USAT has reached an inflection point
Mar. 2, 2017 3:49 PM ET
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Summary
USAT has reached an inflection point as they approach 500,000 connections and shift focus to increasing cash generated from operations.
Increased adoption of cashless options at vending machines and conversions of potential connections will drive profitability.
Reduced pace of SG&A growth and improving margins will contribute to sizable FCF generations.
USA Technologies Inc. (NASDAQ:USAT) is a leading provider in the small ticket, beverage and food vending industry and is expanding their solutions and services to other unattended market segments, such as amusement, commercial laundry, kiosk and others. Primarily acting as an intermediary between vendors and credit card processors, they also provide services such as data collection and feedback. I posit that as a market leader, they are in position to capitalize on industry trends as they approach long-term profitability.
Industry Trends
USAT operates within the unattended point-of-sale (POS) industry primarily in the small ticket electronic payment market both domestically and overseas. The growth of cashless payments and the increasing adoption of mobile payments are expected to fuel revenue growth. By 2019, spending in the U.S. from credit, debit, prepaid, and electronic benefits transfer cards are expected to rise to 67.03% of transactions dollars measured compared to 57.34% in 2014, per The Nilson Report. The percentage of vending machines equipped for cashless transactions increased to 15% in 2015 from 11% in 2014, offering vast growth potential.
Technological developments have concentrated on providing dual benefits for both consumers and the merchants who implement it. Providing the option of non-cash methods increases the number of potential transactions and improves convenience as an individual would not be hindered by a lack of cash or exact change.
Similarly, merchants are able to capitalize on readily available feedback, allowing them to strengthen operations. Emerging electronic transaction functionalities provides them with real-time sales and inventory data useful for forecasting purposes as well as information regarding purchasing patterns and specific payment preferences.
With the increased adoption of mobile payments and the strong forecasted growth, integrating near field communication (NFC) technology will facilitate an increase in possible transactions. Android (GOOG), Samsung (OTC:SSNLF), and Apple (AAPL) are expected to drive this adoption, and USAT seeks to capitalize on this; which is evident considering 70% of the company's connections are enabled to accept NFC payments.
Business Operations and Management Direction
(Source: USAT Investor Presentation)
As stated in the most recent 10-K filing:
[USAT's] primary objective is to continue to enhance our position as a leading provider of technology that enables electronic payment transactions and value-added services primarily at small-ticket, self-service retail locations such as vending, kiosks, commercial laundry, and other similar markets.
The company earns revenue through license and transaction fees resulting from connections to and services provided by their ePort connection service in which payment information is captured and transmitted to credit card processors.
(Source: USAT Investor Presentation)
USAT also offers premium services, which integrate the data collected to assist with planning, marketing, performance evaluation, etc. Current customers are primarily self-service, small ticket retail markets such as food and drink vending and kiosk, commercial laundry, car washes, tolls.
Connections to the ePort Connect service is the most significant driver of earnings (73%) due to the scale. At the close of FY16, ePort had about 429,000 connections representing an almost 30% increase compared to FY15. The company earns a percentage of each transaction (~3%) as well as a fixed monthly fee per connection (~$8/month). These fees are recurring in nature, contributing to USAT having about 76% of revenue as recurring. They maintain the right to do this through numerous contracts with industry leaders Visa (V) and MasterCard (MA).
(Source: USAT Investor Presentation)
Increasing the number of connections will foster substantial growth in coming years and comparing the two reveals that revenue has been growing at a faster rate with recent years, according to data in the most recent 10-K. They also stand to benefit from cashless transactions having a higher average sale amount compared to cash. Management states that there are an estimated 13-15 million potential connections, which offers a substantial portion of the market that is untapped.
(Source: USAT Investor Presentation)
Management feels that USAT is at an inflection point after successfully building momentum, and the focus has shifted to increasing cash from operations. They describe this stage as the Leverage Model where value must be enhanced as quantity grows.
USAT management has often found success in leveraging existing customer relationship to expand their connections, citing their customers as their largest growth opportunity. A company estimate places the potential connections in their customers' portfolios at 2 million. Seeing as 80% of new connections in Q2 FY17 came from existing customers, there is reason to believe that they will be successful in continuing to grow through existing relationships. Assisting this effort is the acquisition of VendScreen, adding about 80 new customers as well as a west coast operational footprint for the self-service retail market.
(Source: USAT Investor Presentation)
As their customer base expands, USAT has developed new sales and financing programs to meet the financial needs of their constituents. Quickstart has been the preferred financing method (~92%) and includes a five-year non-cancelable lease with the option for purchase at the conclusion of the contract. Jumpstart does not require an upfront investment due to higher service fees, while the company maintains ownership of the equipment.
Their consumer-focused R&D has churned out 78 patents in the US and internationally, providing them with competitive advantages to maintain their strong offerings and an end-to-end experience for their clients. They also have the largest installed base of unattended POS electronic payment systems in the unattended small ticket retail market for food and beverage. Ultimately, interfacing directly with clients, being a one-stop shop and offering customers one point of contact makes adopting USAT's technology easy and efficient.
