Introduction

Official Payments (“OPAY”), formerly known as Tier Technologies, is one of the few companies that is forecasting significant strength and visibility in their business going into 2013, but you wouldn’t know it from taking a look at the stock price chart.  The basic situation is as follows:  you have a pretty good, niche payment processing business that has given conservative guidance and raised it in each of the last 4 quarters, is guiding to a very strong F2013, and they are successfully dealing with the largest issue they have as a business that has been hurting their margins for years.  The stock price has been decimated by a huge 10% shareholder overhang that is gone as of last Friday’s 2.1mm share block trade.  You are currently paying .3x revenues and less than 4x F2014 EBITDA (perhaps quite a bit less than 4x). 

The Company has been a long time disappointment, was the subject of a failed activist investor campaign and has not reached out to investors from an IR perspective in a long time.  Conversely, OPAY is in the midst of a significant improvement in financial performance, with a new management team and a series of strong quarterly results and guidance going into 2013.  Despite the strong fundamental business performance, the aforementioned major shareholder started exiting its position into an illiquid market back in May which caused the stock price to move in the opposite direction of business performance.  The improving business performance and recent technical factors causing the stock price to decline have conspired to create a very attractive valuation and entry point for new OPAY investors. 

Business Description

OPAY operates in the payments space, with a niche focus on processing payments for federal, state and local governments, educations institutions and utilities.  OPAYs bread and butter business is processing tax payments for state and local governments – think state income tax payments, estimated tax payments, property tax payments, court payments, traffic citations etc.  They also process payments for the federal government (the vast majority of which is IRS tax payments, where OPAY is one of three vendors to the IRS).  Payments to educational institutions consist of tuition and fee payments, housing payments and alumni donations as well. 

OPAY’s business model is relatively simple:  they charge a fee per transaction, and their biggest expense is interchange - the cut that goes to the payments networks.  Importantly, the fee that OPAY charges is paid by the end user (eg, the taxpayer) as opposed to the client (the govt. entity receiving the tax payment).  This distinction is important because OPAY sells its services to its state/local government clients, but those clients are not particularly focused on pricing because the fee is ultimately paid by the end customer.  With respect to the bread and butter state and local government payments, there is typically just one provider who processes all of the payments.  These relationships tend to be pretty sticky as these types of clients typically don’t have the manpower, focus, will or any economic motivation to change providers.  Particularly in the current environment where governments are under a lot of pressure, they have bigger fish to fry in terms of where their attention is directed.  The Company does not disclose transaction mix between debit and credit transactions, but I believe the mix is roughly 50/50 between debit/credit transactions.

In the LTM period, OPAY has processed 19.9mm transactions with a total value of $9 billion - this represents an average payment size of $453.  The Company’s average revenue per transaction is $6.74 over that same time period, which shows that the average fee charged is 150 basis points.

The competitive landscape in this particular niche is pretty limited.  The space is dominated by OPAY and Link2Gov which is a subsidiary of Fidelity National Information Services.  Link2Gov came to Fidelity through the acquisition of Metavante, who had acquired Link2Gov 2005 for undisclosed terms.   The #3 player in the industry is WorldPay (formerly known as RBS WorldPay), which was acquired by Bain Capital in 2010.

Background

OPAY’s recently improved financial performance and outlook is in stark contrast to how the Company has disappointed investors over the past 5 years.

Historically, OPAY’s margins have been abysmal in an industry where competitors have typically made a pretty good profit.  The thorn in OPAY’s side has long been its technology platform, which was cobbled together over the years through acquisitions that were never integrated properly.  As a result, today the Company operates three technology platforms simultaneously in order to process transactions.  Competitors I have spoken to are consistently surprised by the low margin profile of OPAY and they will typically point to the inefficient technology platforms as the culprit.  In order to run these three legacy platforms, OPAY needs to employ a big team of engineers/IT.  The Company embarked on a plan to consolidate its technology platform to a single platform in the last 2 years and this transition is going extremely well – the Company recently noted that the transition has been easier than expected and as a result will be complete by the end of 2013.

There is probably some fat to be trimmed on the admin side as well, which management has addressed and will see continued benefits from due to the change in headquarters from Reston, VA to Norcross, GA this year.  One competitor I spoke with noted that “Ive looked at it a number of times and they seem to have more than double the number of employees that it would take to run the business.” 

The Discovery Group activist campaign began in 2008 and has always been focused on a sale of the Company.  While they never provided a lot of detail, their original 13D filing back in May 2008 (when the stock was trading at $8.50) stated that they had discussions with large transaction processing companies who would be interested in acquiring the Company at a significant premium.  Again, in their final letter to the Board in April 2011, they noted that “several strategic and financial parties have expressed an interest in acquiring Tier (as it was then known), and have contacted shareholders, management and directors.  An objective analysis of Tier’s inherent value suggests that a sale process will deliver a value range $7.00 to $9.00 per share.”  The only real success Discovery had in its activist campaign was convincing the Company to do a $10mm Dutch tender in January 2011 at $6.10.

Over the course of the activist campaign, the Company also hired Alex Hart as CEO in August 2010.  Hart has a very good reputation in the payments industry and some notable career milestones include serving as CEO of Corillian up until its sale to CheckFree in 2007.  He has also spent a significant amount of time at CheckFree in various capacities including business development.  In light of Hart’s recent hire, the April 2011 final push for a sale by Discovery was probably not the right timing.  At that point, there was enough clarity around the business actually improving that it made sense to pursue those improvements.

