Description

Transact Technologies (TACT) makes printers used for printing receipts in slot machines, lottery terminals, banks (not ATMs) and retail point-of-sale (“POS”) systems.  Over the last few years TACT has also developed its service and parts business which has recurring revenues and high margins. 

TACT could be on the cusp of explosive revenue growth due to large domestic and international market opportunities in its gaming business as well as high growth potential from a new product introduction in its POS business line.  TACT’s business model has high operating leverage, allowing for large contribution ratios on incremental sales.  EBITDA could easily reach $14M run rate within 18 to 24 months, which equates to a 5.4x multiple using the current enterprise value of $77.5M.      

TACT was originally incorporated in 1996 after being spun out of Tridex Corporation, a POS software and hardware provider that went BK in 2002.  The company has been through its share of ups and downs since the spin-out; going through a two year restructuring effort in 2002-2003 after its market cap bottomed at $24M at the end of 2001.  As the slot market converted from coins to ticket-in-ticket out (“TITO”) during 2004, TACT became a bit of a story stock with its market cap reaching $315M.  Today, TACT’s valuation has come down to very attractive levels after suffering through a 2005-2006 slowdown in domestic slot volumes as well as the  conversion from primarily impact printers (legacy printers using a ribbon) to thermal inkjet printers which have a lower average selling price.

Market Segments: 

Gaming:

Year-to-date through the third quarter, gaming sales represented 34% of total TACT sales.  Sales in gaming are driven by: 1) growth of the installed slot base (domestic and international), 2) life of the printer itself (3-4 years), 3) slot machine replacement cycles and 4) market share. 

Gaming represents the most compelling growth opportunity for TACT for several reasons, not the least of which is its size.      In the U.S. market alone, the installed slot base is estimated to be about 850k machines by the end of 2006 – up from 700k in 2002.  (Note:  Average selling price for all TACT printers is about $300, with range from $200 to $600).  Growth will come from new gaming legislation (PA and FL), potential for Native American developments (CA and NY), and the rebuilding of the gulf coast casino market following Katrina .   Longer-term, the anticipated  conversion to server-based games in the next 2-4 years will require new slots and for each a new printer.   TACT also has a couple of specific international opportunities I’ll touch on later.   

Aside from any growth stemming from gaming expansion and the conversion to server-based-games, the domestic market is entering a key replacement cycle.  Starting in 2002 and reaching a peak in 2004, the vast majority of the domestic slot market was converted to TITO technology.  For those unfamiliar with the  slot market, TITO means the gaming patron puts cash into the machine and instead of receiving a payout in coins; the machine prints a voucher that the patron remits to the cashier, or can put back into the machine after taking a break.  The advent of TITO contributed to a surge in sales for TACT in 2003 and 2004, but fell off considerably in 2005 as penetration rates flattened out.  The good news is that these printers typically have useful lives of about 3-4 years, so many of those sold in 2003 and 2004 will need to be replaced soon.  Casinos have zero tolerance for slot downtime due to component failure and are very diligent about their replacement. 

On top of the market opportunity, TACT is gaining market share thanks to a new joint sales agreement with JCM, a privately held manufacturer of slot machine bill-acceptors.  TACT’s primary competitor in slots is FutureLogic, a private company in CA.  FutureLogic had the upper hand in the early years of the decade, but TACT has been able to gain roughly a 50% market share in the U.S.    It appears that this year, with improved sales in a lackluster gaming market, that TACT is gaining additional market share with its new JCM relationship.  JCM has a larger sales force than TACT and is in more frequent contact with casinos since bill-acceptors generally are replaced every two years.  (Note:  slot printers are sold directly to casinos as well as to OEMs like IGT and WMS).  The JCM relationship basically involves the bundling of bill-acceptors with printers as part of a sale.   FutureLogic had forged a joint-sales strategy with bill-acceptor company Mars Electronics earlier in the decade.  

