM’s we are a software company” story. But stepping back – even in the face of an ATM disaster – eps is still growing and as laid out below the rest of the business seems to be humming and it seems very unlikely that you see a repeat in ATM performance off this years weak comp.
3) As far as to the question – what has changed (to 2018, 2019, etc) from 90 days ago – my view is not much. The company on the 3q call seemed to confirm the sense that this is a bad 4q…but that it will pass and there is not much read through to 2018 or beyond (in fact it could be positive in that if orders are just delayed then it would lead to a tailwind vs what one would have thought 90 days ago). From that perspective –while they have not given guidance for 2018, the company seemed to indicate that there is really no reason to adjust 2018 numbers from what they were 90 days ago in a meaningful way. ie something like $3.60-$3.70+ (prior st range) could still be a base case range for 2018 – if you just use the inputs of the pieces of the business they have commented on in the call together with the current margin performance it seems like you get somewhere close to that. The 4th quarter aside, the ATM is a backlog business, so it usually has decent short term visibility. Clearly there have been some delays in the industry as bigger orders have been more complicated and taken longer to get implemented. So it does seem like their view of ATM’s into 2018 should have some visibility and with the windows 7 to windows 10 changeover coming in 2018, there is a large part of the installed base which will likely need to be upgraded in the near term – potentially leading to some acceleration. But even just a return to a flattish/lsd trajectory should be good for numbers.
3) From a stock perspective, my takeaway is the 4q and 2018 numbers have been derisked. They are now very focused on “beat and raise.” And the street has dropped to $3.16/3.35 for 2017/2018. These numbers seem very beatable even before capital allocation which likely puts a floor in the stock.
4) If you back out the ATM performance for this year – eps by my rough math would have grown about 15%...with ATM’s down 20% (and associated attached software)…eps growth is going to be about 5% with the ATM drawdown/headwind. So the strong drawdown in ATM sales is masking otherwise strong performance and ATM’s are much more likely to be a tailwind rather than headwind to that underlying growth in 2018.
5) According to mgt on the call, they think ATM sales should be up LSD (maybe higher next year) which should provide a tailwind to the underlying earnings growth in 2018 – hence the $3.70 or so off a base of $3.13 for 2017 (upper teens eps growth). This would be a real point of inflection. This also will tie with the new CEO coming in – my guess is he wants to come in with a feeling of credibility, momentum, and “see I told you.” (He is the COO and has been there for a year and helped cheerlead the guidance for this year – so this was his kitchen sink opportunity to set the bar before his official CEO track record starts).
6) There is a huge opportunity for aggressive share repurchase (they did a levered dutch tender 3 years ago) and they have PE board members who need an exit. What is particularly interesting from a current standpoint is that given the FCF development by quarter, you are looking at something in excess of $800-$900 million of FCF in the next 5 quarters ($5.70+/share) or around 18% of the market cap - and the balance sheet is where they want it – 2.5x trailing. This could lead to some decent upside – get numbers moving back up. If they just bought back $500 million over that time, that is like 10% of the float while still develerging further.
7) It sounds like there is an analyst day coming in 1q 2018 – likely will give guidance then.
Putting it all together, I think numbers are now derisked. I think ATMs had a really bad year in 2017. I think assuming ATMs bounce back to any degree (ie are positive off a weak comp) – there is a lot of upside to numbers. If you factor in buybacks, then you could walk yourself to the area of $3.70+/- or so next year (the low to mid $4.00 range in 2019). With the street at $3.35 2018, you are now still 9.8x the NTM eps/FCF on what looks like conservative assumptions. There is still the chance that 2018 is more like $3.70+/- and with a reacceleration of ATMs and some beat and raises you could get a mult on that (13x-14x) for a $50 stock (or at least upper $40’s) by this time next year (it was just $50 in March). Ironically the earnings quality now is higher (all software/cloud – no hardware in 2017 given the atm collapse) so in theory they mult should go up (not how it works – I know).