Valuation
I valued USAT using the discounted cash flow method with LTM figures. Recent years have seen growth above 20% and 30% and I believe the industry growth prospects presents a number of catalysts that will allow USAT to approach these growth rates. LTM growth was 25.8% and after evaluating past data alongside current opportunities, I believe the trend of double-digit growth will continue throughout the projection period. This can be attributed to their favorable model of collecting 3% on transaction because dollars processed is to reach a $1 billion run rate during FY17, up from $584m in FY16.
They will also earn recurring license revenues; I forecast strong top-line growth in years to come. I placed a growth rate of 10% for the remainder of the forecast period coupled with a terminal rate of 2.3%, which is in line with Bloomberg's future GDP estimates. Given USAT's ability to increasingly monetize and expand their connection base, it is reasonable to assume that they will continually generate higher levels of recurring revenue.
(Source: Bloomberg)
With a profitable Q2 and the company posting positive EPS, management reinforced their belief that they are moving beyond an inflection point by offering guidance for gross margins and SG&A in the latest earnings call. Gross margin is expected to be around 30% with a near-future target of 35%. Gross margin was grown at 1% per year and kept constant from year six on at 35%. This will be driven by improved margins for equipment sales which increased 310 bps from 2015 to 2016 although license and transaction fee margins will have a greater impact. These margins fell in 2014 after the deactivation of a large customer and have not recovered yet.
SG&A will be around 22% of revenue this year, and over time is slated to decrease as a percent of revenue, falling to just 15% ten years out. Analyzing the individual line items revealed many, which will no longer impact their SG&A such as litigation-related professional fees, VendScreen non-recurring charges, as well other expenses. Remaining items were grown out at historical rates, resulting in an annual increase of $3,000.
Discounted Cash Flow Valuation
In the DCF, CapEx, and change in NWC were built out for five years at 6.1%, 2.0% of revenues, respectively. These are in line with past performance and management expectations laid out in recent filings. For the remainder of the period they were kept constant. Depreciation was placed at 1,200m per year due to expectations outlined in by CEO Steve Herbert in the most recent earnings call. Additionally, USAT stated they had $162m in operating loss carryforwards to offset future taxable income and assuming that they would exhaust these when possible, they would not pay taxes until year eight.
For WACC, I used 10%, which can be viewed as somewhat conservative considering Bloomberg's value is 8.64%. I chose this discount rate to account for future rate hikes as the economy expands. I arrived at an intrinsic value of $6.79 per share which provides a 59.73% upside above the current stock price of $4.25.
My analysis suggests that this security is substantially mispriced in the market. I attribute past issues with profitability to future that are being projected out into the future. While the company has experienced a large collective loss in its history, USAT's present direction will soon lead to large amounts of free cash flow generation led by controlled SG&A costs, federal operating and improving gross margins. I believe these will be realized soon; however, action should be taken quickly before it is priced in.
Risks
A prominent risk faced by USAT is that their operations require contracts with large entities such as V and MA. While these agreements allow them to facilitate credit card transactions, they also affect profitability by way of the interchange fees charged. Sudden increases in fees may adversely impact the financial state of the company and they may always not be able to negotiate favorable terms. However, past pacts have granted reduced rates for some product categories.
Additionally, the majority of contracts the company enters into are binding for a specific period and then become terminable for the remainder of the relationship. Either side is required to provide notice of renewal at a predetermined date and termination 60 days before the renewal period.
USAT faces significant exposure to Compass Group, PLC (CMGPY), a leading provider in vending. While the scale of CMPGY offers more connections and increased revenues, it also accounts for 20% of sales. If this relationship were to end, the company's financial state would unquestionably suffer.
Finally, USAT has a history of losses dating back to their inception at a cumulative total of $181 million. The company acknowledges the reality that profitability cannot be guaranteed, and continued losses will weigh down chances of share appreciation. The most recent quarter was profitable and included EPS of $0.01. As discussed in their investor relations presentation, management sees this as a crucial point where USAT can move beyond building momentum and focus on leveraging their business model to increase cash from operations and boost shareholder value.
Conclusion
While having a long history of losses, USAT is at the point where they can shed their past woes while growing margins into the future, making it a strong buy. The unattended POS industry offers noticeable potential especially in their specialty area of vending. Untapped networks of vendors and limited entrance into areas such as kiosks serve as signs of potential.
Focus has shifted from simply acquiring connections to growing the value of them. Leveraging relationships with current customers can expand their network and maintaining good relationships with companies like V and MA will dictate the bottom line. As costs are controlled in relation to revenues, strong free cash flow generation will facilitate an appreciation in value. The market is still wary of USAT due their unprofitable past. USAT is surpassing their inflection point; get in now before it's too late.
