Description

NCR Atleos – October 3, 2023:

(Please See Disclaimer at the end of this write-up)

Summary:

NCR Atleos (NATL or Atleos) represents a classic special situation. It is a spinoff of a perceptively low-growth, “legacy” business in an industry that is largely ignored by mainstream investors – ATMs. Atleos is in the process of being separated from NCR, with expected first trading date October 17, 2023. NATL will be the leading ATM hardware, software, and services provider globally. Despite its potential secular challenges, the ATM industry is effectively an oligopoly with NCR Atleos (~35% market share globally, 45%+ in North America), DBD (~25%) and Hyosung (~20%) controlling ~80+% of the global market with high barriers to entry. Atleos is the undisputed leader, gaining up on its smaller competitors, with an installed base of 800K+ ATMs (80K of which are owned / operated) across 140 countries. As an industry champion, they service some of the top financial and consumer companies including JP Morgan, Citi, Wells Fargo, TD, Santander as well as Target, Shell, CVS, Walgreens, and many others. Here is a snapshot of their product and regional breakdown that gives a sense of its large scale and scope.

Segment Breakdown – Description of Products and Services:

Atleos has two broad segments. The first is Self-Service Banking (SSB), which effectively sells / leases ATMs and provides associated software and maintenance services. The current installed base is 800K globally with about 80K new machines produced every year (i.e. 10% annual renewal cycle). The legacy revenue model is to sell the hardware (ATMs) and then provide software and maintenance services under a contract as recurring revenues. The new targeted approach is to provide ATMaaS (ATM as a Service) i.e. Atleos will own the ATM and provide all the necessary software and services without the customer having to finance/maintain/integrate the hardware and software on its own. In exchange for this service, NATL will receive a contractual annual payment. The ATMaaS approach increases the recurring revenue component substantially and due to scale also improves the margin profile of the business. The incentive for the client is lower total ownership cost (NATL estimates a ~20% decline) as well as receiving dedicated outsourced, uptodate equipment and services without additional investment. The benefit for Atleos is higher revenues (estimated to be 2.5x more over the life of the contract), as NATL takes on a much bigger share of the customers’ wallet. The SSB division serves financial institutions all over the world. The chart below shows the economics of the legacy ATM model vs. the new ATMaaS approach.

The second Atleos segment is their Networks and Payments business. This includes their AllPoint proprietary network of 55,000 ATMs (as part of an 80,000 large owned/operated ATM collection), installed in convenient locations (drug stores, gas stations, TGT/WMT locations etc) providing surcharge-free access to all ATM services for many banks. The client base includes many traditional financial and consumer companies but also digital native banks that don’t have branches or their own ATM network. There are 75mm cardholders who have access to these locations banking with 1,100+ financial institutions. The AllPoint network is a differentiating feature for NATL as it is the only one that offers this service. As an additional source of revenue, NATL offers Branded ATMs (i.e. Citibank could place their logo on some of these ATMs to increase awareness), which augments profitability.  The key financial highlights of the SSB and Network divisions are presented below.

Secular Trends in the ATM Industry:

Before we dive into the investment highlights of the NATL thesis, it is important to address the secular trends affecting the ATM industry.  The general perception is that ATMs and cash usage are going away. However, looking at some stats, the story looks a bit different. First, per FED data, the cash in circulation has grown at a rate of 5% CAGR between 2010 and 2022. Further, Atleos reported that they are seeing increased cash withdrawal in the last couple of years. Here is a quote from a recent conference call:

“…We've been a big believer in cash all along. Others have tried to talk us out of it. We felt good about the volume of transactions for some time. In this quarter, ATM withdrawals and cash expense were at a six-year high. ATM withdrawals were up 6% year-over-year. And importantly the amount of cash withdrawn per transaction was up another 13% year-over-year. So, think about almost a 20% increase in the amount of cash we spent in the quarter…”

While it is true that some banks have closed branches and the number of ATMs in the US has declined at l.s.d. recently, Atleos has taken share in this decline. Further, there are parts of the world where cash usage remains robust (e.g. Some European and Asian countries) which offsets reductions elsewhere. During their September 2023 investor day, Atleos forecasted that the global installed base will remain stable and in fact will expand at a 1% rate.