Particularly interesting from my point of view - I also point out that we are now below where it was reported the PE bids for NCR were, which was around $37/share, 2 years ago when earnings, ebitda and especially fcf were lower. That seems like a reasonable/interesting entry point. That seems to give you some downside support from here. You can read Blackstone’s take on NCR below.
NCR has been a company in transition for years from a low margin and lumpy hardware business to a largely software business with high recurring revenues that is well positioned for several secular trends in automation and software across the financial (50% of end market), retail (30% of end market), and hospitality (20% of end market) industries. We believe that the company might be at an inflection point in its transformation which can be seen in its increased high FCF conversion (lack of restructuring and pension expenses that have plagued its fcf conversion for years), the outside investment of Blackstone, and the margin expansion opportunities management has laid out. The stock is statistically cheap at around 9x 2018 earnings and free cash flow and has a strong balance sheet at around 2.5x net debt to EBITDA. Understanding the history of NCR helps explain the relatively low multiple and the potential for rerating as the street becomes more accustomed to the new “NCR.” NCR was mostly a hardware/ATM business, which is lumpy and cyclical with a large underfunded pension. The company has been in transition building up its software capabilities through investment and M&A. As a result cash flow has suffered, weighed down by restructuring expenses and pension contributions. It now seems that the pension is taken care of and the large M&A and restructuring are complete, turning NCR into a FCF story with most of is cash flow coming from software, a substantial portion of which is recurring. Looking at management’s long term guidance for the various segments, which seem reasonable, if they are successful in delivering the performance they expect, eps should grow from $2.78 in 2015 to $4.00-$4.25+ in 2019. Given the newly proven high fcf conversion, mid teens organic eps growth, and substantial recurring revenues (43%) - multiple expansion from around 8x today to say 13x-14x seems quite reasonable and would result in a stock price of $55-$60+ in 2019. In addition the company will end the year at a leverage ratio they feel comfortable with and therefore will be in a position to deploy capital. If they just bought back stock keeping net debt at 2.5x, eps could reach $4.50+ by 2019 and the stock could trade $60-$70 at 13.0x-15.0x given the higher eps CAGR. In addition, from a downside perspective, a combination of margin opportunities as well as capital return could drive eps towards $3.50-$4.00 by 2019 without much net revenue growth. Lastly there is a free call with regard to data monetization that we have not been able to quantify yet, but is a real opportunity in the 2019-2020 time frame.
The way management describes, guides and reports the business is with software sales (29% of Revenue/67% of Operating Profit) being a high/upper single digit grower. This can further broken down into around 2/3 of software revenue being “unattached” to hardware – ie do not need to sell a physical unit. This is basically an up-sell/added functionality option, etc. which can grow at an industry growth rate of 16+%. This growth is driven by the secular trends of transformation and platform and digital enablement. Examples would include the Delta app on your iPhone which is unattached software sold by NCR but which ties with the digital enablement add-on that integrates with the hardware Delta already bought from NCR. More examples of what types of software solutions are linked to the platform, channel transformation and digital enablement trends are explained below. Around 1/3 the software sales are “attached” in that it comes with hardware and therefore only grows LSD with hardware sales – this is mostly linked to ATM sales. This is software that essentially “runs” the hardware. Putting together roughly half the unattached software sales growing with the industry at 16%+ with roughly 2/3 the software sales that are attached to hardware and growing at hardware rates of low single digits yields the combined outlook for software to grow at upper single digits. Management talks about hardware sales (36% of revenue / 11% of operating profit) growing low single digits. Hardware sales help drive software as it often comes with attached software but more importantly it is NCR’s large installed base that allows it to add functionality through unattached software sales to its customers like the Delta app mentioned above. Most of the $350 million in emerging market sales falls in this hardware category as most emerging market sales are more straight forward ATM sales. Lastly the service segment (35% of revenue / 23% of operating profit) is guided to be a “little better than hardware.” This makes sense as this segment is largely a “break/fix” business built around servicing the installed hardware base. It is relatively stable and predictable. A broken ATM needs to be fixed. They continue to win a little market share in servicing given their strong network that smaller competitors especially on the low end do not have. This is the way that we model the company and can be thought of as yet another framework for how to think of the company.
