Trading at a mere 6x 2007 consensus EPS estimates, Torex represents a compelling 13% 2006E FCF yield. We believe shares are worth at least £1.14 (100% upside) if Torex just meets consensus estimates and much more if management’s upside case plays out.  We have looked at the margin of safety on the downside a couple of different ways and have determined that the shares should fundamentally not trade below £0.75 - £0.80 (35% upside) even under fairly negative circumstances (details below).  With that kind of asymmetric payoff structure and the possible catalysts of shareholder activism and a potential LBO/MBO, we think this is one of the most compelling value ideas we have seen in a very long time.

 

 

 

Shares are currently down 52% from their 52-week high of £1.20 (and 41% since just early May).  Given this dramatic slide and the unreasonably low earnings multiple (6x) for a growing, profitable, free cash flow positive company, one might assume that the consensus estimates must be unrealistically aggressive (or perhaps outdated).  However, Torex management just recently announced (on July 11^th) that it expects to beat the consensus estimates for the first half of 2006 and that they are “confident of achieving the full-year expectations”.  Should this occur, there is no reason that Torex should not trade at a modest earnings multiple of at least 12x forward estimates, based on its earnings growth prospects and an analysis of its peer group’s trading range (the peer implied multiple is actually closer to 15x as detailed in the analysis below).  Even such a conservative valuation would imply a share price of £1.14, representing nearly 100% upside to recent depressed levels.

 

With such a valuation disconnect, we believe that Torex is likely to experience increased shareholder activism as sophisticated value buyers have begun entering the name.  The Company has now also effectively become a takeover target for both strategic acquirors in this rapidly consolidating space as well as financial sponsors seeking to lead an LBO or MBO.  In fact, management acknowledges that they have been approached by a number of interested parties and that they will take all discussions seriously.

 

 

 

Torex is a UK based supplier of electronic point of sale (EPoS) solutions and services worldwide.  It provides Java and Windows-based EPoS and back office software, hardware, maintenance and related services primarily to the retail, convenience and hospitality industries.  In 2005 (prior to 3 recent relatively small acquisitions of primarily software companies), the revenue split was as follows:  Hardware (35%);  Maintenance (31%);  Software (18%);  Services (16%).  Although the Company does not disclose their operating margins by segment, we estimate that the software sales generate 25-40% EBITA margins, while the hardware sales are probably closer to 10% (these are customized, niche hardware solutions as opposed to the reselling of commoditized equipment for razor thin margins).  Torex’s blended EBITDA margin in 2005 was 18%.

 

 

 

As the market leader in a consolidating industry with economies of scale, Torex has been an aggressive acquirer of next generation EPoS products and technologies as well as customer relationships.  In fact, the Company has spent approximately £350m on 15 separate acquisitions in just the past 2 years (33% in cash and 67% in shares, valued at an average of about £1.00 – 74% above yesterday’s closing price).  Incidentally, we believe that Torex paid just 9.2x fully taxed earnings for all deals done through Q1 2006 – a multiple that drops to an adjusted 6.6x earnings based on the current value of the equity currency used, giving us comfort that they did not overpay in these transactions.  Recently, investors began to express concern that endless acquisition-related accounting adjustments were preventing any meaningful analysis of the Company’s underlying organic fundamentals.  As the acquisitions mounted, fear surrounding this uncertainty began to lead to unsubstantiated speculation that management might be covering up weak organic growth with acquisitions (or effectively hiding problems).  These fears were heightened by the fact that the UK technology sector has had a number of high profile roll-ups that have run into trouble:  BILL LN;  IOT LN (Torex was briefly owned by IOT, increasing the speculation surrounding potential accounting issues);  Cedar Group plc (virtually insolvent before being acquired);  TIG LN;  AIE LN;  PST LN.

