Description

UIS – Investment Thesis

February 2020

Proforma for a recently announced divestiture, this post-turnaround, security-centric, high-recurring revenue, IT-services company is trading at <1/2 the multiple of its peers.  UIS will continue to rerate as the Company funds its massive pension liability and lowers total leverage from > 4x to < 2.5x. 

All figures presented in US$ millions, except for per share data.

EV and EBITDA for UIS, as referenced, adds back pension obligations and pension expense (consistent with management’s definition).

All share price data as of 2/24/20.

Situation Overview

Unisys Corporation (the “Company”, “UIS” or “Unisys”) is a provider of security-focused IT services and software to government (federal, state, local and international) and commercial end markets.

Despite dramatically improved operating performance over the last few years, Unisys’s share price has been tightly correlated with interest rates.  Its underfunded legacy pension plan represents over 50% of its TEV. As interest rates have declined, it pension liabilities have grown. Despite the strong performance of its equity-dominated pension assets, when the 10 year treasury drops so does UIS’s stock price.

On February 6, 2020, the Company announced the sale of its U.S. Federal assets to SAIC, for $1.2bn or 13.0x LTM 9/30/19 EBITDA.  The proceeds from the transaction will be used to pay down $440mm of senior notes and $600mm of pension obligations. Pro Forma for the transaction, net leverage will decrease from 4.2x to 2.4x (including pension obligations), 2020-2022 annual pension cash contributions will decrease by $200mm and interest expense will be reduced by an additional $50mm.  The remaining annual fixed charges for the next 3 years of approximately $120mm will be easily covered by our estimated annual average annual free cash of flow $150mm. 

In addition to mitigating the near and medium term pension overhang, the transaction paves the way for a swap of the remaining pension liabilities for debt; which will be immediately accretive on a cash-basis and reduce any remaining overhang for equity investors.

Pro forma, UIS generated ~$2,260mm of revenue and ~$360mm of EBITDA. Based on the current stock price of $16.26, Pro forma UIS trades at 5.2x LTM EBITDA, a 50% discount to its peers. 

Overview

We recommend Unisys as a long with a target price of $26.49 (~60% upside).

Unisys’s offerings range from data center buildouts and maintenance to CRM and ERP staffing and BPO services.  The majority of offerings are focused on security and >85% are supported by long term contracts.

UIS was the first company to bring cloud to the federal government[1].  In the transportation end-market, UIS is responsible for tracking ~50% of the world’s cargo[2].  In the financial services sector, UIS serves >600 financial institutions and manages clearing houses for over $1tn in daily transactions.  In the healthcare sector, UIS helps pharmaceutical customers optimize their clinical trial processes.

The Company’s Services segment ($1.9bn PF revenue, ~6.5% EBITDA margin) offers outsourcing, infrastructure services, consulting and maintenance services to help clients develop and analyze data, enhance security across platforms and improve cost efficiencies.

The Company’s Technology segment ($400mm PF revenue, >50% EBITDA margins) primarily consists of its ClearPath Forward security-centric operating system.  According to the National Institute of Standards and Technology, ClearPath is the only operating system that has never been forcibly hacked, and as such is used in environments where security is mission-critical: the IRS, New York Clearing House and Lloyds Bank are among the Company’s customers.  Renewal rates exceed 97% and EBITDA margins are estimated to be >50%[3]. This segment also houses the Company’s Stealth offering, a host of security products that are embedded across corporate IT networks. Stealth separates trusted systems, users and data from the untrusted. It further reduces attack surfaces by encrypting all communication between Stealth-protected assets and cloaking the assets from unauthorized users.

Following the sale of the Federal asset, UIS will retain ownership of most of the supporting IP.  As SAIC sells UIS’s IP into its own much larger federal customer base, UIS will receive a growing high margin fee stream.  The Company will retain its state, local and international government businesses and continue to repurpose government approved security-focused capabilities into commercial markets.

 Selected Product and Service Examples (CJS research, 2/26/19)

The Company has additional software offerings which can be sold independently, but are often bundled with their service solutions:

InteliServe: A user-centric, service desk.  Allows users to access support services securely and in a simple and personalized manner across all channels.

CloudForte: Managed service offering that automates secure digital transformation and cloud operations on AWS and Azure. 

TrustCheck: Analyzes the financial impact of risk products.  For example, the insurance industry uses TrustCheck to issue cyber insurance policies.