From a margin perspective – there are two drivers to think about. First is the natural change in mix as software with low 30% margins grows faster than hardware with around 10% margins. That mix effect should lead to 30-40 bps of margin improvement a year. The second source of margin improvement comes from a $300-$400 cost reduction program management has instituted that should play out over the next 3-5 years. Management has guided to reinvesting half that savings back in growth for the business and letting the other half or $150-$200 million fall to the bottom line. This equates to around 2%-3% of margin improvement from cost reduction by around 2019. Adding these two together would yield around 3.5% in additional margin.
From a capital allocation perspective, management has indicated that they are comfortable with current levels that are about 2.5x net debt/EBITDA and feel 2.0x-2.5x is a good long term target. Free cash flow, after years of lagging net income is now expected to be around 95%-100% of net income. The free cash flow is expected to be available for buybacks and additional tuck-in M&A.
When you put all the pieces together, the business model is roughly mid-single digit organic top line growth (about 4%), with mix and margin expansion that translates into 11%-13% organic operating profit growth, which with buybacks and tuck-ins should translate into mid to upper teens eps growth over time.
To dig a little deeper into the drivers of the revenue which was eluded to earlier: management sees 3 primary drivers of the 1/3 of the revenue we identify as “transformational” – most of which shows up in the reported software segment, but also includes some hardware sales. To be more clear, this “growth revenue” can be divided into 3 buckets. About ½ of that bucket can be attributed to “channel transformation.” The other ½ can be split, as of now (over time these two buckets likely grow in relative weight as they are a follow-on’s or second steps to channel transformation), equally between “”platform” and “digital enablement.”
Expanding on each one of these trends with some examples – starting with “Channel Transformation” which could also include what one might call “store automation.” This is hardware lead transformation of bank branches, restaurants, and retail.
For banks (50% of end markets) – one example would be automated tellers with video links replacing people. This helps cut branch sq footage by over ½ (3500 sp ft down to 1200 sq ft as a target size of branch) and lets people come out from behind counters and walk around with iPads helping customers and driving revenue/transactions instead of sitting behind glass just processing requests. This drives both attached software that drives the hardware needed to “transform” a branch as well as unattached software that uses data and adds functionality to drive sales…ie software that flags a customer that is in the branch to make a deposit as a candidate to buy a CD who should be approached. Current trends favor bank transformation – steepening yield curve and less regulations should lead to more investment as banks are able to target higher ROE’s. In addition, one trend that can affect all the segments is a higher minimum wage – or wage pressure that will likely accelerate automation to cut wages or at least make employees more productive from a revenue generations standpoint.
For retail (30% of end markets)– channel transformation would include self check out and omni channel initiatives. Self check out is big in UK – 90% penetration. This allows for employees to get out on the floor with ipads and help drive sales and improve customer service rather than being behind cash registers. Self check out can be with an iPhone scanning items in aisles or with stand alone self check out kiosks. Omni channel is also very important to retailers – big and small. They all need hardware/software that can allow for seamless integration between online sales/returns and brick and mortar stores as the consumer increasingly initiates some part of the purchase on line. It is worth noting, NCR has 80% market share in self check out so will benefit from any growth. Like with financials, current trends favor growth as past few years for retail have been about security given PIN breaches – now that is behind, focus should shift to driving better returns. Like with financials, a higher minimum wage – or wage pressure will likely accelerate store automation.
For restaurants (20% of end markets) – channel transformation is really about automation. Buffalo Wild Wings is a good example. The chain now has iPad ordering by customer at table. Each restaurant has automated handhelds for waitress to facilitate orders and take payments at table without needing a register. In addition, together with the upfront hardware and software, there is some back end integration with processing orders, inventory, staffing that NCR also provides. Another example would be if you order Chipotle on iPhone and pick up in person. Through NCR hardware installed in the restaurant and kitchen and the related app on a customer iPhone (the iPhone app is really “digital enablement” – which is a follow on sale to the channel transformation which Chipotle did by installing NCR hardware), the restaurant is alerted when a take-out customer is physically near store in order to get order out on time. This shows the power of the hardware/software integration that NCR can deliver.
