Description
Investment Thesis
TNS (Transaction Network Services) Inc. is a communication services provider that after a recent guidance reduction is trading like a cigar butt investment at 6.5x earnings and a 18% free cash flow yield. The company is well positioned in 2 of 3 divisions, is buying back stock, and may benefit soon from a recent acquisition that provides dramatic earnings upside optionality. I believe the stock offers up to 100% upside with minimal downside, with catalysts during the next 12 months to drive the stock at least 40% higher.
Business
TNS operates 3 business units:
- Telecom Services (TS) - 52% of Revenues
Operates largest independent SS7 network in US, offering registry, roaming and ID/verification services to fixed and mobile operators globally as well as cable/VOIP operators. SS7 is obviously transitioning to SS7oIP or full IP over the next few years and this is a risk in terms of revenue/margin if their full IP offerings don’t catch on with customers. SS7 is still critical for SMS and remains extremely profitable for carriers so its not going away fully anytime soon. TNS is very focused on transitioning customers smoothly to their LTE platform at the same time as offering non IP buildout customers the traditional SS7 network service, which is very stable right now.
Registry, roaming and clearing services has been a high growth, profitable business for TNS the last several years, as traveling subscribers use their smartphones more and more for roaming data and voice usage. TNS admitted it is experiencing slowing roaming and clearing revenue for several reasons, including stronger competition (Neustar is the primary competitor in TS), smaller sales pipeline and a loss of customers who wish to peer directly for information rather than use TNS. It is still growing nicely (after nearly doubling last year) and is the driver for their 4-6% long term growth rate forecast for Telecom Services.
Cequint is the recent 2010 acquisition and is the focal point to drive mobile ID naming/verification, with the City ID and Name ID products, by providing embedded OEM software to wireless carriers. TNS paid $50mm for Cequint in October 2010, with an additional $62.5mm of earnouts which gives Cequint management plenty of incentive to deliver on software upgrades to handsets and assisting carriers with network infrastructure changes to make this work very well. City ID provides the location of inbound calls where as Name ID offers the name of the person calling in addition to the city, even if the name is not in the handset’s address book. T-Mobile signed up for Name ID in July 2011 and is offering it for $3.99/month, and so far has hit TNS’s internal goals apparently. US Cellular and Alltel signed up for City ID, as did Verizon, offering it for $1.99/month. Ultimately, if uptake is successful for carriers, pricing is likely to come down or be bundled in with the customer’s overall package. We don’t yet know what % of revenue TNS has negotiated but can expect a very high margin after scalability. The company is pushing these mobile ID products, and this is impacting peering and ultimately its existing core wireline caller ID business. Current wireline called ID is priced in per name fees, vs mobile subscription model so some cannibalization will occur in this transition as customers drop wireline phone #s. Carriers are working on embedding tech specs and Cequint software into handsets, driving the manufacturers to work with TNS and getting it perfect. This takes time, and is the main reason TNS lowered Cequint revenue $3-4mm for 2012 (from $18-19mm) in its recent guidance cut, as its 2nd certified Tier 1 carrier recently pushed out Name ID rollout. I think it is AT&T and management is being conservative after being slammed with 2Q guiance to just say 2013 even though handsets are being upgraded with software and expectation is rollout any day now. It alongside T-Mobile should drive nice growth in the Name ID business in 2013. I believe the stock is weak due to management overhyping this business the last few quarters since the acquisition, underestimating the difficulty in altering a carrier’s network infrastructure as well as loading specs in the appropriate handsets. Long term, Cequint’s unique positon of having software on 100s of handsets and connection to carriers could be very powerful as mobile payments and need for security rises rapidly.
- Payment Services (PS) - 36% of Revenues
Transaction delivery and payment connectivity solutions. TNS offers dedicated and managed connectivity network solutions to retailers, ATM dealers, banks and processors. In addition, its gateway product TNSPay works with both card-present and card-not present transactions for merchants and is a big growth driver. E-commerce continues to grow 15-20% annually and the card-not present offering is benefitting.
Economic pressure is having an impact on transaction volumes in PS, running down 4% year over year. The TNSPay service and new customer growth is offsetting this, and management still expects 2012 growth of 1-3% in PS vs 5-7% previously. TNSPay in particular should grow 30%.