I should also note that FutureLogic and TACT are involved in patent infringement litigation, dating back to 2005, regarding a dual-port printer.  The dual port printer allows for connection to a central server at the casino from which the casino can send targeted marketing collateral to the user.  This functionality is attractive to operators and could be differentiating factor as operators choose printers as part of server-based replacement cycle.  TACT was issued a patent in 2005 after which FutureLogic immediately filed a complaint claiming to have had the technology before the patent was officially filed by TACT.  Motions regarding jurisdiction went back and forth during 2006 without resolution.  I was able to become comfortable with the situation talking to management, mainly due to the fact that FutureLogic had ample opportunity to object to the patent during the application process and never did until after it was filed.  FutureLogic, according to company’s website, has similar “patent-pending” technology, namely its PromoPort^TM Architecture and ProMatix^TM Technology. 

Internationally, Asia/Macau offers opportunity if American style slots gain traction.  The more interesting near-term opportunity is Australia, an approximately 250K slot market where TACT has solid access to 90% of the market through an OEM contract.  Australia has been slow to adopt TITO due to regulatory issues.  The conversion has been expected for years, and while there is not definitive time frame right now, my research suggests that conversion will begin in 2007.  The province of New South Wales is expected to be the first to convert.  This can be tracked by paying attention to the Australian Gaming Council, website at www.austgamingcouncil.org.au. 

While it’s hard to predict exactly when industry events will occur and turn into revenues for the company, using the $300 ASP metric, there is substantial revenue opportunity in the next few years domestically and abroad.   Specifically, the Australia situation could represent a total of $54 M in revenues.  (Conservatively assume 80% of the 250k slots convert to TITO, and TACT has 90% (or 180k slots) of the market at $300 per slot).  Knowing this won’t happen overnight, we’ll conservatively assume it takes three years, so we’re left $18M per year from Australia.   Domestically, we can apply TACT’s new (and growing) 50% market share to the growing 850k slot base in the U.S. and assume a four year replacement cycle to arrive at over 106k printers per year for TACT (or about $32M in revenue).  This does not account for market growth, further market penetration or acceleration of cycle due to server-based games, all of which as noted above are real.  $50M of revenue from gaming alone compares favorably to the $23M I expect in 2006, $17M in 2005 and $24M in 2004.     

Lottery:

Year-to-date through the third quarter, gaming sales represented 20% of total TACT sales.  TACT supplies substantially all of the printers used for online lottery terminals made by Gtech, which was a public company until its recent merger with Italian lottery company Lottomatica.  GTech (and now Lottomatica) provides a full-service lottery solution domestically for state governments and internationally.  Contracts typically range for 5-7 years.  Whenever a new contract is signed or an old contract is renewed, Gtech supplies retail level terminals, each with a TACT printer with a replacement cycle ranging from a 3-7 years.  Today, there are about 1 million of these terminals installed around the world.  The good news is that TACT has a long standing relationship with Gtech, is inextricably integrated into their R&D and manufacturing operations, and is under contract with them through 2012.  The business has generated anywhere from $7-$10M of revenues for TACT in each of the last four years.  Gtech / Lottomatica has room to grow by exploiting the estimated 65% of the potential global market not yet served by any online lottery.  The bad news is that the lottery business is highly competitive (Scientific Games and Intralot).  Also, trends in lottery are moving toward instant games, where Lottomatica recently made an acquisition, but Scientific Games has the lead.  The RFQ / contract-specific nature of this market makes predictions difficult, particularly on a quarterly basis.  Upside from the Gtech relationship exists as Gtech is making a push into the gaming market.  In April 2004, Gtech acquired Spielo, a leading manufacturer of VLTs (which are kind of like computerized scratch and win games used in states including OR, LA, NY, WV and MT).  Gtech is also forging an alliance (and 50% ownership position) with Atronic, a leading European slot manufacturer,  Once this agreement is finalized, GTech will be authorized to sell to almost every casino in the world. 

Assume we can expect $8M from Lottery, and our Gaming and Lottery revenues total $58M.  This compares favorably to the approximate $35M expected in 2006.