The second driver of “growth revenue “or bucket is called “platform.” This integrates with the channel transformation and is software that helps integrate offerings – what management describes as “one version of the truth.” Once all the hardware is updated with NCR, clients engage with a NCR platform/software to run their operations. This type of software helps figure out how many yellow sweaters are in inventory, where they are and the best way to deliver them to customer. So if you shop on line and put a yellow sweater in your checkout bucket, you can go to the store to pick up that sweater, or have that same sweater shipped. And the same thing when you return it – if you buy it on line and return it in person, that same yellow sweater inventory is maintained correctly. The Delta app on your iphone is another example – the app is integrated with delta hardware in terminal to deliver one customer experience. You can fill things out on your phone, at a kiosk or in person and they can all work together and share information. In summary, having the platform software allows for an Omni channel experience once the hardware is in place. Consistent customer experience is the key.
The third “growth revenue” driver is “digital enablement.” This is mostly a mobile related piece of software that ties into a hardware customer – especially one that has gone through a channel transformation. Examples include mobile banking (NCR has 8 out of the top 10 most used mobile banking apps), remote deposit, mobile ordering and payment (Chipotle), Loyalty programs, click and collect (on line order – in store pick-up), fraud prevention, real time actionable insights, inventory and labor management.
Channel transformation is more associated with hardware where as platform and digital enablement are more associated with non-attached (ie no associated hardware) software sales. Although it is the channel transformation that opens the client up to platform and digital enablement options as add-ons or up-sells. Furthermore, NCR is still experimenting with moving software to cloud rather than license sales or moving customers to a more click based pay rather than upfront licensing fees or even moving some hardware/software packages to a use fee over sale…something to watch…could be more of an ADOBE transformation at some point…not there yet.
There is also a potential 4th driver of the “growth revenue” bucket. This is a free call. This would involve the potential monetization of “big data.” Currently NCR enables and processes 600 million transactions every day. Billions of transactions occur on NCR hardware, 8 of top 10 mobile banking apps are ncr, etc. As of now, NCR gets $0 for it. Between now and 2020 NCR will begin to explore how to get paid for it. Ideally the thought is that NCR is in position to help provide apps/analytics to help customers mine data to improve sales, profitability and customer experience. It can pool data from other retailers, banks, etc in an anonymous fashion to generate valuable customer insight and charge for that insight. We have not been able to bracket this opportunity, but it does seem to exist and could be an additional growth driver that investors are looking at in the 2019-2020 time frame as something that continues strong growth for NCR for years to come starting in that time frame.
A couple of other investment points to keep in mind:
· FCF conversion which has been terrible for a decade as a result of pension and restructuring costs has now inflected and is expected to be 95% in 2016 and approach or equal 100% going forward. This by itself should speak to multiple expansion.
· 43% of revenue is recurring now (majority of the operating profit). Software is almost 70% of the operating profit.
· Since 2005 NCR has been in some sort of “transformation” trying to grow/acquire software businesses and restructure its hardware business and pension…a process that now looks complete. Management sees no more big deals.
· Its two largest competitors (especially in the ATM/financials segment)are in the process of merging – Wincor and Diebold which should further rationalize the business around 2 big competitors (ie better pricing and retention) and will likely bleed some share to NCR especially where banks want 2 suppliers and previously had Diebold and Wincor. We have not factored this into our growth or margin assumptions.