Managed Public Key Infrastructure: One of a handful of government-certified PKI providers: Authenticates users and devices for networks access.

Digistics: Cargo logistics solution that allows carriers to streamline freight management.

LineSight: Assesses potential risks presented by travelers and cargo shipments.

Aircore: Passenger reservation system with 20% global market share.

Elevate: Digital banking software platform instantly enabling secure omni-channel banking.

ActiveInsights Med Device: Company-wide medical device management and monitoring platform.

 Timeline of Recent Events

The Company’s current CEO has been in place since 2014, having sold the prior two businesses he led (Perot Systems (CEO 2004-2009), MICROS Systems (CEO 2013-14)).  Since his appointment, there has been a material improvement in the Company’s growth trajectory, margin profile and mix of recurring revenues. However, fundamentals have been masked by the massive underfunded pension plan.  Given the downward slope of interest rates, the Company’s pension obligations have increased accordingly, which in turn suppressed its equity value. In addition, lack of sell-side research and thin liquidity has also impacted UIS’s valuation.

Our thesis centers on the following points:

1)  The reduction of pension obligations mitigates the stock’s principal overhang and shifts investor focus back to fundamentals.

2)  PF UIS is an attractive asset: favorable end markets, sticky recurring revenues (>85%), and a long-tenured client base.

3)  As the operational transformation approaches completion and the improved balance sheet supports additional bid activity, margins and organic growth will continue to improve.

4)  Strong FCF and substantial tax assets (>$1.6bn) will further strengthen the balance sheet and drive equity appreciation.

 Investment Thesis

1)   The reduction of pension obligations mitigates the stock’s principal overhang and shifts investor focus back to fundamentals

As shown below, the Company’s share price has historically tracked interest rates as the stock was viewed as a hedge against rates.

We expect the mitigation of pension obligations will attract a broader set of investors who will value UIS based on its fundamentals vs. interest rates.  The reduction in leverage from 4.2x to 2.4x (below the industry average of 3.5x[4]) will also make the stock more appealing to additional equity investors.  

After the Company contributes the $600mm to its U.S. pension liability it will finally have cleared the 80% regulatory hurdle that has prohibited it from refinancing its pension exposure previously.  Management has indicated that in the next few months they will swap the remaining pension obligations with a new leveraged structure. Given the favorable capital markets environment, the Company’s high earnings visibility and strong FCF profile, we expect such a transaction will be immediately cash flow accretive and remove any remaining overhang on the stock.

2)   PF UIS is an attractive asset: favorable end markets, recurring revenues (>85%), and a long-tenured client base

UIS is a leading cloud-based, infrastructure services and software player with expanding margins.  Under the current CEO, the Company’s high-performance, security-centric solutions have gained meaningful traction.  As UIS retains the IP that has been deployed for the federal government, we expect continued wins with commercial customers.  The Company also believes additional cross-sell opportunities remain. The Company’s NPS score is in the mid-40s, a meaningful improvement to historical levels and significantly above peers in the mid-20s[5].  

Revenue Mix (prior to the Federal Sale)

Recurring revenue is defined as Services with minimum 3-5 year contract terms and Technology which has had a 97% retention rate.  In aggregate, recurring revenue has consistently exceeded 80% of total revenue. The top 10 customers have had an average tenure of over 30 years.  Switching costs are high given how deeply integrated the Company’s products and services are within its customers’ processes.   

Operating as a critical vendor for the most sensitive functions of the U.S. government has served as the ultimate stamp-of-approval for the Company’s commercial customers, which span a wide range of sectors including transportation, healthcare, financial services and retail end markets. 

 Selected Customers

3) As the operational transformation approaches completion and the improved balance sheet supports additional bid activity, margins and organic growth will continue to improve.

Unisys’s current CEO, Peter Altabef, has implemented numerous changes since his appointment: a narrowed set of targeted end markets, expanded and integrated security offerings across product suites, a modernized technology stack, discontinuation of unprofitable legacy contracts and the rationalization of costs across the business with a focus on enhancing operating leverage.

The changes have resulted in the reversal of revenue declines and a significant improvement in margins.

Historical Revenue and EBITDA Performance

Management has indicated that they see further opportunity to enhance margins for the remaining business.  As a frame of reference, their non-federal IT services peers have EBITDA margins in the 16-20% range.

The divestiture will free up capital to invest more in R&D, marketing, and bid more aggressively on new projects.  Given current management’s track record of introducing new solutions to drive growth, we are optimistic about their prospects. 

