USA Technologies Inc (USAT)

[FUNMAN]

USAT: Poised To Finally Start Creating Shareholder Value

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USA Technologies: Poised To Finally Start Creating Shareholder Value

By Nathaniel Grob
Feb. 22, 2017 10:13 AM ET

Summary

* Top line growth and non-financial KPIs have been trending nicely over the past several periods. Positive 2Q earnings boosted shares 20% on 2/9.

* I expect the company to turn profitable in the near term (<1 year), and begin to generate positive free cash flow to equity within the next two years.

* My fundamental analysis assumes impressive growth driven by secular trends, a growing customer base, and recurring sales.

* 35%+ upside appears reasonable.

Introduction

A leading provider of wireless and cashless payment devices and services within the self-servicing retail market, USA Technologies (NASDAQ:USAT) is a stock I've been monitoring for quite some time. The company's primary product and service, dubbed the "ePort," allows self-service machines to accept credit and debit card payments, payroll deduction payments, and mobile payments, including Apple pay.

ePort hardware integrates seamlessly into ePort software, and allows business owners to monitor sales and various analytics in real-time. You've likely seen these devices all across the country. If you've used a card to purchase a snack from a vending machine, there is a good chance the transaction was processed on an ePort.

Description of Business

A majority of USA Technologies' sales come through licensing and transaction fees charged to customers for use of the ePort, which account for more than 80% of revenues. Customers may either purchase a device outright, or enter a lease and pay a monthly blended fee based on a flat rate plus an additional transaction cost.

Many customers prefer to lease, as it reduces the initial cost of investment, and allows for smoother matching of cash inflows and outflows. USA Technologies has the option to: 1) keep the lease on its books, and recognize income over the term of the agreement, or 2) sell the ePort outright to a third party leasing agent, and recognize income immediately.

From an accounting perspective, option 1 leases are sales-type, thus a portion of income is recognized at inception of the lease (the excess of NPV over unit cost), while interest income is recognized over the remaining life. These are recorded as "finance receivables" on the balance sheet.

The company calls alternative 2 its "Quickstart" program, which launched in 2009, and has since grown to account for the majority of sales generated off the ePort. Recorded as accounts receivable, the company recognizes income immediately upon transferring rights as the lessor to a third party. This strategy has helped bolster sales, cash flow, and liquidity during recent periods.

As touched upon in the introduction, USA tech also provides various complementary services alongside their hardware, including cashless deployment planning, cashless performance review, and loyalty products and services. The company revealed its ePort Interactive (pictured below) in April 2016, a media and content delivery system that allows businesses to display nutritional information, multimedia marketing campaigns, and other content on a self-serve POS interface.

This device gives vendors a means of interacting with, and more importantly, influencing customers in a way never before possible. Consider the value in displaying targeted advertisements to consumers based on historical sales data and various other metrics directly at the point of sale. In my opinion, the ePort interactive is a monumental addition to USA Tech's product portfolio, and gives vendors an even greater incentive to switch to the company's wireless, cashless POS system.

Financial Condition

USA Technologies carries minimal long-term debt and an abundance of highly liquid assets, both major positives when evaluating the firm's ability to grow and adapt during future periods. A strong financial position gives management flexibility in planning and executing the strategic initiatives necessary to establish and maintain a competitive advantage. I am a firm believer in dissecting a balance sheet prior to making any investment, regardless of valuation multiples, earnings projections, or analyst recommendations.

As of 2017 fiscal quarter 2, cash and receivables sit at $18.0 and $8.2 million respectively, comprising 30% of total assets. Notice the increase in A/R due to implementation of the company's Quickstart program, and the decrease in finance receivables as fewer leases are being kept in house. Despite rising considerably compared to the same quarter last year, inventory remains relatively low at $4.8 million. Goodwill of $11.5 million relates to the 2016 acquisition of Vendscreen, a Portland-based tech company that specializes in developing and marketing touch screen devices for vending machines.

