Description

Elevator Pitch. 

Recent carnage in tech/SAAS world has rightfully brought many high flyers back down to earth.   In my view it is hard to know what many of these companies are actually worth, and in most cases a strong view of a very rosy future is necessary to own them. 

Despite the difficulty associated with knowing what the upside cases might be, I feel confident in saying that a stream of ARR that has been growing more than 100% and that has visibility into doubling once again due to already announced customer wins is worth more than zero dollars. 

Yet, when accounting for Transact Technologies legacy business, the market is telling us that Transact’s newer triple digit growth software ARR business is worth zero dollars. I think that is unlikely to persist, and think that TACT could easily return to recent highs of almost $17 from current prices of close to $10. 

Helping to ensure value creation is realized, at present there are three activists involved with the company, and 2 board members have recently been replaced. 

This is a small company and liquidity is not great, so this is probably only appropriate for small funds and PAs. 

What Do They Do: Rearview Mirror 

Historically, Transact developed and sold printers capable of printing tickets, coupons, receipts, and other documents for niche applications across casino and gaming, lottery, banking, oil and gas, and restaurant POS end markets. Along with the printer, the Company sells spare parts and consumables (razor blades) such as labels and other stock.  

The Company is best known for its products attached to “Casino and gaming”, which in recent years have contributed almost 50% of revenue. Specifically, Transact makes printers for slot machines. As you can imagine, being tied to the casino industry results in lumpy revenue, and since 2009 the Casino and gaming segment has seen revenues as high as $29.1M and as low as $17.5M. 

What appears to be a commodity hardware business on the surface is actually better than one would expect.  Modern slot machines have only two mechanical elements: the printer, and the bill acceptor. If either of these two simple devices fail, you are essentially left with a $10,000+ paper weight. As such, slot machine OEMs place a heavy emphasis on reliability and quality when it comes to their printers. Transact has more than 500,000 installs globally, and boasts a failure rate of less than 0.03% during the warranty period. This level of quality control is difficult to reach, which helps explain why this industry is essentially a duopoly, with Transact and Japan Cash Machine controlling 80+% of the slot machine printer market. 

Additionally, the printer is a small part of the total cost of a slot machine, which makes buyers less cost sensitive. Lastly, slot machines are regulated by government gaming agencies, and when a printer is chosen for a certain machine, the printer cannot be swapped out unless the whole unit is re-approved by the relevant gaming agency.  All of these elements combine to give Transact more pricing power than one would expect, and gross margins in this business are north of 50%, and perhaps as high as 60%. 

The Company also has a long standing relationship with McDonalds (MCD) as their supplier of POS printers.  If you’ve ever gotten a receipt at McDonald’s, then you have interacted with a Transact printer. This business is reported as POS Automation. 

As for its other business lines tied to lotto, banking, and oil and gas, the company has chosen to voluntarily wind them down.  At least one knowledgeable party that we spoke with suggested that these other verticals were never profitable, and were instead tied to a campaign of empire building that is not unusual to see at small and microcap companies. As these businesses were inferior, they masked the true economics of the slot machine business. From my perspective, despite past suggestions of empire building, it is notable to see a microcap company reverse course and voluntarily shrink its business, and I think this is evidence to suggest that Transact is thinking about their future in the right way. 

Lastly, the company continues to operate a spare parts business reported as Transact Services Group that services the existing fleet of printers in the business lines that they have chosen to wind down. 

What Do They Do: Through the Windshield 

As mentioned previously, TACT has a long standing relationship supplying front of house printers to McDonalds. Almost a decade ago Transact received an inbound call from McDonalds complaining that they were having problems with the reliability of their back of house printer, which was manufactured by Avery Dennison. Essentially, McDonald’s asked Transact to develop a back of house printer and terminal that would replace the Avery Denison printer and terminal.  

While on the surface it seems like printers are relatively simple technology, they are more complex and delicate than most realize. In a world that is increasingly digital many of us have likely forgotten how frequently high use printers experience paper jams, ink cartridge misalignment, and smudging due to a clogged ink nozzle. Restaurant back of house is a demanding work environment with variable temperatures, greasy hands, small particulates suspended in the air, and the potential for spills. All of these items make reliable printing challenging. 

The call from McDonalds planted the seed that led Transact to create BOHA! (Back Of House Automation), which is a cloud based software suite with 10 apps that streamline back of house restaurant operations such as food prep, labeling, temperature monitoring, inventory tracking, etc.  