The future of ATMs will include a lot more innovation (face recognition, cash recycling, money transfers, loan application, app access etc.), with some of these features already present in NATL’s latest products. In this world, scale, resources, and scope will give the leaders a leg up to continue consolidating market share. Ultimately, bank branches have proven to provide greater stability to their depositors’ base and as such it is unlikely that we would see drastic reduction in bank stores in the coming 2-3 years. Further, the AllPoint network provides a hedge, as banks that close branches will rely more on outsourced solutions, with Atleos (through AllPoint) offering the best alternative. Notably, some of Allpoint’s contracts are based on monthly fees and not actual transactions, which provides some cushioning of the secular impact.

NCR’s Recent History and Turnaround Efforts:

NCR has been going through a multi-year turnaround with the goal of moving away from the legacy hardware business towards becoming an integrated commerce / banking hardware and software provider with a high component of recurring revenues. Despite such efforts’ success, the market is pricing the company at a significant SOTP discount to peers. Frustrated, the BOD announced a Strategic Alternatives process in early 2022, which despite expectations of a full sale, concluded with a company break-up. There was speculation of PE firms taking a close look, however the financing markets weren’t cooperative. About a year ago, NCR announced a split-off into two separate divisions – Commerce and ATMs with roughly similar revenue basis and EBITDA. The Commerce Business (RemainCo to be named Voyix) will have higher growth, faster rising margins, and larger CapEx. The ATM Division, discussed here, will have somewhat lower growth, stable EBITDA and FCF, more robust margins and lower CapEx (i.e., SpinCo should be more of a capital return story over time).

As far as the Atleos business is concerned, NCR embarked on a transformation to move away from its legacy ATM/Cash register business to a more diversified, high-growth and greater-recurring-revenue business. Blackstone came in with a preferred investment a few years ago, to help fund some of this growth transformation and has gotten out already. The transition has been both organic and inorganic, although M&A did the heavy lifting (targets included Cardtronics, Terafina, JetPay, LibertyX). The acquisitions added significant scale, new product & services (e.g., ATM network, software tools, digital assets capabilities etc.).

The second aspect of the turnaround was transitioning the company’s sales contracts from perpetual licenses and outright hardware purchases to As-a-Service recurring revenues. This transformation has been quite common among legacy tech and usually results in slower growth rates at first, as the revenues are being amortized, but ultimately leads to greater stability and client retention as well as higher growth margins. NCR has made pretty good progress in that transition. The following quote from a recent conference call speaks to this transition to recurring revenues and the adverse initial impact it has on growth:

“…We continue to have success transitioning from one-time perpetual sales into multi-year subscription-based revenue stream. The nature of these contracts shifted $60 million of high profit revenue from what would have been previously recognized upfront to recurring revenue that will convert over the next several years… This intentional deferral of upfront revenue to recurring revenue lowered total revenue growth by three full points…”

The results have been decent. The Company has increased its software and services component (49% of total) and recurring revenues have gone up from 54% in 2020 to 67% at present. Further, margins have improved as NATL has streamlined operations (it reduced manufacturing facilities from 6 to 1), reducing fixed costs and WC requirements. Despite the initial transformational success, the market is still not giving it credit, multiple-wise, for the transformation efforts at NCR and its transition towards higher growth/secular tailwinds businesses. It is not a surprise that the NCR board initiated a strategic review –> their efforts were not being properly valued in the public markets.