POS and Banking: 

This segment, like lottery, has historically been volatile and difficult to predict.  As with the gaming and lottery segment, it is better to split the segment into its two components. 

POS:

TACT is a small (market share of about 2%), niche-oriented player in the POS market, which is dominated by Epson.  They’ve steered away form the big-box and other markets where bigger competitors are well entrenched.  Instead, they’ve focused on markets where their innovations can deliver the most value.  The large opportunity today is in the QSR market for which TACT has developed a printer (the Ithaca 8000) for receipts that printed on sticky paper.  This new technology is beneficial for two reasons: 1) productivity / convenience at drive-thru window as the post-it-note style receipt is easier to apply by the employee and easier to check by the customer and 2) it allows the thermally printed receipt, with its associated chemicals, to be attached outside the bag instead of being thrown on top of the food inside.  TACT developed the Ithaca 8000 about a year ago and is actively testing it with an undisclosed client.  Mgmt says that new product introductions like this usually take one to two years to get off the ground from time of development.  While we don’t know who is beta-testing the product, we do know that TACT has approximately 90% market share at McDonalds (supplied through distributors).  We also know that McDonalds has been making some purchases and reviewing options in POS software.  If this product does take off, it should happen in the next 1-2 years.   

Banking:

TACT sells printers used for validation or receipt printing at bank teller windows.  Contracts in this business are typically awarded through big RFP processes, and as such, sales can be lumpy like the lotto business.  TACT has not had much to say about the banking business in recent communications with investors, leading us to believe opportunities elsewhere are brighter.  However, banking clients do represent a lucrative services / parts revenue stream opportunity (discussed below). 

Services Group:

Provides service on printers, and importantly, sells consumables including toner cartridges and paper.  Toner cartridges and other consumables are typically sold at high (50%+) margins.   A typical TACT printer in use at a bank will go through 4-8 toner cartridges a year at $10-$14 a piece.  TACT’s work to grow this business has been paying off; revenues were $8.5M in 2003 and should come close to $13M this year.  There is still ample room to grow this business however as only 56% of POS/Banking installed base is currently a customer and only 33% of total installed base is a customer (casinos are more prone to service in-house than POS/Banking).   Throughout 2005 and into 2006, TACT added to its sales force and also opened a western regional service center in Las Vegas.   This business line should continue to produce high margin growth while reducing earnings volatility. 

Financials:

If the company is able to capitalize on the opportunities covered above, TACT’s operational leverage will allow for significant earnings growth.  Beneath the mid-30s gross margin, operating costs are relatively fixed now – following the recent build-out of the sales force, addition of Vegas office and an expansion in CT.  According to management, operating costs below the gross margin line, including engineering and development, can support substantially higher sales levels.  Plenty of excess capacity exists at the manufacturing level as well as they are currently only running one shift four days a week.  If revenue potential is met, operating margins could easily reach the mid-teens.  Capex should approximate $2M.  It was unusually high in 2005 for the aforementioned expansion activities and has been higher in 2006 due to new IT system implementation (which is apparently going well and nearly complete).  TACT only provides revenue guidance, $63-$64M for 2006, which implies a flat to down 4Q on Q-to-Q basis.   Coupled with the potential for slightly higher selling and marketing expenses (due to trade shows) in the quarter and we do not expect the quarter to be great, though this is fairly easy to calculate and likely discounted by the market.   More importantly for the long-term investor, real potential for growth in 2007-2009 is readily apparent. 

It’s important to remember that top-line growth over the last several years is a little deceiving as sales have shifted away from higher ASP impact printers to lower (about 40% lower) ASP thermal inkjets.  Volumes are at all time highs, have doubled since the late 1990s, and have plenty of room to grow.  Yet revenues now are only slightly higher than those in the ‘90s.  Point being, with the vast majority of impact printers out of the sales mix, the top-line will no longer have this headwind going forward. 