 

Despite these mounting concerns from investors, Torex management continued its roll-up strategy and on July 3^rd, announced the £50m acquisition of Retail-J (one of its more successful UK competitors).  Furthermore, the acquisition was financed through the issuance of a £65m convertible debt offering (to satisfy a £40m cash payment) as well as the issuance of 12.5m common shares (£10m of equity at the negotiated price of £0.80 per share – 39% above yesterday’s closing price).  Frustrated investors (one large UK investor, in particular) began dumping shares, distressed that management seemed so apparently unsympathetic to their concerns and disappointed with the Company’s decision to finance the transaction with a convert.  Short sellers have since piled on in the ungrounded hope that something is amiss with the Company’s acquisition-related accounting.

 

 

 

As mentioned above, we believe that Torex’s industry leading market share, high margins and extremely low valuation make it a very attractive potential acquisition target.  We understand that management has already received inquiries and is receptive to offers to enhance shareholder value.

Although concerns over a perpetual state of acquisition are certainly reasonable, frustrated investors have lost sight of the larger long-term picture.  Of course Torex’s strategy involves the expected roll-up benefits of removing duplicative costs by standardizing and leveraging existing systems and processes.  But it also involves a tremendous cross-selling opportunity into its acquired customer base.  Not only is the Company gaining the ongoing stream of maintenance and servicing revenue from the acquired customers, but it is also getting the opportunity to sell its next generation technologies (software, hardware and services) into those accounts as they approach their next upgrade cycle – an opportunity that was not available to many of the smaller regional players that Torex has acquired due to their limited product offerings.

 

Among these acquisitions, Retail-J is unique in that it not only brings the usual potential for operating synergies and a strong client list, but it also adds a leading edge product platform that has shown strong success in the UK market as of late, as well as an overseas (ex-UK) distribution network.  Furthermore, the revenue growth rate at Retail-J was an explosive 50% last year.  This deal was viewed by management as an exceptional opportunity to supplement its product platform and strong client account roster – one that they simply could not pass up despite further frustrating some shareholders.

 

The good news, for those concerned, is that the Retail-J acquisition represents Torex’s last deal for at least the remainder of 2006.  Not only have they explicitly stated that fact in press releases (as recently as yesterday, in fact), but with an extraordinarily depressed share price and a fairly full balance sheet, the Company’s ability to complete any further deals seems severely limited anyway.  As a result, the focus is now on the continuing integration – the rewards of which should now become more easily discernible going forward.

 

Torex’s recent purchase of McDonald’s Corporation’s EPoS system (Savista) represents major potential upside for the Company.  To date, the new systems have only been installed in 6,000 locations, with 27,000 restaurants left to complete the roll-out.  At an expected minimum licensing fee of USD $1,600 per installation (which is virtually 100% marginal profit), this opportunity alone represents an additional USD $43m of profit contribution over the next few years – nearly 85% of all of last year’s EBITDA for the entire Company).  Although Savista was previously rolling out the installations at a pace of 5,000 restaurants per year, we understand that Torex is currently in discussions with MCD to dramatically speed up the process, which could result in a significant up-front licensing payment.  The Company further estimates that there is also the potential to cross-sell at least another USD $300 in ancillary services per store annually for at least the next 5 years – representing a potential USD $50m in additional high margin revenues.  Futhermore, the current installations are actually being performed by a third party given Savista’s limited resources prior to being acquired by Torex.  The Company now believes that it is in a strong position to win at least a portion of this installation business in the UK and Europe, providing for additional potential upside.  Finally, Savista is not just intending to service MCD, but also to leverage that high-profile win into other QSR franchises.  We understand that the Company is currently involved in EPoS tender processes with a number of very large US QSR players.  Although management’s guidance is conservatively assuming that they are not successful in any of these pursuits, we understand that they have been short-listed in at least one process that would involve a contract value of about $25m (at an estimated 40%+ EBITA margin).  Consequently, we view Savista as a free, very high value option.