I would not argue that the software by itself is revolutionary, and there are competing software suites. However, where BOHA! Separates itself from the pack is that it is an integrated solution that includes print capabilities.  This is useful for inventory tracking, reducing food waste, and meeting health codes, which reduces the likelihood of fines, but more importantly, protects the reputation of a restaurant. As a use case, consider that all partially used ingredients need to be labeled with time and date information to monitor freshness. So for an extreme example, if a restaurant orders a quantity of blue fin toro at $65 an ounce, and at the end of the night has 12 ounces left, that toro can’t just be shoved in the cooler until the next day. It has to be labeled with date information which essentially documents the useful life of the product.  the same is true of produce and other center of plate items.   

Historically this has been done by hand with pen and sticker labels, and then inventory can be manually updated etc. With BOHA! A restaurant can go to the iPad based work station, quickly navigate to whatever item of food is in question, and print out a label with date information etc., automatically calculated, while also making the inventory adjustment. Again, this software is not revolutionary, but remember, McDonalds – the restaurant with the deepest pockets in the world – could not find a printer that could keep up with the needs of the back of house outside of Transact, so Transact’s printer capabilities are a reason for restaurants to choose Transact’s BOHA! Software suite. 

The company reports this segment as FST (food service technology). Essentially the 10 apps assist with error prone tasks that have historically relied on human capital, but that can be easily automated in order to reduce errors, waste, and manpower, all of which save restaurants money.   To quantify, the company has estimated that BOHA! Reduces food safety incidents by 56% and results in 16 hours of labor savings per location per month. 

To be clear – while the company talks about this business in terms of ARR, in reality the “recurring” part of the ARR is variable as BOHA! Is both the software that helps with the tasks above, as well as a consumable element in the form of labels that are required for properly tracking and storing food inventory at a restaurant. There are various types of labels that are value add, such as easy remove, desolveable in water, color coding etc., and the printer warranty is invalidated if non-Transact labels are used. Having spoken with industry types, there is a strong case that the wrong labels can clog the ink nozzles of the printer, which is a mistake that is likely only made once by those seeking to cut corners and go with cheaper labels. 

In essence, this business is one part software, and one part razor blades, and the company rolls that up into ARR, which is not exactly the highest quality ARR you will come across in your investment journey. The variability in the consumable element of ARR clouds any calculation of ARPU. I believe $1,200 is a reasonable assumption for “Average,” but based on press releases announcing customer wins, the range is quite wide with numbers falling between $500 for regional Convenience stores and $2,500 for a regional food service operator.  Convenience stores will see more of their “ARR” come in the form of labels, while restaurants will see more of their ARR come in the form of software. 

More on convenience stores - in addition to restaurant back of house, the company has had great success selling BOHA! To convenience store operators, and in fact, as Covid slowed penetration in the restaurant space, thus far BOHA! Has been more about C stores than restaurants.  The trend in C stores is toward fresh food, and a simple google search will provide dozens of examples of how this trend is re-shaping the market. Under FDA regulations, this type of grab and go food is required to be labeled with full nutritional/dietary/caloric information that meets FDA standards.  BOHA! Allows chain convenience stores to manage their label content from a centralized location and update labels as new products or SKUs come to market. 

While this is clearly not enterprise level software that becomes the backbone of a C store, it is an essential part of the puzzle, and thus far my diligence suggests that they are the only company offering this service to C stores. They thus have a clear first mover advantage, and should also have a strong competitive position through social proof as 7-eleven, the largest C store chain in the U.S. with 14,000 doors (including the recent addition of Speedway) is a BOHA! Customer, and is in the process of upgrading the fresh food capabilities of their stores.

At present, there are about 9,000 BOHA! Terminals in the market, and the company has guided to 10,000 terminals by year end, with growth having been slowed by Covid Delta fears, as well as the inability of restaurants to find the staff needed to adopt the BOHA! System... which is somewhat ironic as adoption of the BOHA! System will reduce the need for back of house staff. Despite this recent slow down, terminal count is up from 5,688 at YE’20, suggesting 75% growth in the installed base for the full year. ARR growth (their definition) is more difficult to measure due to the previously mentioned variability of the consumables element which is tied to foot traffic.  Q2’21 saw ARR in the Food Services Technology segment increase by 219% YoY, while Q3’21 saw 25% YoY growth as Delta fears slowed foot traffic, the company experienced some product shortages, and the company faced a difficult compare due to heavy inventory stocking of labels in Q3’2020.  Management has said that Q4’21 started strong, and I suspect that full year YoY ARR growth will come out somewhere north of 100%. 