April 2011 marked the end of the activist campaign and Discovery began exiting their position in OPAY a year later in May 2012 as can be seen in their Form 4 filings.  The first form 4 came out on May 18 and the stock has done nothing but go down since then despite nothing but great news from OPAY and a strong overall market.  It seems that their exit is more related to fatigue (they had been in over 4 years at that point, without any indication that a sale of the Company is coming) and it appears that they basically lost interest and sold out. 

Another key point to discuss is the Durbin Amendment, which went into effect on Oct. 1 2011.  Durbin, as you may know, was designed to reduce interchange fees on debit transactions.  Before the Durbin Amendment was passed, the Company was paying on average somewhere in the range of 92bps +$0.15 per debit transaction.  The new debit interchange rates post Durbin is $0.21 per transaction + 5bps.  Because the average transaction size for the Company is relatively high, the Durbin Amendment represented significant savings for the Company on debit transactions as can be seen in the ~700bps increase in gross margin beginning in fiscal Q1 2012. 

As we move into 2013, one of the opportunities the Company has is to encourage their customers to shift their mix from credit to debit transactions.  Given the higher margin profile of debit transactions, this is a nice opportunity and it represents some “low hanging fruit” to drive incremental profitability.

Further to that point, one of the management team’s initiatives has been to go through the overall business and cull transaction volume that is not profitable.  So the overall transaction count numbers, which have been flattish, mask better underlying growth as is reflected by growing overall payment volume (it is growing in $ but not in transaction count). 

One of the key growth areas has been the higher education vertical, which is a product that was launched just recently but has already generated a number of sales and is a large market opportunity.

A further opportunity that has been discussed on recent conference calls is processing payments for “a very large religious organization.”  I will leave it up to you to speculate on who that is, but it represents a large opportunity.  OPAY will initially be providing payment processing services for the philanthropic arm of that religious organization, which allows its members to make donations to various other charities.  That opportunity is meaningful in and of itself, but there is a much larger opportunity to do all payment processing for that organization.

Overall I would describe OPAY’s business model as a solid niche payment processing business that has not earned the appropriate margin historically.  Their business is sticky with local governments who don’t seem to be particularly price sensitive or focused on payment processing.  It is a niche payment processing vertical with few competitors.  They have the wind at their back (as with other payment processing businesses) in terms of shift from paper to electronic.  They have a few good business opportunities both in terms of getting more profit out of their existing book of business as well as the education and religious/philanthropic opportunity.  I actually think ultimately this is a pretty solid niche within payment processing and it is going to look like a good target to strategic buyers in the consolidating payment processing space over time.

Investment Case

With an equity market capitalization of $72mm and cash of $32.7mm you are only paying $39mm for the business.  While you may take a look at the LTM numbers and wonder why that is attractive for a business that only produced $4.6mm in YTD EBITDA, I think there is a relatively clear path to $10mm+ of annual EBITDA a year from now. 

Whereas the Company used to provide no guidance they have recently in the last few quarters been providing guidance, and have basically been sandbagging it as suggested by the consistent increases:

Q4 2011 Call:  $3mm adjusted EBITDA for 2012

Q1 2012 Call: $3.7mm adjusted EBITDA for 2012

Q2 2012 Call: $3.7-4.5mm adjusted EBITDA for 2012

Q3 2012 Call:  $4.7mm adjusted EBITDA for 2012 and, as per the exact wording on the Q3 2012 conference call, “We will share specific goals and expectations for FY 2013 when we report Q4 and full fiscal year 2012 results in a few months. But we're comfortable telling you now that our preliminary view of FY 2013 is that we expect to improve our adjusted EBITDA performance by at least 50% as compared to FY 2012.”

You don’t need to be a master at reading management teams to know that given the history here, they seem pretty darn sure 2013 is looking good and will probably result in better performance than they are forecasting.  But taking them at their word, the current guidance is for $7.1mm in EBITDA in F2013.

All of this sounds good and well, but I think the potentially bigger point is that they will produce a much higher EBITDA in F2013 without any of the benefit of the technology platform migration that has been ongoing and will produce significant cost benefits in F2014.  And here’s how the CEO (who sandbagged 2012) is describing the progress related to the platform migration:

“Our technology infrastructure upgrade is nearing completion, and we've made great strides in a number of related areas. As a result of these improvements, we believe that we'll be able to consolidate on to a single processing platform much sooner and much less expensively than we had originally anticipated.

We're not prepared to discuss specifics today, but I'm pleased to report that we believe that we'll be able to move to a single platform by the end of calendar 2013 for significantly less than $10 million to $12 million we previously estimated it would take to accomplish this key technology upgrade.”

Sounds like things are going quite well on that front.

A further footnote to the valuation is $117mm and $84mm of federal and state NOLs, a small portion of which are subject to Section 382 limitations.  As the business gets more profitable, they will be able to use this nice tax shield. 

So, to sum it all up, you have a pretty good, niche payment processing business that has given conservative guidance and raised it in each of the last 4 quarters, is guiding to a very strong F2013, and they are successfully dealing with the largest issue they have as a business that has been hurting their margins for years.  The stock price has been decimated by a huge 10% shareholder overhang that is now gone as of a few days ago.  You are currently paying .3x revenues and less than 4x F2014 EBITDA (perhaps quite a bit less than 4x).  There are plenty of payment processing comps out there, obviously trading at much much higher multiples incl. GCA, GPN, HPY, MGI, TSS, ORCC etc.

This is an investment with a 1 year time horizon – this time next year, we will be looking at a good trailing 4 quarters and will have all of the benefits of the platform migration to look forward to in 2014.  Furthermore, management will be telling the story to investors for the first time in a long time, and the story will be a very good one.

Thanks for reading and I look forward to any thoughts/commentary on this one,

Madler

Oh and for further background, here are a few M&A comps – while these are not direct comps, I think they are interesting to take a look at: