Description

We believe shares in USA Technologies, Inc. (“USAT” or “USA Tech”) are misunderstood by the market and that the company has an outstanding, cash-generative, non-cyclical business model with a multi-decade growth opportunity in front of it.  In our view, we think USAT shares are worth at least $6-8 per share (100%+ upside) based on our current forecast of year-end 2016 run-rate free cash flow.

USA Technologies, Inc. (NASDAQ: USAT)

USA Tech is a payment processing company located in Malvern, Pennsylvania.  USAT common shares are listed on the NASDAQ Stock Market and currently trade for $2.89 per share.  We believe the company has an outstanding, cash-generative, non-cyclical business model with a multi-decade growth opportunity in front of it – and that USAT shares are worth at least $6-8 per share (100%+ upside) based on our forecast of year-end 2016 run-rate free cash flow.

The Trick to Investing

In 1994, Charlie Munger – Warren Buffett’s partner at Berkshire Hathaway (NYSE: BRK) – gave a lecture at the University of Southern California.  In his speech, Munger described the roots of Berkshire’s investment success:

“The bulk of the billions in Berkshire Hathaway have come from the better businesses…In some cases, we bought the whole business.  In some cases, we just bought a big block of stock.  But when you analyze what happened, the big money’s been made in the high quality businesses.”

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.  If the business earns 6% on capital over 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount.  Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a fine result.  So the trick is getting into better businesses.”

Munger went on to caution that investing is a function of both value and price – there are moments (such as the “Nifty-Fifty” craze of the 1960’s when high-quality companies were bid up to bubble-like valuations) when purchasing better businesses can be a less-attractive proposition.

“But if you can find a fairly-priced great company and buy it and sit,” he declared, “that tends to work out very, very well indeed.”

The Characteristics of a Great Business

So what is it that makes a great business “great”?

The most important attribute of a great business, in our view, is the presence of a moat – a sustainable competitive advantage that permits the business to earn an outsized return-on-capital.

Moats come in many forms.  Supply-side economies-of-scale allow Wal-Mart Stores, Inc. (NYSE: WMT) and Amazon.com, Inc. (NASDAQ: AMZN) to sell products more cheaply than competitors because their scale empowers them to negotiate better prices with suppliers and to invest in some of the world’s most efficient distribution networks.  Signet Jewelers Limited (NYSE: SIG) – the owner of Kay Jewelers, Zales, and Jared The Galleria of Jewelry – achieves more advertising “bang for its buck” because its nationwide presence enables it to buy national television commercials while smaller rivals must rely on less-cost-effective local advertising.

There are also demand-side economies-of-scale.  Unlike mom-and-pop pizzerias, Domino’s Pizza, Inc. (NYSE: DPZ) has the resources to invest in technology such as mobile apps that have proven a game-changer for driving demand and tracking customer preferences.  Facebook, Inc. (NASDAQ: FB) benefits from the network effect of having more than one billion active users on its social media platform.  The wealth of data possessed by Alphabet Inc. (NASDAQ: GOOG), the owner of the Google search engine, and the company’s billions of dollars of investment in its online ecosystem, makes it near-impossible for a rival search engine to emerge.

Another form of moat is a brand.  Consumers happily pay an extra fifty cents for a box of Cheerios (owned by General Mills, Inc. (NYSE: GIS)) or a bottle of Tylenol (owned by Johnson & Johnson (NYSE: JNJ)) instead of the generic equivalent cereal or painkiller, even though the branded and generic versions cost roughly the same to produce.  Regulatory protection grants utilities natural monopolies with “guaranteed” rates of return in exchange for a higher degree of government oversight.  Patents and intellectual property allow firms like QUALCOMM, Inc. (NASDAQ: QCOM) – which owns patents underpinning 3G and 4G wireless networks – to earn a robust return so long as wireless telephone companies continue to rely on such networks for data and cellular services.

But, in our opinion, it’s not just a moat that defines a great business; there are also particular characteristics that make some businesses more valuable than others:

·         A company with growth is worth more than a company that is shrinking.

·         A firm with a #1 or #2 market position is more valuable than an undersized peer.

·         A non-cyclical business with dependable cash flows is worth more than a cyclical business with cash flows that fluctuate across economic cycles.

·         An asset-light company with low capital requirements is more valuable than an asset-heavy company that requires significant expenditure to maintain or expand its operations.

·         A firm with a diversified customer base is worth more than a firm that relies on only one or a few customers for its revenues.

·         A business with good visibility on future profits due to high recurring revenues and low customer churn is more valuable than a business with poor visibility, low recurring revenues, and high churn.

Though none of these characteristics are a “moat” per se, they are important traits that help distinguish a high-quality business from its lesser peers.

A World Going Cashless

In the 1987 Berkshire Hathaway letter to shareholders, Warren Buffett outlined his thoughts on investing in good businesses.  He observed that “really good…companies are in businesses that, on balance, seem rather mundane.  Most sell non-sexy products or services in much the same manner as they did ten years ago.”