While triple digit growth is clearly not sustainable for any reasonable period of time, based on already announced customer wins (press releases available on the company website), the company appears to have line of sight to nearly 19,000 terminals in the market, or a near doubling from current levels, assuming no additional sales wins. 

Additional BOHA! Sales Wins Extremely Likely 

In Q3’20 the company revealed that they had received an inbound call from Apple (AAPL) requesting that the  BOHA! Workspace use an iPad rather than a fixed terminal, and Transact has thus designed the new workstation to pair with an iPad, and adjusted some of the apps to seamlessly work with iOS.  In an unusual move for Apple, their head of sales and strategy for the restaurant vertical recorded a video with Transact’s VP of Global Sales which was essentially an endorsement of BOHA!, and there are now about 100 Apple sales reps who are trying to sell iPads to restaurants. As part of the sales process those people point to BOHA! As part of the solution that Apple can provide.  I am not super close to AAPL, but I can’t recall another instance of AAPL essentially agreeing to co-brand themselves with an external software product by recording a video. 

Transact has stated that roughly half of their ~$150M sales pipeline is now tied to leads generated through Apple. With Apple now focusing on enterprise level sales and larger customers, Transact has for the first time started a small and medium business sales effort in the restaurant space.  It is worth noting once again that BOHA! Essentially cuts down on labor expense for restaurant back of house by replacing a series of clipboards, thermometers, egg timers, and grease pens with software.  For restaurants dealing with food inflation and wage inflation, software that saves money seems like a good idea. Management has commented that through the pandemic restaurant software has been all about front of house as that was what was necessary to survive the pandemic.  Now that we are moving past the pandemic and most restaurants have their front of house figured out, the next leg of restaurant software to explode higher is likely to be back of house where the ROIC is justified by efficiency gains and cost savings. 

Importantly, with the Apple partnership, the math around the capex investment decision changes for restaurants.  The hardware spend tied to BOHA! Implementation is now likely bucketed as “cost of iPad” and “cost of Transact printer,” rather than as “cost of Transact work station.”  In other words, due to Apple’s brand strength etc., purchasers likely don’t associate the cost of the integrated solution entirely with Transact, so Transact’s piece of the puzzle looks pretty cheap. 

What is the Casino Business Worth? 

As mentioned previously, the slot machine printer business is essentially a duopoly, with Transact and FutureLogic, which is owned by Japan Cash Machine (JCM) being the gorillas.  JCM purchased FutureLogic in 2014 for ~$70.6M on $47.2M in revenue, or 1.5x sales. However, as evidenced from the below, which is a snap of FutureLogic’s 2013 website, in addition to the slot printer business, FutureLogic was involved with a bunch of other commodity crap, which I believe artificially deflates the multiple that the pureplay slot printing business would deserve. I thus think that 1.5x sales represents a conservative valuation floor for Transact’s Casino business.

Average revenue for Transact’s Casino and Gaming business from FY2007-2019 was about $23M, and I consider this to be a useful definition of “normal” sales. At 1.5x I thus consider a floor valuation for this business to be $35M, or a bit more than 40% of the current EV. 

Anecdotally, having spoken with former executives that served in the mid 2010s (prior to BOHA!), it seems that internally it was widely believed that the Casino business was worth more than the entire market cap of the company, but the market did not appreciate the value due to the other business lines (that have since been shut down) that polluted the financials.  Broadly speaking the market cap at this time was mostly in the $60-80M range.  

As a sanity check to the opinion of former execs, I believe for an acquiror the Casino segment could do 40% EBITDA margins (or higher) in a normal year with much of the savings coming from the Sales and Marketing line and Engineering, Design and Product Development line.  As a reminder, historically the company operated in several less desirable/more competitive/unprofitable segments which caused cost inflation in both of these lines vs. The Casino business that has limited Sales and Marketing expenses etc. due to the duopoly nature of the industry and high switching costs. 

Examining other printer transactions shows an average transaction LTM EBITDA multiple of 10.3x, with those transaction targets being less differentiated than Transact’s Casino business. 

If we haircut the multiple to 8.0x, and assume 40% EBITDA margins in a “normal” year, that suggests a value of about $74M, which is in line with the anecdotal suggestions of informed parties. 

What Are the Odds and Ends Worth? 

I haven’t spent a ton of time on the McDonald’s printer business or the Spare Parts business, but given transactions multiples of ~1.5x sales for other printer businesses, I think the McDonald’s business is conservatively worth 1.0x sales. Yes, there is customer concentration risk here, but at the same time, recall that the whole BOHA! Evolution started because McDonalds came to Transact and said that they could not find anyone to make reliable back of house printers. Clearly the relative quality here is high. 