Most retailers have not upgraded their front-end EPoS systems since 1999 or earlier, in connection with Y2K preparations.  As a result, industry experts believe that we are currently on the verge of a 2-3 year tailwind of very strong market growth.  Consequently, Torex management believes that core revenues (before accounting for the explosive growth potential of Savista and Retail-Java) should grow in excess of the industry’s expected growth rate of 6-8% over the next several years.  Given the high operating leverage and the improving margin mix (as well as the benefits of deleveraging), we expect this to lead to a corresponding increase in profit of 15-25%.

 

Even without such robust industry growth on the horizon, Torex has an enviable, stable, low risk business model.  As a result of the long replacement cycle and the high switching costs (which makes for very “sticky” customers), an estimated 90% of Torex’s revenue is generated by servicing its more than 6,500 existing customers (no one represents more than 2% of sales) – a fact which offers tremendous downside protection should the anticipated upgrade cycle be delayed for any unforeseen reason.

 

Although Torex’s free cash flow has been poor historically due to ongoing acquisitions and related integration expenses, the Company is expected to generate strong free cash flow for the remainder of 2006 and beyond (helped by the low capital intensity of the software business).  The most recent analyst estimate (Arbuthnot Securities) calls for £29m of FCF in 2006, which equates to £0.073 per fully diluted share (392.8m shares pro forma for all recent acquisitions and options outstanding) or a 13% FCF yield (at yesterday’s closing price of £0.575).

 

The Company is expected to have a non-convertible net debt balance of £150m as of June 30, with an additional £65m of converts relating to the Retail-J acquisition.  Pro forma for the repayment of a small revolving credit line (£10m line, but only partially drawn) from some of the excess proceeds from the convertible offering and the £30m of free cash flow generation expected in the back half of the year, total net debt at YE2006 could be as low as £180m (or just £115m of non-convertible net debt).  That represents 3.6x Net Debt/EBITDA (based on the 2006 consensus estimate of £50.3m) and just 2.3x Non-Convertible Net Debt / EBITDA – certainly a reasonable level given the high margin, recurring nature of the Company’s revenues.  We believe that there is significantly value simply in the deleveraging that should occur over time here.  Importantly, management has confirmed that they are comfortable with the above estimates for FCF and EBITDA as well as with the current pro forma net debt calculations.

Although a critical component of Torex’s strategy involves taking full advantage of its account relationships to provide its customers with end-to-end EPoS solutions (hardware, software & maintenance services), management is deemphasizing the Company’s focus on hardware sales as they represent the lowest gross margin (as mentioned above).  After the Anker and RSS acquisitions, hardware revenues (and hardware related maintenance revenues) had increased to nearly 50% of sales.  This proportion is now coming back down with the recent acquisitions and should continue to decrease (benefiting overall margins) given management’s strategy going forward.

Besides the growth related to the acquisitions discussed above and the numerous cross-selling benefits that they represent, there are a couple of other promising growth avenues that the Company is pursuing:

 

1.   Having chosen not to update its legacy 4690 based EPoS offering, IBM is effectively withdrawing from the retail software market.  This creates an ideal opportunity for Torex to win a portion of IBM’s installed base, having just entered the US market in 2005 through acqusitions.

2.   The hotel and hospitality industry represents a very large and virtually untapped opportunity for Torex to leverage its current industry leading position in the retail and convenience markets.

CEO Chris Moore has recently been consistently buying stock in the open market at much higher prices than current levels.  He just spent USD $460k in March to acquire shares for £0.93 – 62% above yesterday’s closing price), bringing his personal holdings to 12.3m shares or 3.3% of the Company’s common shares (roughly USD $13m at the current valuation).  Prior to that, in November 2005, Moore acquired 435k shares in the range of £1.10 per share – a 91% premium to the recent closing price.  Accel-KKR also just took (and committed to hold for a period of one to two years) 21.9m shares in the Savista deal, representing roughly 6% of the Company.  And in yet another vote of confidence, Retail-J’s founder (and now the new Torex CTO) also took £10m (12.5m shares) worth of equity consideration and as a result now holds more than 3% of the Company’s fully diluted shares.

