TIO Networks: Low Risk, 100%+ Upside
Aug. 25, 2014 10:20 AM ET
Disclosure: The author is long TNCGF.
Summary
TIO trades at a hefty discount to fair value. Based on 2x 2015E revenues of $55 million, the company should trade at $1.97/share v.s $0.82 as of August 24th, 2014.
Recent acquisition of Globex Financial has lifted gross margins from 20% to 30% over the past 3 quarters, and there is still room to go.
TIO's partnership with AT&T and exclusivity with AT&T's discount brand Cricket Wireless provide significant revenue growth going forward, driving revenues from $41 million LTM to $55 million in 2015.
Due to TIO's small size, sluggish historic revenue growth, and sub $1 share price, it's off the screens of many small-cap fund managers and investors, presenting a great entry opportunity.
(Editor's Note: Investors should be mindful of the risks of transacting in illiquid securities such as TNCGF. TIO Networks' listing in Canada, TNC.V, offers stronger liquidity.)
Summary
Every now and then an investment comes along whose extraordinary risk/reward characteristics coupled are to a plethora of catalysts to help close the valuation gap between market and intrinsic value. TIO Networks is one of those investments.
What do they do? TIO Networks is a Vancouver based company which specializes in processing payment transac1tions. The company offers multi-channel bill payment processing capabilities. These include self-service kiosks; point of sale, mobile and web channels; and retail money order services.
Why does the opportunity exist? The company has historically shown slow revenue growth and a lack of profitability, which have left the company off the screens of most of the small cap fund managers and investors.
What's changed? TIO's recent acquisitions of Globex Financial have increased gross margins from 20% to 30% over 3 quarters, and have assisted in growing transaction revenue from $9 million to $11 million per quarter over the same period. This performance is likely to continue, especially given TIO's recent acquisition of Chargesmart in August of 2014.
Further, with the launch of AT&T's discount wireless brand Cricket Wireless, there is significant room for future revenue growth. AT&T has long been aTIO billing partner, and all of the transaction activity from Cricket Wireless is set to go through TIO. Given the resources and reach that AT&T has in the market, this single deal is likely to generate $50 million of revenue per year in 5 years for TIO with a quick ramp up period, and almost no incremental SG&A for TIO: much of the gross margin will fall to the bottom line.
What's the upside? TIO trades at a huge discount to fair value. TIO's comparables, while larger, trade at a median 2.9x sales, whereas TIO trades at just 1.2x LTM sales. Given the company's improving financial situation, multiple expansion is likely to give shares a hefty lift going forward. Based on 2.0x estimated 2015 sales, the company is worth $1.97 per share, presenting investors with a low risk opportunity for 140% upside.
What's the margin of safety? TIO already trades at a heavy discount to peers and management has shown already that it can execute on its growth targets. The company also maintains a healthy cash balance that should continue to grow as the business improves. A conservative valuation would place the company at 1.5x FY2014 sales, which would have the shares trade at $1.25; thus the company trades at least at a 50% discount to conservative fair value.
Business Description
TIO Networks is a Vancouver based company which specializes in processing payment transactions. The company offers multi-channel bill payment processing capabilities, which include self-service kiosks; point of sale, mobile and web channels; and retail money order services.
TIO targets the large underbanked and unbanked market in the United States. These (roughly 68 million) people, outside the traditional banking system, rely on alternative means to do such mundane tasks as paying bills or rent; this is where TIO fits in. Though its Transaction Processing System,TIO enables the underbanked and unbanked to pay their bills quickly and easily. TIO's system allows customers to pay at kiosks, at retail point of sale, via the web, and with TIO's excellent mobile app.
Revenue Model
TIO earns revenue through transaction fees, which have historically ranged from $2-3 per transaction, at a gross margin of around 20%. Over the course of 2014, these metrics have changed significantly: revenues per transaction have decreased to $1-2, but gross margins in absolute terms have held steady, raising gross margins for the company to 30-35%.