Why Is the Market likely Not Assigning a Higher Multiple to NCR:

There are few headwind factors that impacted NCR over the last 6-12 months:

1)      A Perfect Storm in 2022 -> NCR was hit on multiple fronts – a) Supply Chain issues raising input costs, delaying deliveries and draining working capital; b) rising interest rates, which boosted interest expense as well as ATM rental leasing expenses (NCR finances its owned and operated ATM fleet), and higher cash cost (interest is incurred on the cash in ATMs), c) wage inflation and labor issues; d) Russian exposure that had to be shut down; e) negative FX exposure f) high oil prices affect the servicing / cash collection at ATMs, as Atleos is responsible for that. As an example, higher fuel expenses boosted operating costs by ~$60-70mm last year. A good portion of these trends have normalized or reversed in 2023.

2)      Negative Perception of Cash Usage / ATM industry -> this is more of a perception than a real negative impact as it relates to Atleos, as discussed above, however there is still a substantial portion of the investment world that views this industry as a “melting ice cube” and would stay away.

3)      Failed Sales Process and Investor Turnover -> Investors expected that NCR was going to be sold post the strategic review. Event-driven investors pounded on the stock and had to exit when the outcome wasn’t a sale. The stock sank ~25% upon the announcement.

4)      Digestion of M&A and Transformation -> Some investors are still trying to fully comprehend the business, its transformation and new divisions. The turnaround is leading to some significant charges add-backs and some retail commentators are pointing to the lower quality earnings and the large adjustments between earnings and adjusted EBITDA (e.g., Net Income was $64mm in 2022 but adjusted EBITDA was $1.35bn, the company announced cost savings but then took similarly sized one-off charges). 

5)      Transitions to ATMaaS and R&D investments Mutes Top line and Margins-> The transition to ATMaaS is artificially muting revenue growth (revenues are being amortized), which combined with sales growth investments is leading to lower top line and margin rates. Thus, NCR screens worse on top line growth than peers who have made this transition.

6)      Payment Sector Multiple Compression -> The Payment Fintech subsector has taken a massive derating due to decelerating growth, competition from alternatives and economic slowdown. Secular trends of cash-to-card conversions are also feared to be slowing down.

7)      Leverage, high Equity Comp and Poor FCF generation -> NCR / Atleos ran a rather working-capital-intensive business. Due to supply chain issues, NCR ran up its WC leading to large miss in FCF generation and failed to de-lever. This trend reversed in q4’22 and q1’23 leading to $400mm+ in FCF. Lastly, equity comp is still relatively high – it amounts to about 1/5 of earnings, which some investors don’t adjust for and don’t like.

8)      Legacy issues – Pension deficit ($400-$500mm) retained by Atleos – old environmental liabilities from the 1980s and 1990s that are still lingering in the background.

Investment Highlights:

Oligopolistic Industry with high barrier to entries: Similar to other low/no growth industries (e.g., tobacco / telecom / cable) – the ATM industry is oligopolistic with high barriers to entry. This dynamic somewhat limits the competitive threat. The second largest player, Diebold Nixdorf filed for bankruptcy this year and is in the process of. Atleos’ management has acknowledged that they have been taking some market share from them.

Undisputed Leader and Market Share Taker in an Oligopolistic Industry: Atleos is the undisputed leader offering the greatest variety of products and services to its customers with high NPS scores. It is important to note that, Alteos is a leader not only in hardware but also in software, in fact many non-NCR-ATMs run on Atleos software, while 100% of NCR machines run on their own systems. Despite a leadership position, there are still opportunities for growth, especially in international markets as recent client wins suggest (Santander, Bank of New Zealand, Bank Baroda India etc.).

AllPoint Network a Differentiating Asset: The scale of the Allpoint network rivals the combined footprint of the top three U.S. banks, with 80% of the U.S. population living within five miles of an Allpoint ATM. The network footprint allows even the smallest participating financial institutions to offer consumers a self-service banking experience typically afforded only to customers of the largest money-center banks. In turn, participating institutions can efficiently foster loyalty and attract and retain more consumers. Further, Atleos announced an expanded partnership with Payfare Inc. which powers instant payouts and loyalty rewards for the largest gig economy platforms in the United States including DoorDash and Lyft. The expanded partnership allows Payfare Inc. cardholders to gain access to Allpoint cash-accepting ATMs, enabling cash deposit in addition to withdrawals. Currently the Allpoint network extends throughout the U.S. and to the U.K., Canada, Mexico, Australia and New Zealand.