We have already discussed the investor (over)reaction to frustration over the Company’s continued acquisition spree as well as the unfounded speculation that some form of acquisition-related accounting fraud is a possibility.  In addition to these pressures, we believe that the stock has also been driven down by investors involved in the recent £65m convertible offering looking to hedge out some of their economic exposure by shorting the common equity.  As the Company delivers on its earnings targets and these irrational fears subside, many of the speculative short positions will likely be unwound, creating dramatic potential upside for the shares.

 

 

First of all, a quick overview of the current capital structure.

 

Share count = 326.5m basic shares as of Dec. 31, 2005 + 31.3m issued for Savista + 7.3m issued for TQIPS + 12.5m issued for Retail-Java + 15.3m options outstanding (using the treasury stock method) = 392.8m fully diluted shares.  Therefore, the market capitalization at yesterday’s closing price of £0.575 is £226m.

 

According to management, the Company’s net debt as of June 30, 2006 (to be reported in a couple of weeks) was approximately £150m (roughly £165m of debt less £15m of cash).  With proceeds from the £65m convertible offering issued in conjunction with the Retail-Java acquisition, the Company paid down around £5m on one of its credit facilities and obviously subsequently increased its debt balance by the amount of the convert.  This brings Torex’s pro forma net debt figure to about £210m.  As a result, the Company’s enterprise value is approximately £436m.

 

As discussed above, Torex is currently trading at a scant 6x consensus 2007 EPS estimates (£0.095) and represents a compelling 13% FCF yield (based on the most recent Street estimates for 2006E free cash flow – £29m as per Arbuthnot Securities).  Even a return to a conservative peer multiple of 12x consensus forward earnings would imply a share price of £1.14, representing nearly 100% upside from yesterday’s closing price.  And this is just based on Street estimates.  If management is successful in driving growth and increasing aggregate margins through integration-related cost savings, improved product mix and success with the recent acquisitions, the share price appreciation could be phenomenal.

 

Given an understanding of the magnitude of the potential upside, let’s attempt to quantify the possible downside.  We believe that there is a meaningful margin of safety in the shares at these low levels as demonstrated by the two methodologies that we lay out in the Risks section below:  1) even a 25% earnings miss and a conservative forward earnings multiple (12x) should still justify a stock price of £0.80 (40% upside);  and 2) even if EBITDA margins were to immediately fall from the current 18% down to 14% (despite management’s assertion that they should actually continue to increase over time), the shares should still be worth £0.74 (29% upside) based on 2007 Street consensus revenue estimates and a 12x earnings multiple.  Details for both of these analyses follow below.

 

With the asymmetric payoff structure of a stock that is still 30-40% undervalued even under fairly negative scenarios, but should double if it just meets Street expectations and potentially much more if the Company meets management’s expectations, we believe this is one of the most compelling opportunities we have seen in a long time.  Add in the catalysts of possible shareholder action and interest surrounding a potential takeout and you have a recipe for significant share price appreciation.

 

 

The current valuation suggests that investors do not believe the Street’s earnings estimates.  So, the question is whether or not the discount being placed on the shares as a result of the uncertainty surrounding upcoming earnings is warranted.  We understand from management that 60% of the revenues in any given period are effectively “in the bag” as they primarily relate to ongoing contractual maintenance, services, installations, etc.  That only leaves variability relating to 40% of sales.  If we were to conservatively assume a major miss of 25% on this portion, we are really only talking about 10% of total revenues.  Given the operating leverage, this 10% top-line miss could translate into as much as a 30% earnings miss.  However, even assuming such a draconian scenario, the Company should still earn £0.067 per share next year, implying that the stock is trading at just 8.6x this low probability downside scenario.  A more appropriate (and still conservative) multiple of 12x this downside case would yield a valuation of £0.80 per share – implying nearly 40% upside from yesterday’s closing price.