In early 2014, one of TIO's largest billing partners (likely AT&T) changed the way they pass on revenue to TIO from a flat convenience fee to a back end fee per transaction. This lowered TIO's revenue per transaction in the first quarter of 2014. Furthermore, TIO's acquisition of Globex financial diluted the revenue per transaction, since Globex generates $1-2 per transaction. However, despite both of these adverse events, TIO's gross margin increased in Q1 2014 to 22.28% vs 20.09% in Q4 2013, largely because of the higher margin Globex revenue.
Over the course of the year, the gross margin story has continued to improve, largely as a result of the higher gross margin contribution from Globex Financial. Gross margins for the latest quarter (Q3 2014) stood at 30.83%. These margins are likely to increase further as the Chargesmart acquisition begins to add to TIO's results, and as more of TIO's users transact through the TIO Wallet (described below) which generates higher gross margins than TIO's kiosks.
Recurring Revenue
Of particular importance is that 98% of TIO's revenues are recurring, something highly desirable in small tech companies as it reduces revenue volatility and thus business risk. 96% of revenues are transaction based; and because customers pay multiple bills every year, these are recurring in nature. It is also worth noting that TIO managed to grow revenues from 2009-2012 in the weak US consumer environment, indicating that its revenues are relatively recession proof. This makes sense when one considers that, recession or not, bills must be paid.
2% of TIO's revenues come from hardware support related to Kiosks. As the company increases focus on web-based applications, and as the TIO Wallet contributes a larger portion of revenues, this maintenance revenue should decline as a percentage of sales.
The remaining 2% of revenues that are not recurring comes primarily from software and hardware licensing.
Business Strengths
TIO has a history of success despite stagnating revenues over the past few years. The company offers a wide range of billing partners, raging from AT&T to Duke Energy, which allows great ease of use for customers, but also creates a huge barrier to entry. TIO has also never lost a billing partner, something that shows the success of the company's relationship management.
TIO also offers a wide range of services (with potential for expansion) to its clients, most notable of which is the TIO Wallet.
TIO Wallet
TIO's business is still largely kiosk based. This is surprising given the huge penetration of the web and smartphone in modern society. TIO's Wallet offering allows customers to access, through the web, mobile, and kiosks, a centralized site where they can pay bills, add new bills, and view their payment history. In effect, TIO's Wallet acts as a pseudo-bank for the under and unbanked.
Because of its convenience, TIO Wallet effectively raises switching costs forTIO's customers allowing the company to get more value per customer. Going forward, TIO can use the Wallet as a way to offer its customers other services, such as consumer credit and stored value accounts. Further, because the wallet may be accessed through mobile phones and the web as well as through kiosks, the margins for transactions done within the wallet will be higher than the transactions done via kiosk. As more and more customers migrate to the Wallet, profitability for the company overall should increase.
TIO Wallet is already a success, with subscriber growth from 73,390 in Q4 2013, to 220,924 in Q3 2014. This represents growth of 201% in less than a year.
Management
Key to any business is management. This is particularly true in smaller companies, where a good management team can earn shareholders astounding long run returns, and where a bad management team can bankrupt a company. Fortunately for TIO shareholders, TIO's management has proven itself to be highly competent.
The CEO, Hamed Shahbazi, has a long history with TIO, having been a Director since 1997 and President since 2000. He has proven a capable leader for TIO, leading the company's re-invigoration and executing the successful acquisition of Globex Financial(which has already shown to be a good strategic acquisition). Mr. Shahbazi also has been responsible for securing a number of key connections with various clients of TIO as well as for managing strategic alliances with HP, Microsoft and Cisco Systems.
In terms of alignment, management doesn't own much of the company. However, given Mr. Shahbazi's importance to the company, it is reassuring to know that he owns 2.3 million shares, or about 4% of the company.
Industry Overview
According to the CFIS in 2011, the walk-in bill payment market alone generated $700 million of fees on $32 billion in transaction values. Money Order markets generated a further $250 million of fees on $45 billion of transaction volumes.