ATMaaS Transition presents a Strong Tailwind: The transition, while not yet fully palpable in the financials, should provide a strong tailwind to revenues and margins. So far, the company has transitioned 21K ATMs to such contracts out of a 800K+ installed base. To hit their 2027 targets (shown below) they are projecting 125,000 ATMaaS in 4 years. This is a relatively steep growth rate, however their customers own many machines, so winning over a smaller number of larger customers could lead to hitting these targets and driving strong revenue and margin growth. The incentives for the customers are lower overall costs and an outsourced solution, allowing banks to focus on core business without having to manage a large ATM network. The management has highlighted that a bank switching from perpetual license to ATMaaS breaks even after 22 months. The benefits to Atleos are substantial, as highlighted, the revenue uptick is 2.5x over the life of the contract with higher margins.

Headwinds of 2022 Are Normalizing: As highlighted above, higher interest rates and oil prices are a headwind. The company has taken measures (i.e., partial rate hedges), however any improvement from here will be a positive tailwind. Working capital trends have improved and that should bode well for FCF generation vs. what we saw in 2022.

Focused Management Team: In recent years, NCR’s management focus was directed primarily at the growthier part of the business (Commerce). As such, the ATM business was somewhat less of a priority. Further, two activist investors were heavily involved with the strategic repositioning of the business, which was completed with the separation. Hence, there should be less of a distraction from execution of the core business directives. Lastly, an incentivized and focused management team should increase productivity further and help complete the turnaround.

Capital Return / M&A: The AllPoint business was acquired through the purchase of Cardtronics, an asset that saw quite a bit of PE interest. A solid cashflow business like Atleos is potentially likely to get PE interest, as speculated in the media during the strategic review process. The Management has outlined capital return strategies focused on de-levering, dividend payment and strategic tuck-in M&A, which should be value-enhancing over time.

Potential Upgrade Cycle Driven by Innovation: The level of innovation in the ATM industry has ticked up, which is likely to lead to a new upgrade cycle at some point in the near/mid-term future. New features include bill payment, cryptocurrency, purchasing, money transfers and digital wallet loads.

Attractive Valuation: The price of NATL is not set yet; it will start trading on a when-issued basis on 10/11/23 with regular way distribution on 10/16/2023. We believe a fair target price would be in the mid-to-high $30s. If the shares start trading in the mid-to-high $20s, or below (equivalent to ~10% FCF yield with our 2023E FCF / share of $2.93), it would offer an attractive entry price.

Valuation and Key KPIs:

The key KPIs to watch are: 1) SSB – a) number of ATMs converting to ATMaaS from perpetual license model – currently there are about 21,000 with target amounts set for 125,000 by 2027. b) % of revenue under recurring contracts and 2) Network – number of endpoints (ATM units deployed) and revenues per endpoint.

From a valuation perspective, we have used the following comparable companies, slower growth legacy fintech companies. We have also used Western Union as a valuation floor, an “old world fintech” company with declining sales and EBITDA trading at ~6x EV/2023 EBITDA (albeit with an attractive dividend).

Guidance has been set conservatively at 1-3% growth with no margin expansion. The reason for that is some accounting restatements due to the separation that increased historical revenues leading to tougher comps.

Based on the peer set, we believe a conservative valuation range is 6.5x-7.0x, which implies a target price in the high $30s (mid-point $38)

DISCLAIMER:  This is not Financial Advice. Do NOT rely on this analysis for investment decisions. Please do your own work as I may have made errors and omissions in this write-up. I do not own securities in the company, however that may change at any time without additional notice. 

Catalyst

Spinoff completion; Transition to ATMaaS; Debt Reduction; Dividend Initiation in 2024