· NCR has a strong emerging market position which has been hit by f/x, Russian and Chinese weakness. Emerging markets was $800 mil of revenue now $350 mil. Management sees an end to this headwind, one day will be a tail wind. Acceleration or regaining lost growth in emerging markets is not in our numbers. Should that occur it would be incremental. This would be mostly hardware as emerging markets are largely ATM sales, but recapturing an incremental $400-$500 in sales would help the topline optics and likely add $40-$50 million in operating profit over and above our numbers or maybe an additional $0.20 of eps.
· The geographic break out is:
Europe is mostly naturally hedged with manufacturing in Eastern Europe and hedges for 60-70% of the exposure. In 2015 f/x hit revenue by $420 million and operating profit by $70 million. In 2016 it hit revenue by less than 1% or about $50 million and eps by $0.08. Still working on a better analytic measure of the impact of currency moves.
· The effective tax rate is 25% but the cash tax rate is only 13% until around 2019/20 when it starts to move up towards the effective rate. The difference is because of all the pension contributions.
· There were some rumored LBO interest and a strategic review in 2015. The rumor was that Blackstone and Carlyle group bid $10 bn for NCR (around $37/share). The end result was that Blackstone invested $820 million at $30.00 a share on 11/12/15 for 17% of the company and 2 board seats. The Blackstone cash along with some incremental debt helped fund a $1bn dutch tender done at $26.75.
· Here is what Blackstone presented as their thesis at the NCR investor day which I found instructive:
Good afternoon. It is a pleasure to be here today. What I'd like to do is cover the investment thesis that led Blackstone to make this investment and the couple of value creation levers that we're working with management team on. We'll start out by saying that this is the largest investment in the technology area that Blackstone has made in the last seven years. We're very pleased to be shareholders at NCR. We think the investment thesis starts and ends with the fact that NCR is a significantly undervalued company. This is a company trading at less than 9 times P/E. We believe it has enormous free cash flow generation potential. We think the perception of the company is misunderstood by the market. When we analyze the organic growth of the company, it is 3.5% on a constant-currency basis over the last three years and we think the company can achieve that or higher going forward. Yet, the company is trading under 9 times P/E. We think that the company has a safety net with regards to its downside, but yet, a lot of upside levers that the management team is exploiting and a lot of really good opportunities up ahead of it.
We think the company competes in a very favorable environment, in an oligopoly where the recent combination of its competitors actually add to the company's present and competitive position. The position of the company as a market leader in a very cash recurring, highly regenerative business we think is terrific. We think there's a 95% renewal rate for the company. We think of mission critical software and hardware for NCR products, and we think the company has a terrific brand name with leadership positioning in across its market lines. So, you take a look at here. We talk about the strategic rationale, some of which I have covered. Part of our due diligence is not only learning about the company but understanding some of the perceptions regarding cash and the ATMs. As you know, we all are concerned about the glide path of cash and that was one of our key diligence items for NCR.
We took a look at cash and how it's growing in developing markets. But in the U.S., cash is actually shrinking in terms of number of transactions, but it continues to grow in terms of absolute dollar or value of cash spent. So, if you take a look at the transactions, the cash projections over the next five years is projected to grow at 0.5% and we think that portends well for NCR because it's a little bit misunderstood. A lot of the new forms of payment are actually taking away from debit and credit, whereas cash remains a stable. In developing countries, we took a look at the most radical, drastic downturn of cash, which is in Sweden. In Sweden, as you may know, there has been a 40% decline in the usage of cash in the last decade. But yet the number of ATMs remains stable.
So, in a worst case scenario for the U.S., if our analysis is wrong and cash has a much sharper glide path, we believe that ATMs will still be a staple and will not decline. In fact, we believe that ATMs will grow in number of transactions, in number of locations, but as importantly, the number of high-value ATMs will be much more important at the number of branches in the U.S. The banks are reducing their number of branches. They're consolidating. So, today, you have about 93,000 branches. That's projected to go down to 85,000 to 90,000 over the next five years. But what you see is the number of ATMs will remain stable, and, in fact, the number of high-value ATMs will increase over such period of time.
