Disclosure: I am/we are long USAT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Summary
* USAT is at an inflection point and will generate significant amounts of free cash flow on a go-forward basis.
* 75% recurring/repetitive revenue makes this a very high quality business.
* Under-penetrated market yields multi-year runway for significant growth opportunities.
* Prior sale-accounting methodology masks underlying profitability, has lead to the stock screening poorly and creating opportunity for those willing to dig into pro-forma financials.
* Based on DCF and LBO analysis, intrinsic value of the business is $5.89, implying 104% upside from current levels.
USA Technologies (NASDAQ: USAT) is the leading end-to-end electronic payment solution provider for the small-ticket, unattended retail market - a traditionally cash-only market sector that continues to transition to cashless payments. In simpler terms, USAT attaches credit card and NFC readers on vending machines and other non-attended applications such as laundry machines and parking systems that allow customers to pay for a service without the need to use cash. USAT readers accept a wide variety of cashless methods such as credit cards, debit cards, Apple Pay and Google Wallet. While chances are most people have used the company's service, the fact is that the cashless payment market (particularly the vending machine market) is massively underpenetrated as of today. As the leader in this market, USAT has a multi-year, if not multi-decade, runway that could see the company triple or quadruple its current connection total, and that would be only serving its current customer base. Moreover, this shouldn't be a difficult feat to accomplish, as this is a win-win-win for USAT, its customers, and the ultimate consumer. More importantly, the company is at an inflection point whereby on a go-forward basis it will be producing very high levels of free cash flow due to the stable nature of its fixed costs and its game-changing QuickStart sales program. Therefore, while the stock has made a very nice move from $1.60 to $2.89, based on various valuation methodologies, including DCF, price to earnings, and an LBO analysis, I believe shares are worth $5.89, or 104% higher than today's price of $2.89.
(Source: Phil Johnson - Writer/Editor at ITworld. ITworld.com)
It's no secret that the use of cash is declining dramatically with the advent of credit cards, debit cards, and other forms of cashless transactions. According to a consumercredit.com survey, 80% of people use their debit cards to pay for everyday purchases, while only 14% use cash. This survey also indicated that 100% of 18-24-year-olds responded by saying they use their debit cards for small, everyday purchases. This change is visible all around us. From toll booths to car washes, food trucks to coffee shops, the trend away from cash towards cashless transactions is here to stay. This trend is the underpinning of the multi-year retro-fit cycle that USA Technologies is prepared to facilitate. USAT provides products and services that enable cashless transactions at unattended terminals in a wide variety of end-uses. The company's largest end market is the vending machine space, although it also has a presence in laundry, parking and other verticals. At present, USAT has 302,000 connected terminals, 220,000 of which are attached to vending machines. Total connections have doubled over the past three years from 164,000 at the end of fiscal year 2012 (based on management guidance for at least 331,000 connections at the end of fiscal 2015), and in my view are going to accelerate going forward.
The beauty of this business is that it benefits each member of the supply chain, as well as the end consumer. From USAT's perspective, obviously the more readers they sell and take transactions charges from, the better the company does. An important part of the story, though, is that there is a very real economic benefit for the vending machine owner. For a touch of background, the fact is that the vending machine business has been struggling over the past 10-15 years, and most blame that on the fact that people don't carry spare change and cash, and therefore can't transact with the machine. In addition, vending machines have struggled to raise prices as the demand at vending machines is very elastic and price sensitive. However, I would also argue that a primary culprit is that vending machines simply haven't been able to carry the type of products to which consumers have been switching. This change, for example, is to sparkling water or organic juices from carbonated soft drinks (CSDs), or to a pack of almonds from a bag of potato chips. And why has this been the case? Because consumers haven't been willing to pay that much at a vending machine with cash. With cashless transactions, though, price per transaction is significantly higher because a) people have access to more spending power via their credit/debit cards, and b) it's much easier to spend when you don't actually have to use cash (e.g., the effect of using poker chips instead of cash at a casino). The end result is that sales at vending machines with USAT's terminal are 20% higher than those without it, and operating margins at those machines are 300bps higher than those without the product. The machines are doing more volume, with a higher ticket per transaction, and they're selling higher-priced items such as energy drinks and sparkling water versus CSDs. Not only are there revenue and associated margin benefits, but vending-machine owners are also able to track, in real-time, inventory levels at their machines, which allows them to better manage their working capital, leading to a more efficient cash conversion cycle. The benefits of this simple retro-fit make this application an absolute no-brainer for the vending-machine owner. Moreover, the end consumer benefits because he/she is offered a more appealing variety of products to choose from when they transact at a machine that is equipped with a USAT terminal.
