July 16, 2009 - 2:24pm EST by
2009 2010
Price: 11.00 EPS $0.60 $0.90
Shares Out. (in M): 160 P/E 20.0x 14.0x
Market Cap (in $M): 1,800 P/FCF 10.0x 8.0x
Net Debt (in $M): -400 EBIT 340 380
TEV (in $M): 1,400 TEV/EBIT 4.1x 3.7x

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NCR- Long
I believe that NCR shares offer a compelling opportunity to take advantage of market mispricing of risk and pension liability.  Alternatively, if I am wrong and the market indeed values the pension/risk accurately at NCR, then the shares simply provide incredible value for equity holders.  Either way, I think buying the shares provides very compelling risk/reward.  Shares are at ~$11 (varies by the day) with upside to over $20 and risk to $9.

NCR manufactures and services three primary types of equipment:  ATM machines for financial institutions, point of sale (POS) systems for retailers, and self service kiosks for a range of industries.  The company has leading market share for most of its products including #1 market share positions for ATM machines, self-serve POS machines, and airline kiosks and #2 market share position in retail POS machines behind IBM.

Revenue is well diversified globally with 43% of revenue from North America, 39% from EMEA, and 18% from Asia Pacific and Japan.

Revenue mix is approximately 42% service, 8% consumables, and 50% equipment hardware and software (30% ATM and 20% retail).  This makes approximately 50% of revenue relatively stable and 50% of revenue tied to capital spending cycles at banks, retailers, airlines, hotels, and other end markets.  Within ATM, large national banks account for approximately 60% of revenue and smaller regional banks account for 40%. 

The company was spun off of ATT in 1997 approximately 7 years after ATT purchased it.  In late 2007, NCR spun off Teradata, an unrelated database warehouse business which now has 2x the market capitalization of NCR.  That really only left late 2007 to pre-market meltdown 2008 to see how the market valued NCR's core business.  Then everything changed and pension became the overriding issue at NCR.  At the time, NCR traded at an EBITDA multiple of 8-12x and a P/E of 15-20x.  This was in line with its nearest peers DBD and Wincor.

NCR froze most of its pension plans and was slightly overfunded ($318m) at the beginning of 2008.  However, it was 66% invested in equities and the $318m overfunded pension became a $1,200m underfunded pension by the end of 2008.  This became THE focus for investors with NCR.  They saw the reported pension liability on the balance sheet of $1,400m (vs. $1,200m underfunded status) as of Dec 2008 and panicked.  As the market continued to fall through early March 2009, the shares fell from the ~$25 per share before the market meltdown and pension scare to $6.67 per share.  As of its Q1 2009 earnings call, NCR indicated that the pre-tax discounted value of its underfunded pension was $900m based on Treasury department pension rulings.  This means that NCR could contribute $900m to its pension today and return to a fully funded status.  Cash contributions to pension provide a tax benefit and are deductible for cash tax purposes.  So the net underfunded status is the $900m less tax benefits.  Assuming NCR's 25% book tax rate can be applied, this means the true underfunded status of the pension is closer to $675m or $4.22/share.  However, in April 2009 on the first quarter earnings announcement, a new #1 issue surfaced...

DVD Kiosks:
NCR bought TNR the remaining equity stake in TNR, a DVD rental kiosk business, and created a JV with Blockbuster.  This acquisition set up NCR to compete with Redbox, the wildly successful division of Coinstar that offers new release movies on DVD for $1/day at kiosks outside of grocery stores, Walmarts, and other retailers around the country.  The investment in DVD rental rocketed to the #1 issue for NCR investors, reducing pension to a #2 issue.  NCR wants to grow its DVD kiosk business to 30k locations in the next 3 years and thinks its business can do $1 billion of sales and 15% EBITDA margin.  Redbox will produce about $750m of sales and 16% EBITDA margin in 21k locations in 2009.  NCR announced that it will invest $60m in this business in 2009 and that it would have reduce EBIT by $30m for the year.   It is impossible to predict how successful the DVD business will be for NCR.  It could be a hit as management predicts and generate $150m of EBITDA or it could be a dud.  At this point the investment in DVD is relatively small and provides management an opportunity to test out the business model for a relatively small investment.  Success for this business would be 6x $150m or $900m of value in a few years time.  Failure is the loss of $100 to $200m of capital on investment in this business.  That is $5.60/share if it works and $1.25/share if it fails.