What does that mean for NCR? The value of those high-value ATMs for NCR will mean that each transaction or each ATM, NCR would generate 30% to 40% higher value for each ATM. And for the banks, it is a savings and replacement of its tellers, and the banks will also save money because it's replacing a lot of the tellers inside the banks. The other thing that we took a look at is the competitive nature of the competition of NCR. We were all worried about the Korean competitor. Our analysis concluded that the Korean competitor is very focused on low-end ATMs. While it looks to have the same market share as NCR and growing, the portion at which it competes against NCR, it only has 3% to 5% market share. And we don't believe that's going to be a major player because the focus is going to be on software and the focus is going to be on servicing, both of which the Korean competitor does not have a strong presence in. So, in conclusion, our strategic rationale in terms of investing in NCR is that it's a grossly undervalued company, high cash flow regeneration, reasonable organic growth rate with a significant upside in terms of continued transformation into a software company.
The competitive threats out there, we believe, are low given its oligopoly. The combination of its competitors bode well for NCR and the low-end competitor, the Korean competitor, does not really compete in the markets that NCR competes in. And so, this misperception has led to the undervalue of the company. And what we plan to do is work with the management team on focusing on two things. One is transforming the company more rapidly into a software company and two, margin enhancement, capturing a great upside in the market.
So, in terms of the growth into a software company, the management team has done a good job thus far, taking NCR from an old line hardware company to today. Today, 47% of the gross margin dollars are already from software. It's about 25% of revenues, but 47% of the gross margin dollar. We think that trend will continue to persist and more and more will be attributed to software. Now, some of this is attached software, but that's what – NCR has an advantage in terms of the attached software. We would like to work with the management team on transferring the culture, the focus and keeping our pedal on the gas pedal to transform it to a software company.
The second thing is to capture more of the gross margin and the margin improvement. We think there's significant cost cuts that could be done at NCR. As Bob has told you, $300 million to $400 million of cost reductions will be projected going forward, and about half of that will flow down to the bottom line. We think in addition to that, the margin shift, just from naturally from software to hardware, will improve the margins in addition to the cost cuts.
If you take a look at a very simple model, NCR has been growing at 3.5% per year. If you take the downside scenario and let's project the company grow at 2% instead of 3.5% over the next five years. And if you assume that there's $125 million of cost cuts, a number lower than what Bob has forecasted, and you assume that this company is worth 10 times PE, that gives you a return for shareholders of 20% per annum. If you take the other side of the band, if you assume that NCR will grow faster than its historic 3.5% which we do think that it will be, at 5% growth rate, same assumptions, and let's say NCR gets restored into – has a P/E multiple to its historical number of 14 times P/E, you would have a 30% shareholder return for that. So, those are the goalposts of how we think about the investment.
Obviously, this is not assuming significant acquisitions. This is not assuming a massive upside in multiple where the company will be valued as a software company rated at 14 times P/E. But if you assume the goalpost of 2% to 5% growth and assuming very reasonable P/E and a lot less cash reductions than management has forecasted, you will get a 20% to 30% return.
And we also wanted to say that we've been impressed with management doing our due diligence. Management has done a terrific job explaining the business. This is a management team that knows its business very, very, very well.
And as a management team that's also focused on shareholder value, the management team was exceedingly objective in looking at a buyout, a return of cash to shareholders by looking at dividend recaps, by looking at share buybacks, and ultimately, partnering with Blackstone in doing a preferred. And Blackstone, we think we can deliver a lot of value to the company in addition to counsel. We have a portfolio of over 52 companies of over $120 billion of revenues that I think the company, that NCR will work to derive revenue synergies towards the Blackstone portfolio of companies. We also have joint purchasing initiatives that we're starting with NCR right now, that the company will save a bunch of money for its non-cost of goods sold as SG&A. And we think that we will bring the best practices of Blackstone toward NCR. As I said, this is the largest investment for Blackstone in the tech sector in the last seven years. We're very pleased to be here. We think it's a great company, and we think it's significantly undervalued. Thank you.
The 4th q and potentially an upcoming analyst day early in 2018.