In the 2Q, TNS launced a white label (affinity) program with AMEX in four countries for its payment gateway service, and AMEX is marketing it heavily this year and next. Management is excited about the growth prospects for this but contract did cause $3mm bump in deferred revenue to next year, one of the reasons for the recent guidance cut.
- Financial Services - 12% of Revenues
Provide full function trading extranet, with FIX, equity, forex trading globally to over 600 customers. Equity volumes are down ubiquitously but new customer additions and one off projects are helping to offset. This business is monthly recurring revenue from each customer through connect and usage fees.
Guidance reduction - what happened?
TNS reduced guidance with its August 2Q earnings release for a variety of reasons, and the stock reacted negatively falling from $19 to today’s $14. It appears investors no longer think TNS can grow mid-single digits as TNS has stated regularly before, and is taking a wait and see approach.
Several things accounted for the guidance cut and recent weakness, as management cut 2012 revenue from $570-580mm to $540-550mm and EPS from $2.38-2.52 to $2.17-2.32:
1) Currency impact cost $2mm of revenue and $.03/share.
2) Cequint growth with 2nd Tier 1 carrier was pushed into 2013, just to be safe. This cost $3-4mm of revenue and $.10-.11/share.
3) Although very successful so far, $3mm of deferred revenue from AMEX White Label deal is pushed into 2013, costing $.08/share.
4) Transaction volumes down in PS division more than expected, reducing expected revenue $1.5mm in 2H2012 due to economic pressure in Europe and US.
5) Lastly, FS division revenue outlook was reduced to flat from 1-4% growth as equity volumes down globally.
It’s disappointing that management isn’t more proactive in hedging currency risk.
Cequint and mobile apps is a big growth driver for TNS and if 2nd carrier launches as expected, I expect the $.29-32 loss/share from Cequint in 2012 to be erased, at least getting TNS back to the $2.50/share range in EPS.
$3mm in deferred revenue is more an accounting change than anything else, this revenue is locked in.
The last 2 points above are what they are, first is economic/Europe pressure, and the second is possibly a secular trend and crackdown on HFT.
Balance sheet/Liquidity
TNS refinanced its term loan and credit facility ($350mm and $100mm respectively) in February 2012, reducing interest expense by $3.5mm annually and now is well positioned at 2.5x Debt/EBITDA, well below historical comfort levels of 3-3.5x. With $22mm in cash and the Board approving another stock buyback up to $30mm, I feel good about their liquidity, FCF generation and continued use of cash for buybacks and debt paydown. Given over $60mm in FCF for 2012 expected, management hasn’t given a breakdown on uses, but a 50/50 split for stock buyback and debt paydown is a reasonable assumption.
Valuation
Price - $14.05
S/O – 24.8mm
Mkt Cap - $348mm
Net Debt - $330mm
EV - $678mm
2012 EBITDA guidance - $135mm (low end of guidance), 5x EV/EBITDA
2012 capex - $49mm
2012 FCF - $62mm ($2.50/share), 18% yield
2012 EPS - $2.20, down 2% yoy
2012 Rev - $540mm, down 3% yoy
Even with zero growth this year, TNS appears to be a great value as I am not seeing a lot of high double digit FCF yields with reasonably stable underlying businesses paying down debt and buying in stock. ROE is good not great at 12-15% annually and a fair value for this business is likely 6-7x EBITDA or 10x FCF, ie $22-23/share, 55-65% above today’s price. If Cequint gets further penetration into carrier’s budgets and achieves high % (40-50%) revenue sharing agreements, the upside to earnings could be dramatic.
Ruby wrote this up last year and it was a nice winner, if you sold in the $20s. I believe we will get there again if they just don’t reduce guidance further and show new ID growth with Cequint and carrier uptake. I believe management did actually kitchen sink guidance as they admitted on the recent call, and this is clearly reflected in today’s stock price.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
- Launch of 2nd Tier 1 carrier for Cequint
- Continued growth in TNSPay and AMEX affinity program
- Actually hitting guidance for a change after kitchen sinking post 2Q
- Buyback of $30mm in stock, nearly 10% of shares
- Continued debt reduction