As for the spare parts business (Transact Services Group), it is likely high margin but declining.  Finger in the air 0.5x sales. 

What is Left? 

Combining the value of the Casino business, McDonalds business, and spare parts business suggests that together they are worth about $82M.  Given the current EV of about $82M, that suggests that investors are getting the fast growing ARR software business for free.   

But what is it worth? It depends on what you want to believe about the future. 

My approach is to believe that they can get to 20,000 installs with $1,200 ARPU, which would generate 24,000 of ARR. Again – this is not the highest quality ARR – but assuming 20,000 installs essentially assumes that they barely break the number of potential installs that the company has already press released.  

Said differently, assuming 20,000 installs assumes that Apple contributes zero incremental sales.   

Said yet differently again, assuming 20,000 installs assumes that the company’s nascent SMB effort – which is likely targeted at SMBs that use Square via iPad - results in zero incremental sales. 

If you believe that this ARR is worth 1x sales, then the stock has about 30% upside.  if you believe it is worth 2x sales, then the stock has about 60% upside, and so on and so on. 

What I am NOT suggesting is that because this is ARR growing triple digits with an enormous TAM it should trade at 30x sales or whatever.  It is not pure enterprise software and does not have pure software margins (although gross margins on some of the labels are north of 40%) so even though growth is high and the TAM is huge, it doesn’t deserve a crazy multiple.... but if you think it deserves a touch more than a 3x revenue multiple, then you have a stock price double before assuming any growth in addition to what has already been announced. Personally I don’t think 5x revenue is crazy. 

The People 

CEO and Chairman Bart Shuldman has been with the company for 25 years and the stock is basically flat over that period, which clearly does not speak well of management. That being said, I have heard the argument that holding a printer business stock flat for 25 years is actually quite an accomplishment.  

Maybe. 

From my perspective, what is important at this point is that this old dog clearly wants to learn new tricks. He has reversed former empire building by shutting down underperforming segments in order to fully focus on the future, which is BOHA!  Shuldman owns ~6% of the equity, but in my view he believes that Transact is his baby. At the same time, he realizes he is at the tail end of his career, and I believe that he views BOHA! As his retirement package... meaning that he realizes that this business probably gets sold at some point. I would note that he seems to have a preference for over-promising, but I think the board and activists are trying to reign him and make him more conservative in his pronouncements. 

As for the activists, there are three at the table (Harbert Discovery Fund, Grand Slam Asset Management, and most recently 325 Capital), and they collectively own about 20% of the equity, and I am quite certain that they disagree with Bart’s view that Transact is his baby.  In the not too distant past 2 board members have been replaced and upgraded by new board members that I believe have the blessing of the activists.  One is Manny Hilario, CEO of STK Group, who is very well regarded in the restaurant space.  Hilario’s restaurants have adopted BOHA!, and his executive chef has recorded testimonials on how BOHA! Helps improve restaurant work flow etc.  I don’t think that this necessarily carries the same social proof weight as 7-eleven in the C-store space, but it is a strong endorsement.

The other is Haydee Olinger, former Global Chief Compliance Officer at McDonalds.  It is harder for me to get a read on her, but the fact that she spent her career inside of an extremely high-functioning organization like McDonalds likely places her miles ahead of the other board members. 

The activists have not made any public demands, but the company recently submitted a plan to de-stagger their board to a non-binding vote (which passed), so I suspect further changes at the board level may be in the works.  What I think is obvious is that the activists would like to see the Casino business monetized so that the company can become a pureplay Food Service software business.  

Why It is Cheap / Risk 

I think TACT is currently suffering from tax loss selling as the stock approached $17 earlier this year, and has traded down since. This is probably exacerbated by the fact that in late August Transact completed a follow on offering at $14.50 per share. The book runner was Roth Capital, and a fair bit of that stock probably wound up in weak hands. 

Additionally, in what they have described as “only for a worst case Covid scenario” the company recently filed a shelf. I think the shelf spooked the market into thinking they might need equity capital in the near term... but given some $28M in liquidity and the likely sale of the Casino business at some point in the next maybe 12 months, I don’t think that will prove necessary. 

Beyond that, the company has indicated that they were having some temporary trouble getting inventory due to supply chain constraints, and 2021 BOHA! Installs will be coming in at the low end of guidance as Delta slowed the roll out, and as restaurants have indicated they are so under-staffed they haven't been able to implement. 

The big picture of course is that anything related to not-yet-profitable tech has gotten shot in recent months.   

Catalyst

Activists / Sale of Casino business / Growth