With that as a backdrop, the next step is to analyze USAT's current penetration and the total addressable market. USAT currently has 302,000 connections, 220,000 of which are attached to vending machines. USAT's current vending-machine customer base has a total of 2.25M machines in the US alone, and in total there are approximately 6M vending machines domestically. That puts USAT's penetration levels at 9.8% of their current customer base and 3.7% of the US TAM.
These figures, as well as the aforementioned economics, lead me to believe that USAT is in the very early innings of what could prove to be a very lengthy upgrade cycle that could last a decade or more. This is without even considering the possibility of international expansion, which has an approximate TAM at least equal to the domestic TAM.
So how does a vending machine owner purchase one of USAT's ePorts? There are three methods to acquire a connection. The first method is an outright purchase, which costs roughly $250 up-front, a per-transaction fee of 3%-6%, and a monthly payment of $6-$8. This currently represents approximately 20% of new connections. The second method is called JumpStart, which debuted in December of 2009 as a way to lower the initial cash outlay for customers. JumpStart requires no upfront costs, has a transaction fee of 3%-6% and a monthly "rental" fee of $10-$14. While JumpStart was very popular among USAT's customers versus the outright purchase, it forced USAT to tie up most of its funds in working capital and capital expenditures. This is why there has been little to no free cash flow over the past few years, despite accelerating connection volume. As of the most recent quarter, JumpStart represented only 15% of new connections. The third method, which was introduced in September of 2014, is called QuickStart. QuickStart is a game-changer for USAT in my opinion, as it has the benefits of an initial sale as well as the transaction and "rental" fees. With QuickStart, USAT sells ePorts to a third-party financier for approximately $200, and then collects 3%-6% per transaction, as well as a $5-$9 monthly fee. This enables the vending-machine operator to take advantage of essentially the same terms as the JumpStart program, while allowing USAT to free up its balance sheet by moving the "lease" off its books and significantly lowering its capital expenditure profile (USAT gets to recognize the sale, costs go into COGS as opposed to no sale revenue and the costs are allocated to capital expenditures). From the lessor's perspective, it's a great deal as well, as by my calculation, the third-party financier is able to generate a 22% IRR on its investment over the five year, non-cancelable lease.
QuickStart should, therefore, allow USAT to remove the bottleneck/headache of needing to internally finance what was previously new JumpStart connections; and, given the return characteristics to the lessor, I would argue that the advent of the QuickStart program should accelerate the growth of new connections.
With respect to competition, the two primary competitors are Crane (NYSE: CR) and Cantaloupe. While USAT is the clear market leader, these two have similar technologies and comprise roughly 25% of the market. The key difference between USAT and the competitors is that USAT is the only company that not only handles the physical terminal, but also functions as the payment processor. If you were to go with a competing product, you would need to obtain the terminal and then set up a separate, third-party contract with a payment processor. This is clearly less optimal than the one-stop-shop USAT offers, and it can also create headaches when there is a problem with the terminal or connection, as you have multiple parties who could be to blame. Another difference is USAT's terminal are wireless, whereas the competitors' products need a hardline connection, which limits the location possibilities.