The core business:
Issue #3 for investors is the core business.  Exposure to banks and retailers is not ideal in this environment and this has clearly impacted NCR.  The core business does $1.55/share of EPS, $450m of EBITDA ($2.80/share), and $320m of EBITDA-capex ($2/share) at the low end of guidance.  This should be the focus for investors as long as the core business has a multiple on EPS or EBITDA is higher than you can count on one hand.  The results for the core business are despite severe weakness in retail, regional banks, parts of EMEA, and Japan which are down ~20% year over year.

Long term growth story:
There is a long-term secular growth story to NCR's core businesses as companies increasingly go to NCR solutions to increase productivity, lower capital spending and/or reduce ongoing costs.  Banks can reduce the number of branches by installing new ATM machines and upgrading existing ATM systems can lower the number of teller transactions.  Retailers can reduce the number of cashiers with self-serve POS machines.  Airlines have seemingly eliminated all check-in agents.  NCR solutions typically have 2-3 year paybacks with 7-10 year operating lives and offer compelling economics for customers (as long as they are not capital constrained). 

There is an ATM upgrade cycle being driven in the US by Check 21 legislation that provides for digital imaging of checks and has created demand for automated deposit ATM machines.  So far, the largest banks - including JP Morgan, Bank of America, Wells Fargo - have been aggressive in rolling out automated deposit ATMs.  This should continue for the next couple years.  Smaller regional and community banks have not yet begun to automated deposit rollouts, but are likely to do so in the next couple years as there is pressure to maintain deposit and provide good retail customer service. 

Developed Europe and Asia have cash recycling driving ATM upgrades.  Cash recycling allows the same bills deposited to be recycled out to other customers.  This lowers operating costs for ATM (don't need to send the armored car as often to pick up the money in the machine) and reduces risk of theft (less $ in the machine).

The developing world has a low installed base of ATM machines, so increased penetration drives the growth story.  This is the typical infrastructure build out story.  There are 1,300 ATMs per 1 million Americans.  There are 100 ATMs per 1 million residents in China.  There are 80 ATMs per million people in Eastern Europe.  I don't know exactly what this means other than to say that there is plenty of room for build out of ATM networks in the developing world.

Self-checkout POS is also in the early stages of rollout at retail.  Larger retailers and grocers are first to install these machines.  Penetration is low thus far, but the opportunity for replacement is large as in ATM. 

Overall, management estimates annual market growth rates of 4-5% in ATM and 3-5% in retail.  Clearly, the growth may be delayed in this environment, but the long term opportunity remains.

How the market misses valuation:
I believe the core problem investors have is that they double count pension in the valuation of NCR. 

One way investors value this is to value the core business on EBITDA and then treat pension liability as debt in EV calculations.  The numbers work like this:

+$310m EBIT before pension (low end of guidance range)
+$30m DVD investment in 2009
+$110m D&A
-$170m pension expense
=$280m of EBITDA after pension
* 8x (DBD multiple and historical NCR multiple)
= $2,200m of value for core business
+$400m net cash on the balance sheet
-$900m pension liability
= $1,700m of equity value or ~$11/share

The problem with this calculation is that the pension total gets added once as $170m * 8x = $1,360m and then again as $900m for a total of $2,260m.  The actual FV of the liability is really closer to $675m (see pension analysis above).  This overstates pension by ~$1,585m or ~$10/share.

Alternatively, investors are valuing this on earnings and again mispricing the pension.  Investors take the core business low end guidance of EPS of $0.75/share and apply a low end of range DBD and historical NCR multiple of ~15x to get a share price of $11.  However, imbedded in the $0.75/share is a pre-tax pension expense of $170m or $128m after tax (assuming NCR's 25% tax rate).  Effectively then, the market is capitalizing the pension expense at 15x $128m or ~$1,900m.  This overstates pension liability by $1,200m or ~$8/share.