He might as well have been describing USAT, which operates in a decidedly unsexy industry: vending machines.

There are six million vending machines in operation today in the US.  Total annual industry sales are roughly $45 billion, which works out to about $7,500 per vending machine per year.  The average transaction size is very low, clocking in at just above $1.00, and the low-dollar nature of the business makes it steady and non-cyclical.  Ownership of vending machines is fragmented with an estimated 17,000 unique owners ranging from single-unit proprietors to professional organizations with more than 100,000 machines.

Since the first modern coin-based vending machines were invented in the 1880’s, the vending machine industry has been largely cash-based.  Even today, with credit cards nearly ubiquitous and consumers increasingly moving to digital payment systems (like PayPal or Venmo) and near field communication-enabled (“NFC-enabled”) mobile payment systems (like Apple Pay, Android Pay, or Samsung Pay), 5.5 million vending machines in the US still do not accept credit cards or mobile payments.  The “cashless” revolution has arrived, but more than 90% of vending machines remain stuck in the stone age of cash and coin.

USA Tech represents the tip of the spear changing this dynamic: USAT provides a complete end-to-end cashless ecosystem for the unattended point-of-sale (“POS”) market which includes (i) vending machines and (ii) other unattended units such as commercial laundry machines and kiosks.  The vast majority of USAT’s connections are vending machines with other POS end-markets comprising a tiny piece of the pie.

Once upgraded with USA Tech’s solution – a front-end proprietary ePort Connect device and back-end transaction processing and remote monitoring systems – unattended POS units are able to accept a variety of cashless forms of payment such as credit/debit cards and all major NFC-enabled mobile payment systems.  USAT acts as a third-party payment processor (a “TPPP”) and provides value-added services including online sales reporting, inventory management, asset monitoring, loyalty programs, and data analytics.

Importantly, USAT’s product serves a genuine, economic need of its customers.  Vending machine owners are increasingly losing sales from customers who do not carry cash or who prefer to pay using a cashless method.  In addition, the average transaction size is far higher in a cashless transaction – enabling vending machine owners to stock more-expensive, higher-margin products (e.g., a can of Red Bull instead of a bag of pretzels).  One recent customer found that after installing USAT’s solution, 34% of sales were completed using cashless forms of payment and the average cashless transaction was 43% higher ($1.74 vs. $1.21) than the average cash transaction.  The impact on the bottom-line for vending machine owners is significant and undeniable.

Boring Can Be Beautiful

Vending machines may be a “mundane” industry, but we believe USAT’s business model is outstanding.

USA Tech has achieved scale with 333,000 in-force connections, more than 5x the number of connections of its nearest competitor and a dominant #1 market share of 70%+.  The company’s operations are asset-light as third-party contract manufacturers produce the ePort Connect devices and USAT’s customers provide the “feet on the street” to install the devices one-by-one onto vending machines.

Customers pay USAT a monthly license fee and a percentage (generally 3-5%) of sales transacted using cashless methods; we forecast that in FY2016, more than 85% of USAT’s revenues will be recurring in nature in this largely non-cyclical industry.  Churn is de minimis at less than 1% per quarter (and even then churn is likely overstated as a vending machine moved from one location to another is generally counted as a “deactivation” followed by a “new connection”).  USAT’s customer base is well-diversified with more than 9,600 active clients.

We think USA Tech has three important sustainable competitive advantages that constitute the company’s moat.  First, USAT is the only major provider of cashless solutions to the vending industry that is also a TPPP.  USAT’s primary rivals – Crane Payment Innovations (“CPI”, part of Crane Co., NYSE: CR) and Cantaloupe Systems (“Cantaloupe”) – are not TPPP’s and therefore cannot offer full end-to-end solutions.  USAT’s rivals have attempted to stake out targeted niches (CPI focuses on hardware while Cantaloupe specializes in vendor route management software), but they are nevertheless at times obligated to partner with USAT to win business.

Second, the practical realities of managing a vending business accord an advantage to first-mover suppliers who, once deployed, are difficult to dislodge.  To deactivate USAT’s units in the field, for example, a customer must physically visit and remove each system one-at-a-time.  Finally, vending owners prefer a single cashless ecosystem over dealing with multiple platforms; by gaining a foothold with more than half of all vending machine owners, USAT has capitalized on its scale and first-mover advantage to build a high barrier against new entrants.

USAT’s growth runway can be measured not in years but in decades as the firm benefits from a triple-tailwind:

1.     Customer Acquisition.  USAT has nearly tripled its active customer count over the last three years from 3,300 to 9,600 and continues to add roughly 500 new customers per quarter.

2.     Customer Penetration.  USAT has only penetrated 10% of its customer base, which owns an estimated three million vending machines.  Over time, we believe substantially all vending machines will shift to accepting cashless payments and that USAT’s largest opportunity is with existing customers.