Another line item of note, the deferred tax asset in excess of $27 million, represents future tax savings resulting from the firm's large net operating loss carryforward. The IRS allows corporations to carry operating losses back two years, and forward twenty years, to offset taxable income, thus significantly reducing, if not eliminating, income tax expense. A majority of this amount will be available to offset taxable income over the next twenty years.





Most of USA Tech's liabilities are current, with accounts payable, accrued expenses, and a line of credit due of $9 million, $3 million, and $7 million, respectively. On the surface, these figures might concern some investors. However, I anticipate creditors should feel more comfortable granting an extension to a firm forecasting profits and strengthening cash flow. If necessary, though, USA Tech holds enough in cash and receivables to pay the line(s) off in full.






Operating Performance

The chart and table below illustrate USA Tech's impressive top line performance over the past several years. Revenue has consistently risen by double figures, and is on pace to do so once again during fiscal year 2017. The company typically sees higher relative sales during the latter half of the year, so the year-over-year top line increase will likely exceed 25%. TTM gross margin is on par with 2015 and 2016, at around 27%.

Note that because the company sells its Quickstart leases to a third party for a lump-sum cash payment, such transactions typically yield a lower gross margin. In order to compensate the buyer for default risk, the lease must be sold at a discount. I expect gross margin to hover around 27-28% in future periods, although it might decline slightly as sales become even more Quickstart-focused.







While bottom line results have bounced between the red and the black over the past several years, USA Tech appears to be on the cusp of turning consistently profitable. A handful of significant expenditures incurred during prior periods were either non-recurring or fixed. Take for instance SOX 404 audit fees of $700 thousand, and $1.6 million in costs related to the Vendscreen acquisition. The former is a fixed, recurring expense.

The latter is a non-recurring expenditure, albeit an expenditure that will help create profits and value over the long term. Both items, though, are highly material to an entity with less than $100 million in sales. If the company can maintain its top line momentum, it will be in excellent shape to hurdle expenses such as these and begin consistently generating shareholder value.

2nd Quarter Earnings Results

Positive second quarter earnings results, announced after market close on 2/8, boosted shares in excess of 20% on 2/9, hitting a high of $4.85. While the stock is typically thinly traded and quite volatile, such a dramatic jump is nonetheless intriguing. The company posted earnings per share of 1 cent, beating Wall Street's expectations of a 1 cent loss. Revenue, however, missed consensus estimates clocking in at $21.70 million vs. average expectations of $22.52 million.

$16.6 million represented recurring licensing/transaction fees, while $5.1 million related to hardware sales. In the conference call, management noted ePort net connection adds of 21,000, with total connections at period end of 469,000. These results represented a continued positive trend in both connections and cashless transactions processed as shown below.








Industry Outlook and Thoughts on The Future

In a recent article on PYMTS.com titled "How Self Service Retail Is Becoming Mainstream," USA Technologies' Vice President of Marketing Maeve McKenna Duska discusses the rapidly changing landscape of the self-service industry. She states:

The wave of vending operators that are embracing cashless and mobile continues to roll through the sector, because consumers like it and spend more. We've been seeing this build over the past year and a half or so, and the industry is really accelerating now.
The piece cites a recent major win for the company, an exclusive partnership with Premier Services, a Denver-based supplier of vending machines and coffee kiosks. The self-service industry is evolving into much more than just one-time, impulse purchases of coffee, sodas, and snacks, though. Vendors are using cashless payment technology to track spending habits, implement loyalty programs, and offer rewards benefits; this helps broaden the appeal of self-service vending to a myriad of new sectors.

The goal now is for those vending and self-service clients to meet traditional retail and brands where they do really well: technology, rewards, and payments. Duska said that customer relationships, self-service kiosks and vending machines can be used to expand those brands' reach and reputation...the evidence of that is popping up in the general retail ecosystem all the time: Snapchat releasing its Snap specs via a vending machine as part of its pre-IPO announcement buzz generation, or McDonald's recent efforts to give the world a free Big Mac-vended from a machine for the price of a twitter handle.
Duska's remarks got me thinking quite a bit about what the retail industry as a whole might look like in the future. It is not unreasonable to state that as a society, we seem to be drifting from both "attended" POS systems and cash only transactions. Our desire for human interaction, in all facets of life, is dwindling, while our infatuation with machines, and our favorite glowing rectangles, is only strengthening. I believe USA Technologies is at the forefront of the movement, and well positioned to capitalize on such a palpable secular trend.