Roll-ups can be very difficult to execute properly, although Torex has a strong track record in this area.  However, the Street clearly has a lack of confidence in the Company’s current forecasts and seems to distrust the current management team.  The CFO’s departure in the Fall of 2005 did not help in this respect – although the Company just yesterday announced the appointment of a new group CFO (just 31 years old) with “considerable experience in the retail sector” that will report to Finance Director Mark Pearman.  Yesterday’s press release also announced the realignment of the existing management team “in order to fully focus on maximizing organic growth opportunities in the coming period”, further stressing the Company’s renewed focus on growing organically.

With the recent issuance of £65m of converts in conjunction with the Retail-J transaction, Torex now has a fairly full balance sheet.  However, strong free cash flow generation (and a lack of further acquisitions near-term) should help to bring this balance down significantly over the next 2 years (as detailed above).

The second half of the calendar year generally represents two-thirds of the year’s revenues as well as the majority of profits and cash flow.  This is because retail installations tend to occur just prior to the Christmas holiday season.  The seasonality is also exacerbated this year due to the recent acquisitions which will be more fully online in the back half of the year (Savista, QTIPS, Retail-Java).

We are aware of an argument put forth by bears that Torex’s margins (18% EBITDA margin in 2005) are just too high versus its competitors.  To check the validity of this argument, we put together an analysis of Torex’s UK technology peers along the lines of the Company’s product offerings.  In short, we found that applying the average EBITDA margins of each industry group to Torex’s business mix (see below for details) would yield an implied EBITDA margin of roughly 14% vs. the 18% reported last year.  However, the Company maintains that its margins deserve to be higher for a number of reasons:  1)  hardware margins for retail EPoS are higher than the traditional commodity hardware resellers that are often used as comparables;  2) efficiency benefits from integration of acquisitions;  3)  increase in higher margin software mix from recent acquisitions;  4)  industry market share leader (as opposed to price leader, for instance).  Nevertheless, to be very conservative, let’s assume that Torex’s EBITDA margin does decline to the 14% implied average.  Applying this margin to the Street’s 2007 consensus revenue estimate of £303m implies EBITDA of £42.4m.  Subtracting out £8m for interest expense and assuming the Company’s normalized tax rate of 30% would imply 2007 net income of £24m or £0.061 per fully diluted share.  Even if this were to occur all at once (which seems very unlikely), Torex shares would still be trading at just 9.4x forward earnings, a 22% discount to the low end of the trading range of its peers – a discount that we believe is unwarranted.  A conservative peer multiple of 12x this figure would yield a share price of £0.74 – 29% higher than yesterday’s closing price.

 

In case you’re interested in the details of the margin analysis we did, we looked at the following UK technology players and applied their average margins to Torex’s business mix (detailed above):

 

Sofware (22-26% EBITDA margins):  LSE:AU, LSE:AVV, AIM:OPN, LSE:IOT, LSE:MCRO, LSE:NSB, LSE:RYB

 

Sofware/Services Blend (14-17% EBITDA margins):  LSE:AIE, AIM:CIV, LSE:DCM, ASX:ESV, LSE:ICM, LSE:ITL, LSE:MSY, LSE:NIS, AIM:SUG, LSE:XAN

 

Services (14-17% EBITDA margins):  LSE:AXO, LSE:DCA, LSE:LOG, LSE:PNX

 

Hardware (5-8% EBITDA margins):  LSE:CGR, LSE:CCC, JSE:DDT, LSE:MOR, LSE:RM.

 

Incidentally, applying the same mix proportions to the current forward earnings multiples of this same peer group would imply a 14.6x multiple for Torex, well above (by 22%) the conservative 12x multiple that we are using for our valuation herein.