Description

TNS is an international communications company that provides networking, data communications and managed services to many of the world's leading retailers, payment processors, financial institutions and telecommunications providers.  TNS represents a modestly growing recurring revenue business with attractive operating leverage, low capital reinvestments requirements trading at a very  attractive free cash flow yield of nearly 14%.

Description

TNS provides connectivity for customers in three market segments: 1) Point-of-sale (POS) retail where they provided data transport for transaction processors (e.g., Global Payments) for applications/devices such as retail POS terminals, ATM machines, kiosks, etc.; 2) Financial services (FSD) where they provide data and voice connections to over 1,700 financial service community "end-points" (serving 625 companies) representing buy-side and sell-side institutions, market data vendors, exchanges and alternative trading venues; and 3) Telecommunications services (TSD) where TNS provides outsourced services for call signaling (SS7 protocol) and database access (e.g., calling name directory for caller ID applications).  The company operates these businesses globally and has historically reported in four segments: POS, FSD, TSD and International (ISD), of which 90% has been POS services and 10% financial services.  Beginning with Q4 2009, TNS revised its segment reporting to incorporate ISD into the other segments.

TNS consummated a highly value creating acquisition of the Communications Services Group (CSG) from Verisign on May 1, 2009, buying a high margin business laden with Verisign allocated overhead for less than 4x EBITDA. The CSG acquisition has significantly improved the company's telecom services offerings by:
1) giving TNS the largest unaffiliated SS7; 2) providing it with proprietary database and registry services (e.g., caller-name identification for caller ID services) and; 3) making TNS a viable alternative to Syniverse (SVR) for the provision of roaming and clearing services for CDMA network operators in the wireless space.  The CSG acquisition has also provided TNS with the scale to invest in next generation (electronic numbering) signaling protocols that will eventually supersede the SS7 protocol as legacy networks evolve into IP networks over time.

Investment Thesis

Since TNS serves several end markets it does not fit neatly in a single bucket.  Most of the sell-side analysts who cover the company lump it together with transaction processing companies (e.g., Global Payments, Alliance Data Systems) because of its presence in the POS market, but that is inappropriate.  TNS is combination of a B-to-B network operator (leased as opposed to owned), albeit one with less capital intensity than other networks, and a telecom support services provider with much less customer concentration than is typical in that space.  TNS' business model is based on the number of transactions it transports and the number of connections to its networks.  TNS has an attractive economic model with substantial free cash flow (FCF) generating ability characterized by:

• A revenue stream that is highly recurring under largely under multi-year contracts, usually with minimum transaction or revenue commitments from customers
• An attractive margin profile: low to mid-50's gross margin; mid-20's EBITDA margins
• Maintenance capex at low single digit percentage of sales; total capex is expected to be about 7% of sales this year (~$40MM) due to new product development and growth in endpoints on the network (which requires investment in switches, routers)

The growth profile for the company's three segments looks like this:

• Payments (formerly POS and 90% of ISD): expecting 6-8% growth in 2010. The POS segment had experienced several quarters of revenue declines as the economy slowed in 2008 but started to grow again in 2009. In addition, the international portion of the Payments experienced currency headwinds for the first three quarters of 2009
• Financial Services: expecting 7-9% growth in 2010. This segment had been growing in double digits until the middle of 2009 when the business experienced some customer attrition. Financial services industry consolidation had led to the consolidation of trading relationships (connections to the end-points on the company's network), but the reduction in the number of connections has played out and the business should start to show stronger growth
• Telecommunications: expecting 27-32% growth in 2010 based on having the CSG business as part of the company for a full 12 months. On a pro forma basis, this actually represents a revenue decline as certain customer relationships that TNS had prior to the acquisition terminated and TNS experienced a planned for re-pricing of certain CSG customer contracts upon renewal. Investors reacted negatively to this outlook for the Telecom segment when the company released Q4 results, which drove the stock down. We think investors overlooked these aspects of the acquisition integration and were too quick to assume immediate revenue synergies from the deal. Management expects these revenue headwinds to dissipate after Q1 2010 and for the segment to deliver 4-6% growth

The company's free cash flow generation is the core of our thesis.  We are estimating 2010 free cash flow (after all capex, not just maintenance) of $90MM, which is approximately $3.35/share (assuming 26.9MM fully-diluted shares). At a current stock price of $24.50, the stock is trading at 7.3x free cash flow.  TNS management guides to cash EPS, which adds back intangibles amortization and applies a 20% tax rate (higher than actual cash tax rate).  For 2010, TNS has guided to cash EPS of $2.80 - $3.00 (P/E of 8.8x - 8.2x).  Normally, we take cash or pro forma EPS calculations such as these with a grain of salt, but in TNS' case the true free cash flow per share actually exceeds cash EPS.

Having taken on $230MM in debt to buy the CSG division, TNS currently carries approximately $342MM of net debt giving it an enterprise value of approximately $1.0BB.  We are assuming 2010 EBITDA of $160MM so the stock is trading at 6.25x forward EBITDA.  We believe using forward EBITDA is appropriate since a) the CSG division was only a part of TNS for eight months in 2009 and b) the company should be able to realize $6-7MM in cumulative merger cost savings through 2010, which we believe is conservative.  The company has committed to use at least 2/3rds of its free cash flow ($60MM; $15MM/quarter) to pay down debt and is reserving the balance to consider tuck-in acquisitions.

So we feel that TNS represents a stable, modestly growing, free cash flow story with attractive operating leverage and low required reinvestment.  The stock is trading at nearly a 14% free cash yield and management has committed to using the lion's share of its free cash flow to pay down debt.

Risks

• Price as a factor in connectivity business. Telco services is a business with a downward sloping pricing curve. The company will benefit on the cost side over time by being able to lease network capacity at lower cost. Competitors include large domestic and international telcos who can price aggressively. While price is always a factor, our customer checks have revealed that customers find genuine value in TNS' managed services and its global footprint. Additionally, telco costs tend to be a small cost in of the value chain for retail point of sale transaction processing and securities trading markets
• The Payments business is economically sensitive. The legacy part of the company's Payments business support dial-up transactions and the company's revenue stream is volume-based. The company's strategy is to migrate terminals where appropriate to broadband connections that create fixed, recurring revenue
• Potential customer churn. The Financial Services segment has seen a reduction in its growth rate due to customer consolidations. The Telecom Services segment also saw churn with the acquisition of CSG. Lastly, the Payments space has seen a competitor, HBNet (part of Hypercom - HYC), form a venture with the former CEO of TNS called Phoenix Managed Networks to go after the retail point-of-sale business. HBNet has been a small player (estimated $4MM of annual revenue) historically and the retail POS business accounts for less than 10% of TNS' overall revenue. We are not too concern about the threat from Phoenix but it bears watching

Catalysts

The primary catalyst in our minds is execution.  Investors have (naively) expected more immediate revenue growth from the acquisition of CSG but have been told to wait until Q2 2010 to see that growth.  We believe that the Payments business has turned the corner cyclically and the Financial Services segment's growth rate should improve.  If the company executes, investors should see the free cash flow generation we expect.

Catalyst