3.     Cashless Adoption.  USAT is paid only on cashless transactions.  Though the average vending machine achieves $7,500 in yearly sales, the typical USAT customer’s vending machine executes only $1,300 per year in cashless transactions (less than 20% of sales).  As the proportion of cashless sales rises towards 50% and beyond, USAT will capture an increasingly large slice of the vending machine revenue pie.

With some sophisticated customers already accepting cashless payments on 100% of their machines, USAT’s market opportunity is in the millions of connections with sales per connection well above the current rate.  Over the last four years, USAT has grown connections 29% per year, license and transaction fees 28% per year, and revenues 30% per year.  We believe USAT can continue to grow at a similar pace for many years to come.

A Shift in Business Model

USA Tech was founded in 1992, but the firm did not hit its stride until the early-2000’s when management re-focused the business on developing cashless payment solutions for the unattended POS market.  In 2005/06, MasterCard Incorporated (NYSE: MA) and Visa, Inc. (NYSE: V) partnered with USAT to install 40,000 cashless devices on vending machines.  The large contract enabled USAT to up-list to the NASDAQ in 2007.

At the time, USAT’s ePort Connect device cost $500 apiece, making it uneconomic for most vending machine owners to install.  By 2010, USAT had driven the cost down to almost $200, but the still-meaningful initial expense in a low-margin, cash-based industry remained an important barrier to customer adoption.

In late-2009, USAT launched its JumpStart program with USAT paying for each device’s up-front cost and charging customers an ongoing rental expense.  The program worked – perhaps too well.  As connection and revenue growth accelerated, USAT grappled with the difficulties of a model that required substantial capital outlays.  In FY2014, for example, free cash flow (defined as cash from operations less capital expenditures) was negative $4M as $7M in cash from operations was more than offset by a staggering $11M in cap-ex spend.

Ten months ago, USAT went live with the final step in its business model evolution: the QuickStart program.  Under QuickStart, third-party lessors purchase the ePort Connect devices and then lease them under five-year contracts to USAT’s customers.  As a TPPP, USAT sits in the middle of the transaction – allowing the third-party lessors to minimize counterparty risk (as they are paid first), making the leases attractive to the lessors at reasonable terms.  Sales under QuickStart represented most of USAT’s devices sold in the most recent quarter.

We think the QuickStart program is a game-changer for USAT and a win-win-win for the parties involved.  Customers can continue adding connections without a large up-front cash outlay.  Third-party lessors can achieve attractive IRR’s on leases that have a history of minimal defaults.  And most importantly, USAT has dramatically improved its visibility and free cash flow profile as QuickStart has a de minimis impact on cash from operations, capital expenditure drops precipitously from double-digit millions to a few hundred thousand dollars per year, and customers are locked into five-year commitments to continue using USAT’s services.

Over the last six years, USAT’s connections have grown more than six-fold while operating expenses (“SG&A”) have remained flat.  As QuickStart takes hold and USAT continues adding connections, we expect the company’s operating leverage and free cash flow production to be substantial.

A Timely Opportunity

We believe it is a favorable moment to invest in USAT for two reasons.

First, our thesis is predicated on USAT generating meaningfully more free cash flow going forward due to the shift from JumpStart to QuickStart.  We believe the benefits of QuickStart, launched in mid-FY2015, were masked over the last few quarters (i) as USAT experienced a build-up in finance receivables while getting QuickStart off the ground and (ii) due to an accounting technicality that caused millions of operating cash flow to appear in cash from financing rather than cash from operations.  We anticipate that in FY2016, the build-up in finance receivables will reverse and the company’s cash flow production will be clearly visible in the financials.

Second, USAT shares experienced recent volatility as the company delayed the filing of its 10-K by two days due to a modest (less than $300,000 net) restatement of its bad debt expense line item.  The restatement occurred weeks after hiring a new, more-experienced CFO who was previously the CFO of a multi-billion-dollar bank.  The prior CFO has since departed the firm.  We believe the restatement is behind the company and that the new CFO is capable and has implemented procedures to correct any problems that existed before his arrival.  We also were pleased to see the company’s auditors provide USAT with a clean bill of health.  It is only a matter of time, in our view, before the market puts this event in the rear-view mirror as a non-issue.

Conclusion

USAT shares trade at $2.89 apiece.  By year-end 2016, we think the firm’s annual free cash flow run-rate will be $12-15M.  In our view, a non-cyclical business with long-term contracts, strong revenue visibility, and 30% annual revenue growth should trade at an extremely high multiple of those cash flows.  A 20x multiple on $12M of free cash flow is a $6.50 stock.  A 25x multiple on $13.5M of free cash flow is a $9 stock.  A 30x multiple on $15M of free cash flow is a $12 stock.  In this case, we do not know exactly what USAT is worth, but we are confident that $2.89 per share is not the right number.  And importantly, as the company adds connections and generates cash flow, we believe the business increases in value every day.

Catalyst

• Recent volatility from two-day delay in filing 10-K fades from memory as a non-issue.
• Substantial free cash flow shows up in the financial statements in FY2016 and beyond.
• Company continues to grow net connections at a rapid pace.