I recently (and joyfully) learned of a "Pizza Atm" taking Xavier University campus by storm, which encouraged me to speculate what other services might become automated in the future. If engineers designed a machine capable of assembling, cooking, and distributing a pizza, could they not build similar devices for other products? I may come across as a bit too imaginative, but perhaps these machines could replace entire restaurants, allowing businesses to save on labor and overhead costs, while ensuring consistent quality and timely service.

Admittedly, it may take some time for consumers to get comfortable with the idea of eating fresh food processed, prepared, and distributed entirely by a machine. But on the other hand, the sheer novelty appeal might entice some individuals to at least give the technology a try. And I believe once consumers recognize the convenience of such transactions, they will become engaged by the self-vending experience in a way never before thought possible.

Putting It All Together: USA Tech's Fundamental Valuation

I typically avoid attempting to value firms that have not consistently produced free cash flow to equity. An exception to the norm, I see USA Tech as a company on the cusp of generating consistent bottom line returns. Further, I hold an extremely bullish stance on the cashless, automated retail industry, and USA Technologies' position within it; my forecasts in the paragraphs below reflect this belief.

In valuing the company using a DCF model, I assume year zero free cash flow (outflow) to the firm of -$1.86 million, USA Tech's trailing twelve-month operating cash flow of $.456 million, minus capital expenditures of $2.31 million. To determine free cash flow to equity, I subtract trailing twelve-month debt payments of $.516 million. Thus, free cash flow to equity in "year zero" equals $-2.37 million.

My cash flow assumptions are aggressive. Driven by an expanding customer base and the impending growth in cashless transactions, I project, on average, a 27% annual increase in revenue over the next 5 years, tapering downwards to a 15% growth rate in year 10. I forecast gross margins to decline by 25 basis points during periods one through three, as sales become more Quickstart-concentrated.

From years four through ten, gross margin sits constant at 27.55%. I assume an increase in SG&A expense of approximately 20% annually, based on a look-back analysis of the relationship between discretionary operating expenses and revenue. During year 1, I assume the firm will pay back $5 million of the amount due on its line of credit, and refinance the remaining portion.

In calculating the cost of equity, I utilize a risk-free rate of 2.45 %, representing the yield on a 10-year US Treasury note. I assume a market rate of return of 9.84%, implying a risk premium of 7.39%. My beta calculation blends the standard deviation method and a bottom-up approach, and comes in at .84. Thus, the cost of equity used in my model is 8.66%, determined by adding the risk-free rate to the market risk premium multiplied by the stock's beta.

The assumptions discussed above, and illustrated below, yield a fair value per share of $5.64, indicating upside in excess of 35%.







Note: As discussed and presented in USA Tech 10-Ks and 10-Qs (see "Accounting Policies" in the annual filing), a portion of depreciation expense, relating to the company's leases, is included in cost of sales. Depreciation on fixed assets, however, is presented as an operating expense. Thus, the total depreciation in my free cash flow to equity calculation and related forecast includes the portion attributable to leases (lumped into total cost of sales/revenues), and the portion relating to fixed assets.

Final Recommendation, Closing Thoughts

When writing research reports, I have a rule to avoid putting forth anecdotal evidence when at all possible. Let me relax this principal for just one moment. I live in the Midwest (one state over from USA Tech's Malvern, PA headquarters), and I see more and more ePorts popping up everywhere I travel. We have one installed on our office vending machine, I've seen them all over college campuses, and I've paid for my laundry using one.

I feel as though witnessing an industry develop rapidly right before my eyes, which makes it difficult to be completely impartial in my analysis. Nonetheless, I believe in the industry and I believe in the company. Invest at your own risk, but I consider USAT a buy, and assign a fair value of $5.70 a share.