Both of these methodologies assign effectively $0 value to the DVD business.  While the value of DVD is hard to determine, the DVD analysis above suggests that there is $5.60/share of upside and $1.25 of downside.  Applying a 40% probability of success and a 15% discount rate and 3 years to achieve full valuation for DVD gets an additional $1/share of value.  While admittedly low, this still appears to be a low cost embedded option.

What if I am wrong and the market is valuing pension properly?

Or the core business is absurdly cheap:
If the market applies the proper valuation to NCR's pension, then the math works like this:

-$400m of net cash
+$675m of FV after tax pension liability
= $275m of net debt
+ market cap of $1,900
= $2,175m of EV

The core EBITDA excluding pension is $450m at the low end of guidance so the shares trade at 4.8x EBITDA.  This compares to DBD at ~8x EBITDA and Wincor at 6.5x EBITDA and historical NCR (pre-pension crisis) of 8-10x EBITDA.  Using capex of $130m, this is also 6.8x EBITDA-capex.    This implies 50-100% upside to the shares given the capital structure.

Another way to think about this is core earnings of $0.75/share (low end of guidance) + $0.80 for pension expense addback ($170m pretax, $128m after-tax) = $1.55/share of core EPS.  The true pension cost is $675m or $4.22/share.   Solving the equation:  ($1.55 - $4.22/(PE mult) = $12/(PE mult)) tells you that the market is applying a PE multiple of 10x PE to the core business.  This compares to DBD at 14x, current NCR at 20x, and historical NCR multiple at 15-20x.  This would imply 50-100% upside for shares.

A final way to view this is to assume NCR raises capital to fully fund the pension.  Thus, the company can raise $675m (pay $900m and get tax refund of $225m) and remove the problem.  The balance sheet would still be extremely healthy under this scenario with net debt of $275m and EBITDA of $450m at the bottom end of management's guidance.  This is less than 0.6x levered.  Assuming an 8% interest rate, the company adds $40m of after-tax interest expense or $0.25/share.  So EPS would go to $0.75 (low end of guidance) + $0.80 (pension add back) - $0.25 (interest) = $1.35/share of adjusted EPS.  This implies NCR trades at 8-9x adjusted P/E again vs. historical of 15-20x and DBD at 15x.  Again this is 50-100% upside.

In the near term, the 50-100% upside potential can be realized if the pension problem goes away (market recovers, NCR funds it, or investors figure it out).

Target price:
$20/share.  This is the current share price of $11/share + $8-10/share adjustment for pension double counting adjustment (if market values pension incorrectly).  Alternatively, this is 15x $1.35/share of PF EPS if pension is paid off, in line with DBD multiple and historical NCR multiple.  Or this is 7.5x core EBITDA.  Or this is 10x core EBITDA - capex.  I give essentially 0 value for the DVD business in these scenarios.

Additional upside would come from assuming any recovery in the core business.  Sequential growth in retail or regional banks which are down 20%+ year over year would provide incremental margins of 20%+.  Further upside could come from cost savings.  The company achieved over $440m of EBITDA in 2007, $480m of EBITDA in 2008 and has been working through a $250m cost save program that will mainly show benefit in 2010 and 2011.  So you can apply a higher multiple on trough or believe a normalized EBITDA or EPS is much higher than the 2009 low end of guidance.

I see downside risk to price of approximately $9/share.  This is applying 5x EBITDA (7x EBITDA-capex) to the core business increasing the pension liability to $1,200m net and adding back net cash and giving no value to the DVD business.

The biggest risks for NCR:
Core business deteriorates in retail and financial services.  However, revenue is already down significantly this year. 

Pension gets materially worse before management can solve the problem.  However, management has shifted allocation away from equities somewhat, and as shown above, the net pension cost is manageable.  As much a disaster as 2008 was in equity markets, the next impact on NCR was a $5-6/share of true value destruction going from overfunded to underfunded.  Given how underpriced the shares are today, this seems to be more than accounted for.

Company loses substantial capital building DVD business.  This has risk of $1.25/share.


Pension issues go away through market recovery, NCR funding, investors figure out the true pension liability.

Management increases cost cutting program and improves profitability.

Sequential improvement in order patterns from retailers or banks.

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