Given these estimates of market size, we can infer that TIO commands a respectable 6.5% market share (assuming $5 billion in transaction volume attributable to TIO). Given this market's significant degree of fragmentation (5 public market players, and many more private players smaller than TIO), this market share gives TIO significant ability to grow through consolidation of the industry. With the acquisitions of Globex Financial and Chargesmart,TIO has shown it is willing and able to be a consolidating force in the industry.
The cash preferred markets in which TIO operates are largely comprised of less affluent families and includes many immigrants, but also younger members of all demographic groups. This demographic composition creates a strong base for industry growth; millenials (specifically 23 year olds) are thelargest group in the United States, and they are increasingly turning to mobile payment and billing solutions and away from banks in their lives.
TIO's mobile strategy is also applicable across the world. For example, 170 million people in Latin America are underbanked or unbanked, and 70% of Latin American citizens own a mobile phone. TIO's web and mobile focus allows them to effectively tap this market, something they have already done in the United States. Even TIO's name (which means "uncle" in Spanish) has deliberately targeted the Hispanic community, which has historically not been trusting of banks.
Catalysts
In any good investment thesis there will be a misevaluation; however, it is not enough simply to identify an undervalued company; one must also identify catalysts to close the gap between market value and intrinsic value. Fortunately, TIO has a number of catalysts that will close the gap over the next few years.
1) Aio/Cricket Wireless
Historically, TIO has seemed a stagnating company. Its largest billing partner, Cricket Wireless, had declining subscribers because of poor network coverage; and transaction revenue to TIO declined accordingly. Despite this huge drag on revenues, TIO did manage to achieve revenue growth in 2011; but for 2012 and 2013, revenue growth stagnated and so did shares of the company, many investors losing interest because the company was no longer a growth story. But in 2013, things changed.
On June 6th, 2013 TIO, in an inconspicuous press release, announced that it would be the sole billing partner of Aio wireless, AT&T's attempt to break into the prepaid market. Given the success of other telcos, such as T-Mobile, in this space, Aio looked to be a huge success. TIO stood to gain massively from this success.
From a transaction revenue perspective, Aio was expected to be the size of Cricket Wireless in 5 years, with all of the transaction revenue going to TIO.TIO only processed about 25% of Cricket's transaction volume. This revenue to TIO amounted to approximately $20 million per year in 2013; in total Cricket generated approximately $80 million a year in transaction revenues. If the expectations for Aio materialized, then in 2018 TIO would be generating $60-70 million per year in transaction revenues from Aio alone; nearly double TIO's existing revenue.
Things improved further for TIO in May 2014. Aio bought Cricket Wirelessand merged it with its Aio entity, renaming the combined entity Cricket Wireless. After the acquisition, AT&T announced that it would be moving all of Cricket's dealer locations to TIO. This has led to an increase in daily transactions from 14,000 to 51,000, and revenue growth is sure to follow.This 271% increase in daily transactions will significantly impact the company's revenue in Q4 2014.
As mentioned earlier, AT&T has changed how it passes on revenue to TIO to a back end convenience fee model, something which has lowered revenue per transaction. As such, the total revenue for TIO derived from Cricket Wireless is likely to shrink relative to the original estimates for Aio's size of $80 million in 2018. Assuming the old revenue per transaction was $2.50 and the new revenue per transaction is $1.50, we can estimate that Cricket's new revenue potential in 2018 is approximately $48 million per year for TIO; still a very impressive number.
Perhaps most importantly, this additional revenue comes with very little cost for TIO. Management estimates that all it needs to manage the extra business would be 2 additional staff members. Assuming salaries of $80,000 a year (to be conservative) this only adds $160,000 a year to SG&A. At a 34% gross margin, this Cricket business results in $16 million a year in pre-tax profit.
