Description

Unisys is an IT services business that has been discarded by the market after years of failed strategy and declining revenues.  The last 2 quarters offered the first credible signs of a turn since CEO joined 3yrs ago and overhauled leadership. Only 3 analysts cover it, and market cap is $875m.  Enterprise value is $2.8B, largely due to legacy pension plan that closed in 2006, but has ballooned due to poor asset performance and declining interest rates. If management achieves stated goals, UIS is likely worth ~$18.  If interest rates rise any meaningful amount, the equity upside can be material, as each 25bps increase in assumed discount rate reduces the pension obligation $253m.

Thesis rests on the following pillars:

1. Business appears to be near, if not already reached, inflection point reversing nearly a decade of revenue declines
2. Well regarded CEO, Peter Altabef, with new senior leadership appears to have accomplished culture change at poorly performing company.  Also sold the last two businesses he led--Perot Systems (2009, to Dell), MICROS Systems (2014, to Oracle)
3. Valuation highly sensitive to interest rate increases, do not invest here if you expect lower long-term rates (pension obligation declines ~$250m for each 25bps increase in discount rate)
4. If profits sustained, potential to unwind $1.4B deferred tax asset valuation allowance; also potential value to an acquirer
5. Underappreciated “Lollapalooza effect” in bull scenario.  

Company information

Unisys provides global IT services focused on security, operating in Services and Technology units.  Service (88% rev) includes cloud and infrastructure services, business process outsourcing and others.  Technology (12% rev) develops servers and software products. The company was founded in 1886, and had traditionally been hardware focused.  The current incarnation is product of the merger of mainframe computer companies Burroughs and Sperry in 1986--Unisys has shifted to a mostly service model over time.  The company has been under new management since 2015.

Technology is an inherently high margin business, selling software products to clients for specific business needs.  Services are much more labor intensive. Technology margins are improving under a new strategy of focusing on the most “leverageable” existing products and selling them across customer base.  Under prior regime, technology solutions developed for a client served that purpose only and sat on shelf.

What’s different this time?

This is a company which, under new management, has refocused its go-to-market to an industry basis

• Deeper relationships in fewer sectors

• Greater transparency within company.  Had been very siloed and solutions created for a specific client were not sold to other relationships.  Stealth is the prime example of this.

• Believe security tools are differentiator to other Service competitors.  Security embedded in every product and discussed in every interaction with customers and investors.

Unisys is a high recurring revenue business, with average contracts 3-5yrs and many customers remaining with the same provider for decades.  These attributes are attractive as an incumbent, but make it very difficult to win new business. This also helps explain why the recent turn in business has come 2-3 years after new executives joined.  As a subscale player, Unisys has lacked the product offerings to guide customers on their long-term IT roadmaps, and has slowly lost many of them over time. New management has worked to stanch this decline by ceding business where they had no proprietary offering, while focusing deeper in the handful of areas where they have 1) a technology edge, 2) ability to hold solid market share, 3) end market growth.  This strategy seems sensible.

Recent results suggest the plan is working, as after a long history of declines, revenues are beginning to flatten as of Q4 17.

Backlog growth has also reached its highest level in years:

Continued progress will depend on execution, as prior leadership fell short on variants of a similar strategy.  I haven’t gotten a definitive explanation of what went wrong in the past, but all parties I have spoken to offer some variation of prior leaders “took their eye off the ball.” While this is a concern, based on the current team’s track record with other companies and early results at Unisys, betting on them seems worth the risk given upside optionality.

CEO/management background

An interesting aspect of the business is that CEO Peter Altabef joined at the end of 2014, and sold the prior two businesses he led.  First was Perot Systems (CEO 2004-2009), followed by MICROS Systems (CEO 2013-14). If UIS develops a path to growth, they may also be an attractive target.

M&A aside, Altabef has recruited a decent group of senior leaders for a company assumed to be in peril.

Balance sheet

The balance sheet is benign on a net debt basis ($9m net cash 3/31/18).  No material maturities until 2022. However, pension deficit is significant, and the crux of the story.

Pension: The pension had a modest surplus a decade ago, but now has a $1.9B deficit, largely due to $3B+ actuarial losses over the last decade, primarily due to lower interest rates.  As mentioned, the obligation declines by ~$250m for each 25bps increase in discount rate. The obligation at FY17 assumes 6.8% and 5.3% return on US and non-US assets, respectively.  This has come down from 8.0% and 6.4% in FY13, possibly suggesting some conservatism.

DTA: At 12/31/17, the company had a $1.55B deferred tax asset, though is was mostly offset by a $1.44B valuation allowance.  As the company returns to consistent profitability, this value may be recognized, although my valuation assumes zero.

Risks

The fundamental risk is this is an average business in a highly competitive market.  Regardless of inherent customer stickiness, many larger companies comprise the bulk of market share in Unisys core areas.  The world would survive in the (unlikely) event Unisys went away. The more pressing risks are:

• Interest rates materially decline

• Business recovery stalls

• Leadership departures

• Economic weakness

Given the leverage embedded in the pension deficit, there is less room for operational or macro challenges than at a typical company.

Valuation

Several different approaches to valuation.  In DCF, assuming 2% long-term revenue growth (industry 2-4%) and 5.1% adjusted EBIT margins improving to 8% in 2021+, implied share price is $13+ using 9% WACC.  Management’s 3-5 year target is 2-4% revenue growth and 9-12% adj. EBIT margin (these assumptions result in the ~$18 DCF value referenced in introduction).

“We think it’s a realistic plan.  Would I be satisfied with that plan as a company?  Yes. Do I think we can do better as a company? Yes, I do.” Peter Altabef, November 2017

Looking at trailing performance, UIS earned $400m adj. EBITDA and $232m adj. EBIT in FY17.

Peers trade in the ranges shown below, implying modest upside for UIS using lowest peer multiple.

Neither of these approaches assume any benefit from interest rates.  As mentioned, each +25bps in discount rate reduces pension obligation $253m, roughly $3.45/sh, or 28% of current market cap.  I do not include any value for the deferred tax asset, although it could have value to an acquirer or as UIS regains sustained profitability.

Conclusion

The opportunity here is an average (at best) company showing signs of improvement under new management that has a strong history of improving and selling businesses.  On this basis it is modestly undervalued, but any increase in interest rates should offer meaningful upside to equity owners.

Catalyst

Improving business performance driving profit and unwinding valuation allowance

Potentially higher interest rates

Sentiment shift as revenue trajectory returns to positive

Acquired