TACT Historical Financials ($ in mlns)                                                                                                                        

                                                FY 03      FY 04      FY 05      Mar-06   Jun-06    Sep-06    YTD        TTM

POS and Banking                14.0          17.7         16.4         4.7           4.4           3.6           12.7         16.5

Gaming and Lottery             29.5         31.9         23.6         8.6           9.1           8.5           26.3         32.6

Services & Spare Parts        8.5           10.3         11.0         3.1           3.3           3.2           9.6           12.1

Total                                      52.1          59.8         51.1         16.4         16.9         15.3         48.6         61.1

G-Tech Sales                           9.8           8.2           7.1         3.7           4.2           1.8           9.7           13.1

Implied Slot Sales 19.8         23.7         16.6         4.9           5.0           6.7           16.6         19.5

Gross Profit                           15.5         22.0         15.6         5.7           5.7           5.4           16.9         20.0

Op Income                             3.8           8.2           0.2           1.6           1.4           1.6           4.6           3.5

EBITDA (excl. stk comp)    5.5           10.2         2.2           2.2           1.9           2.1           6.2           5.6

EBITDA - Capex                   4.2             9.0         (0.6)       1.2           1.1           1.7           4.0           2.7

EPS                                                         $0.52       $0.04       $0.11       $0.09       $0.10       $0.30       $0.22

Margins                                                                                                                

Gross Profit                           30%        37%        31%        35%        34%        36%        35%        33%

Op Income                             7%          14%        0%          10%        8%          10%        9%          6%

EBITDA (ex. stk comp)       11%        17%        4%          13%        12%        14%        13%        4%

Valuation:

Stock is at $8.30 per share with a $82M market cap.  TACT has no debt and $4.6 million of cash as of Sep 30 so the enterprise value is $77.5M.  Assuming EBITDA in 2006 will be somewhere between $7.5 and $8.0 million, this is equates to a decent multiple around 10x, and a lofty P/E in the 23x range. 

Looking ahead, I expect substantial EBITDA growth, primarily driven by gaming and lottery, will drive the stock price.  Using the $58M revenue assumption for gaming and lottery and adding $17.5M for POS / Banking  (high single digit growth from 2006), which could be much higher if Ithaca 8000 takes off, and $14M of Services and Parts revenue, (low double-digit growth from 2006 which is consistent with prior years and should be conservative given new sales staff and focus and growing installed base) I approximately arrive at $90M of revenue.  On the expense side I assume TACT can maintain a 35% gross margin and I add some dollars to the fixed cost base.  Specifically, I grow selling and marketing to $8.5M ($2 M higher than what I believe to be the current run rate, with the new staff) and I grow G&A a little to $7.5.  I leave engineering and development costs alone at $3M.   This results in an EBITDA forecast of $14-$14.5M, and a margin of 16%.  I’m not sure exactly when this will happen, probably won’t all happen in 2007.  But, TACT should at least be on its way to this number in 2007 and possibly hit it in 2008.  If they do, the company is currently trading at 5.4x EBITDA, 10.7x P/E and an 10x FCF multiple.

Finding direct public market comparables for TACT is not easy.  Zebra Technologies (ZBRA) is perhaps its most direct comp.  ZBRA is much larger (over $700M of sales) and has a much broader line of printers than TACT.  Most are focused around thermal receipt and label printing.  ZBRA’s business is somewhat more predictable, which argues for a higher multiple.  The stock currently trades at around 14x trailing EBITDA (12.4x 2007E EBITDA).  Other printer related companies include PTNX (makes printers for labels and other forms used primarily in industrial settings), EFII (makes superwide format printers and inks as well as medium and high speed printers for a range of end-markets from office to high-end production) and LXK (Lexmark sells printers and associated supplies and components for the home and office market).  EFII and PTNX trade around 9x 2007 EBITDA whereas the slower growing LXK trades at 7.6x 2007E EBITDA.  Looking at the slot OEMs, the average 2007E EBITDA multiple of IGT, WMS, SHFL and PGIC is 13x. 

Catalyst