2) Acquisitions
In the past year, TIO has stepped up its acquisition activities, aiming to consolidate the highly fragmented bill processing market, as well as to expand its own geographic footprint and the services it can offer its customers. TIO's acquisition strategy reflects well on management, as both of the large acquisitions in the last year (Globex and Chargesmart) have added to gross margins, and are likely to be accretive to earnings.
Globex Acquisition
On January 1st, 2014, TIO completed its $8 million acquisition of Globex Financial, a bill payment and money order company based in Maryland. The acquisition was financed with $2 million in debt, $3 million in shares, and $3 million in cash. Globex had revenues of approximately $16-18 million in 2013, meaning the transaction was completed at around 0.5x sales.
The Globex transaction made immense sense for TIO for a number of reasons. First, it expanded TIO's presence in the eastern United States, adding ~3,400 locations. Second, Globex's customer base consists largely of utility customers (including Duke Energy and Florida Power and Light) helping to diversify TIO's business away from wireless telecom companies, and further adding to the company's recession-proof nature.
Globex also had the effect of raising the company's consolidated gross margin. TIO's pre-existing gross margin was in the 20-25% range, while Globex margins are in the 50% range. The pro forma gross margin for the company should stabilize between 34-35%, a significant improvement over historic metrics. Already, as of the quarter ended April 30th 2014, gross margin increased 102% YoY, and stood at 34%.
Chargesmart.com Acquisition
On August 7th, 2014, TIO announced the acquisition of Chargesmart.com, which provides online bill payment solutions for US customers. The company processes over $100 million in transactions per year. Assuming revenue per transaction of 3-4%, Chargesmart earns between $3 and $4 million in revenue per year.
This acquisition stands to increase TIO's gross margins further, as the transactions via Chargesmart are at a higher gross margin than TIO's existing business. The acquisition also stands to expand TIO's web based presence, adding 700,000 new customers. Because of this significant customer increase, one can assume that there would be significant opportunities to cross sell for TIO.
Future Acquisitions
Given TIO's relatively large market share, it is definitely able to acquire smaller players in the bill payment space. Management has indicated that acquisitions are certainly on the table as a means of growth for the company, and normally this might be disconcerting especially if the company begins to look like a roll up. Fortunately, TIO's recent acquisitions were sensible strategically and were prudent financially. This shows investors thatTIO's management isn't going to embark on an acquisition spree, rather, they will selectively acquire when it makes sense.
Catalyst Summary
The growth of Cricket Wireless, Globex Financial and Chargesmart acquisitions, and the potential for future acquisitions serve to improve the financial picture of the company going forward, and will drive shares higher for a number of reasons.
When small cap fund managers and investors screen for potential investments, many of them are screening for traditional "growth" companies: ones that are growing revenues at 20% or more a year and have high margins that accompany that growth. TIO had neither until the past few quarters; and as such, slipped under the radar screen of the market. Furthermore, with shares under the $1 mark, it carries the dreaded "penny stock" moniker that likely turned off larger investors.
These things are all about to change. First, as growth picks up and margins improve, the company will look much better to more fund managers and investors, which should drive flows into the shares. Second, as the shares cross the $1 mark, even more people are likely to notice the company. The market is likely to wake up to TIO in a very large way.
Valuation
Comparables
TIO trades at a heavy discount to its peers for some legitimate reasons. The company is still relatively small and so there should be a higher risk premium built into the valuation. Furthermore, as outlined above, TIO's historic performance of low margins and stagnant revenues meant its discount valuation was earned.
Thanks to the changes in the recent months, namely higher growth going forward coupled with higher margins, TIO now deserves a more fair valuation. Even taking into account a reasonable size discount (to reflect business risk as well as illiquidity risk), TIO should trade at 2.0x sales given it's growth potential. TIO's larger comps trade at a median 2.9x LTM sales.
At 2.0x LTM sales, TIO should trade at an $82 million enterprise value, or $1.48/share, representing 80% upside potential.