4)  Strong FCF and substantial tax assets (>$1.6bn) will further improve the balance sheet and drive equity appreciation

We estimate that post the transaction, UIS will generate over $150mm in annual free cash flow.  The Company currently has ~$1.6bn[6] of tax assets which will limit tax leakage on the sale as well as future cash taxes.

PF Free Cash Flow Build

The Company’s 15% FCF yield is highly compelling, particularly in the context of a growing, IT-services asset with high recurring revenues.  We expect the FCF profile of the business to support a successful refinancing of the remaining pension obligations.

A refinancing also opens the door to M&A.  The IT services market is highly fragmented and UIS has been unable to participate in sector consolidation due to its high leverage and high cost of capital.  Management has attempted to proactively address prospective capital allocation concerns; referencing a successful prior track record of and interest in accretive, bolt-on assets vs. strategic, transformative acquisitions.

Valuation

UIS trades at a material discount to its peers in the IT services segment.  We believe a degree of discount is warranted given relative scale, remaining pension obligations and lower margin profile, but view the current trading discount as excessively punitive.

Comparable Companies Analysis (7)

For purposes of our valuation, we have assumed an EBITDA multiple range of 6.0x-8.0x.  If the Company continues to leverage its strong security offerings for further growth and margin expansion, these multiples should prove absurdly conservative.  

Valuation Range(8)

As an additional check on valuation, an 8% FCF yield would result in a share price of $29.41, 80% above the current trading price or equivalent to an EV / EBITDA multiple of 7.5x vs. the current trading multiple of 5.2x.

Risks

1)      IT budgets

IT budgets are not impervious to economic cycles or the Coronavirus.

However, Gartner forecasts growth of 5.5% for IT services, and expects that cloud security will grow over 40% over the next five years[9]. 

We believe UIS is uniquely positioned to succeed given its focus on industrial-strength security solutions and will take share in an environment where security vulnerabilities are top-of-mind. 

2)      Competition

The Company is a fraction of the size of its largest competitors.  However, our customer checks have been consistently positive and confirmed an incredibly high retention rate. We believe there will ultimately be takeout interest for the remaining business from competitors who possess greater distribution capabilities, but covet UIS’s product set, related-IP and long term commercial customers.

3)      Pension obligations remain outstanding and a further decrease in interest rates may result in a higher pension obligation

With >$1bn in pension obligations outstanding and $40mm of ongoing annual cash contributions in the near term, the Company’s stock is still likely to be influenced by the trajectory of interest rates.  We view incremental refinancing as the principal catalyst for a further stock re-rating.

4)      Flat to low-growth Technology segment

While retention rates for the Technology segment have exceeded 97% for several years, a reduction in Technology revenues would have an outsized impact to EBITDA given its strong margin profile. 

Management is forecasting continued high retention, but limited Technology segment growth.  The TAM of potential customers that require the exceptionally stringent security at scale for mission-critical operating systems (that has never been breached) is fully penetrated.  However, management does see opportunity for greater growth in the Services segment supported by its deep security capabilities and improved balance sheet.

5)      Company reports Q4 results on February 25th

The stock is up big post the announcement and probably looks “overbought” on all technical indicators.  While the Company has already confirmed 2019 guidance, we have no view on guidance for 2020 or “the market’s” expectations.

[1] https://www.unisys.com/news/News%20Release/With-Help-from-Unisys-GSA-Becomes-First-Federal-Agency-to-Transition-to-Cloud-Based-Google-Apps-for-Government-Solution

[2] Call with management, 9/26/19.

[3] CJS equity research, 2/7/20.

[4] UIS call, 2/6/20.

[5] UIS call, 4/9/19.

[6] Prior to the announcement of the Federal transaction. The Company has not yet quantified PF tax assets.

[7] UIS EV, Revenue and EBITDA are PF for the sale of the Federal segment.

[8] PF LTM 9/30/19 EBITDA calculated as LTM 9/30/19 EBITDA of $451.6mm less $92.3mm Federal Segment EBITDA (based on the consideration of $1.2bn and a 13x LTM multiple).

[9] https://www.gartner.com/en/newsroom/press-releases/2019-10-23-gartner-says-global-it-spending-to-grow-3point7-percent-in-2020

Catalyst

 Catalysts

1)  Refinancing and/or repayment of remaining pension obligations

2)  Additional sell-side coverage

3)  Continued marginal margin expansion and growth