Description

Optimal Robotics (“OPMR”) is a company in the midst of a significant strategic transformation. It has a bulletproof balance sheet, with >$5.30/shr in cash, and a number of near-term catalysts that I believe could move the stock towards its intrinsic value of $13.30/shr in the near-term. This writeup will be necessarily short on business detail, as a result of the many moving parts and lack of current management disclosure. However, the impending release of the company’s proxy detailing its merger plans with Terra Payments (“Terra”, Canadian listed: ticker TPI) should provide a significant amount of detail regarding the combined entity and, in addition, could prove to be a major catalyst for the stock.

Until recently, OPMR was a manufacturer of self-checkout scanning systems, however, several recent developments have significantly changed the company’s profile. First, in January of this year, OPMR announced its intention to merge with Terra, a provider of payment processing services (credit card, electronic check, direct debit). Second, in mid-February OPMR announced that it would sell its self-checkout scanning business to NCR for $30mm cash. The self-checkout business, which was a major growth engine several years ago, has been hit hard in recent years by cutbacks in supermarket capex. Although the market punished OPMR for the announced divestiture, I believe that it was the right decision as growth prospects for the foreseeable future have disappeared and the business belongs with an entity with much deeper pockets that can afford to wait out the trough. OPMR retained a servicing business, and has subsequently made a $3mm acquisition of another service entity (Systech) that has approximately $11mm in annualized revenue.

So what will the business look like pro forma for the various mergers, divestitures, and acquisitions? Therein lies the rub. Terra’s historical financials are available, but the segment disclosure in the historical OPMR financials is insufficient to get a truly clear picture of what the retained service business encompasses (not to mention issues regarding proper allocation of overhead between the divested and retained businesses). Management has asked shareholders to wait for the upcoming OPMR/Terra merger proxy in order to get a clear picture of what the merged entity will look like, and this proxy is expected to be filed within the next several days. Despite the lack of clarity, I believe that it is possible to triangulate to an estimate of the new entity’s balance sheet and earning power.

Scenario #1:

Terra:
Terra has been ramping both revenue and operating profit nicely over the last few quarters (although sequential underlying rev growth in 4Q was masked by adverse currency movements as financial statements are denominated in Canadian $). Terra has a high degree of operating leverage given the relatively fixed cost nature of the business, and went through a major restructuring in 2002 and the early part of 2003 to bring costs into line. Mgmt at Terra estimates that it could double processing volume from existing customers without making any incremental capital investment. In addition, over the past 12 mos, employee headcount has dropped from 300 to roughly 100. In 4Q 2003, Terra generated $2.2mm (C$3.0mm) in economic operating profit (earnings prior to equipment amortization less capex). Annualized, this equates to $8.8mm, which I assume grows for 2004 at 20% to yield $10.6mm in 2004 economic operating profit. As an aside, this growth rate represents a decline from recent sequential trends in operating profit improvement.

Optimal:
Optimal’s earning power is less clear. We know that the “Hardware and Software Maintenance” segment has been generating annualized revenue of roughly $18mm in recent quarters. In addition, OPMR is adding $11mm in annualized service revenue through the Systech acquisition. Mgmt is guiding to an 8% pre-tax margin run-rate by year-end, which I believe is aggressive. I give them credit for a 6% normalized margin, which yields $1.7mm of operating profit on the $29mm revenue base.

Shrs outstanding PF for merger = 22.4mm (company guidance)

Earning power:
EBIT = $10.6mm Terra + $1.7mm OPMR = $12.3mm, 35% tax rate yields $8.0mm net income = $0.36/shr

I apply a 15x multiple to this to yield $5.40/shr in business value.

Cash balances:
12/31/03 – OPMR $78.5mm + $30mm NCR - $3mm Systech = $105.5mm total
12/31/03 – Terra C$15.2mm = US$11.4mm (note that this is Terra’s unrestricted cash, i.e. is not offset by customer reserves or security deposits)
Total cash PF for merger = $120mm

Cash per shr = $5.35/shr

So total value = $5.40 + $5.35 = $10.75/shr (40% upside)

Scenario #2:

Mgmt has stipulated that a major reason behind the merger is for the Terra team to gain access to the OPMR cash balance in order to diversify its processing revenue stream. It is likely that they will do this through the purchase of merchant portfolios. These can be transitioned to Terra’s existing processing platform relatively painlessly. Typical transaction multiples for these portfolios are roughly 1x revenue, and the incremental operating margin to Terra should be at least 30% (again, as a result of the relatively high fixed costs). These portfolios typically show a relatively healthy attrition when they are sold, since a certain percentage of customers will not want to be transitioned to a new processor. Assuming an immediate 20% attrition rate upon purchase, and that the entire cash balance is ultimately used to buy merchant portfolios, the following would be implied:

Purchased revenue = $120mm cash @ 1x rev = $120mm revs
20% attrition yields $96mm net revenue
30% incremental operating margin yields $29mm incremental EBIT
35% tax rate yields $18.9mm incremental net income = $0.84/shr

Add this to the $0.36/shr of current operating EPS (detailed above) to get $1.20/shr earnings power

12x = $14.40/shr (lower multiple to reflect acquisition risk, >100% upside)

Average (of two scenarios) target value = $12.60/shr (90% upside)

Risks:

Terra exposure to online gaming – currently, roughly 50% of Terra’s processing volume is generated by processing transactions for online gaming sites. This is an area of heavy scrutiny for US regulators. While it is unlikely that anything will move through either the Senate or Congress during this election year, the issue could be revisited in future years. If online gaming is squashed it would be a significant setback for Terra. This, in part, is why Terra is moving aggressively to diversify its revenue base by purchasing non-gaming merchant portfolios.

Poor execution of merchant portfolio acquisitions

Catalyst

Release of Optimal/Terra merger proxy, removal of arb pressure, transformation of company to create a cleaner more focused story