To get a sense of the long-term trajectory for the share price, it's worth modeling where sales, and consequently, where cash flows are going. TIOguided $45 million in revenue and $17 million of gross margin in calendar 2014 (not to be confused with TIO's fiscal year, which ends in July) when it acquired Globex Financial, and the subsequent acquisition of Chargesmart and the AT&T acquisition of Cricket Wireless will bring calendar 2014 revenues come in significantly higher than $45 million.
After FY 2014, TIO's growth is likely to accelerate as Cricket Wireless begins to grow again because of AT&T's efforts to turn the business around. Based on organic growth prospects for the existing business, revenue synergies from TIO's two recent acquisitions, and growth at Cricket Wireless, it is likely that FY 2015 revenue will come in between $55-60 million with FY2016 revenue reaching $65-70 million.
Based on these estimates and a 2.0x EV/sales multiple, we can construct a range of price targets for TIO, seen in figure 8.
If these numbers hold true, and there is obvious risk in forecasting 3 years into the future, then one can expect a 51.3% annualized ROI over 3 years. This return should more than compensate for the risk of investing in TIO and represents an incredible opportunity for investors.
One thing worth noting is that TIO's valuation multiples are likely to improve over time. It may be worth 2x sales, but it will take some time for TIO to trade there. As such, the 1 and 2 year ROI given above is very likely to be exaggerated. As multiple expansion is impossible to forecast, the trajectory given in figure 8 will have to suffice.
DCF
With high growth companies like TIO, a DCF is of limited use, but of some use nonetheless. Using the assumptions embedded in the multiples analysis above, along with a 13.8% discount rate, TIO's valuation works out to $1.42 per share, still providing a hefty 73% upside.
(click to enlarge)
Figure 9: DCF Model
Valuation Summary
Regardless of the method used (2.0x LTM sales, 2.0x NTM sales, or DCF) one comes to the conclusion that TIO is significantly undervalued.
Risks and Mitigating Factors
Competition: While it is standard boilerplate to name competition as a risk to the business, it is a fact that the bill payment market in the US is still highly fragmented, and that there exist competitors who have exponentially more resources than TIO. This risk is greatly mitigated by TIO's suite of billing partners and existing offerings to customers that create high switching costs. Further, because TIO is trading at an attractive valuation, a larger competitor is more likely to want simply to purchase TIO outright than spend the money required to out-compete them.
Customer Concentration: As stated above, AT&T and Cricket represent a large share of TIO's business, and that share is likely to increase as Cricket begins to grow. The acquisition of Globex did reduce TIO's customer concentration, and it can be expected that further acquisitions would have the same effect. Regardless, customer concentration remains a large risk forTIO, and AT&T's size gives it significant bargaining power over TIO.
Management: The CEO, Hamed Shahbazi, has been the driving force behindTIO's success. His leaving the company could be detrimental to the future for TIO. Given Mr. Shahbazi's ownership of 4% of the company as well as the bright future for TIO, it seems highly unlikely that he would consider leaving the company.
Currency Risk: Because TIO operates in the United States, but reports results and employs staff in Canada, it is susceptible to movements in the CAD/USD pair. In Q2 2014, this amounted to a $140,094 drag on earnings compared to a $16,579 lift a year earlier. The company is able to hedge this exposure to some extent.
Liquidity Risk: TIO shares have traded an average of 59,623 shares per day over the past 30 days, only allowing for around $55,000 of activity in the shares. There isn't much an investor can do to overcome this except to build a position over a long period of time and hold the position for the long term. Also of note are the varying bid/ask spreads that can range from 0.02/share to 0.05/share depending on the orders in the market.
Conclusions
TIO represents an opportunity for investors to get in on an attractive turnaround story. Revenues are set to increase swiftly going forward, coupled with a continued lift in margins. As this turnaround occurs, the market is likely to take notice, and TIO is likely to see multiple expansion in addition to the lift provided by improving financials.
Based on 2015E sales, TIO is easily worth $1.97/share, which represents 140% upside to the current price.