The best place to start analyzing the company's financial status is the analysis of USA Technologies' capital structure. At present, there are 35.7M common shares outstanding. In addition, there are 4.2M warrants that strike at $2.61. Since the company has not been profitable on a GAAP-basis, these shares have not been included as they would have been anti-dilutive, i.e., made the loss "less." For this analysis, I'm going to assume full conversion of the warrants as I expect the company to be GAAP-profitable on a go-forward basis, and the stock is currently trading above the strike price. Assuming full conversion, the market capitalization of USAT is $115M. Including the cash inflow from the warrant exercise, the company has $19.4M of cash and $6.1M of debt. In addition, the company also has preferred stock. This is a really unique case, but the implications are important. The shares were issued in 1994 and accrue $332,226 of value every six months. There are 444,468 preferred shares outstanding, which are publicly traded under the ticker USTAP, and are currently valued at $19 per share. Thus, the market is valuing the shares at essentially $8.4M. The interesting twist is that although there is a charge in the income statement every six months, this is a non-cash payment. The only way the preferred shares receive payment is if the company is bought out, in which case they are ranked senior to the common shareholders and behind the debt. The current (as of 6/31/2015) liquidation value to the preferred holders is $17.4M, indicating the shares are trading in the open market at 48.7% of liquidation value. The simplest way to interpret this is that given the binary nature of the shares, the expected value in each case, and the current trading price, the market is indicating a roughly 50% chance that USAT gets bought out. I'll show why I think this is in fact a legitimate possibility, but for now this is the capital structure picture:
Turning to the P&L, the company breaks revenue generation into two segments: 1) License and transaction fees, and 2) Equipment Sales. License and transactions fees are derived via the per-transaction fee and the monthly license fee. These revenues, which represent roughly 75% of total revenue, are essentially recurring, and therefore of very high quality. I forecast revenue in this segment by analyzing historical license and transaction fee revenue per connection, applying an estimate for that metric on a forward basis, and then multiplying that by the estimated number of connections during the period. While having fallen from 2012, the average license and transaction fee per connection has been relatively steady over the past seven quarters, at around $37.50 per connection. The other revenue segment is equipment sales, which is comprised of ePort sales under outright purchases and the QuickStart program. As previously noted, units are sold for roughly $200 under the QuickStart program and $250 in the case of an outright purchase. The units costs $150 to produce, so depending on the ultimate purchase price, gross margins are in the mid-20% range. Discounts can be given for volume purchases.
Over the past three fiscal years, revenue growth has been healthy, coming in at 27% in 2012, 24% in 2013, and 18% in 2014. In addition, revenue growth during the first three quarters of fiscal 2015 has been 21%, 21% and 47%, respectively. The primary driver behind the growth has been the growth of connections, which on a net basis has increased by 37%, 30% and 24%, respectively during F12-F14. These figures also include the loss of a 26,000-connection contract in August 2013 that was brought in-house by Coca-Cola Refreshments (CCR). These 26,000 connections have been getting phased out over the past seven quarters, with only 800 remaining at the end of the most recent quarter. Outside of the CCR connections, connection growth in F14 would have been closer to 30%-35%, and at the midpoint of guidance this year (65,000-75,000 new net connections) growth would have been around 29%. Including the CCR loss, net connections are expected to grow by 26% in F15 at the midpoint of guidance. For reference, 80% of USAT's new gross connection additions are coming from its current customer base. Going forward, I'm projecting net connections to increase by 25% in F2016, 21% in F2017 and 20% in F2018. Through F16 and F21, I'm projecting connections to grow at CAGR of roughly 20%, which would indicate approximately 966,000 connection by the end of F2021. At this level, assuming USAT customers don't add any machines, penetration level would be roughly 30% within their current customer base, up from roughly 10% today.
Moving down the income statement, while the most significant leverage going forward is in the SG&A line, there will also be an adjustment in the COGS line due to the shift from JumpStart to QuickStart and because USAT is selling some of its JumpStart "leases" to third parties. When USAT sells a terminal via the JumpStart program, the costs are allocated to capital expenditures and then a PP&E asset is created. These assets are thus depreciated accordingly over their useful life, which USAT estimates to be 5 years. For example, in F2014, USAT had an average of approximately $26M of terminals leased out under the JumpStart program. Since the company depreciates the terminals on a straight line basis, this means there was roughly $5.2M worth of associated D&A, which is located in the COGS line on the income statement. As the company shifts away from JumpStart to QuickStart and sells off its on-balance-sheet JumpStart leases, this depreciation figure will fall, creating a 100bps-200bps gross margin tailwind per year and allowing the company to become GAAP-profitable relatively quickly. With respect to SG&A, this is where I believe the most leverage will come from in the future. During F12-F14, the company spent $15.5M, $12.1M and $14.0M respectively. I'm projecting an SG&A spend of $16.4M in F2015, but not too much growth in this area going forward, and falling significantly as a percentage of revenue. This is due to two main factors. First, the company doesn't manufacture the terminals, so overhead costs are relatively low and stable. Secondly, and most importantly, 80% of new connections are coming from current customers. There is little to no incremental sales and marketing needed to generate these sales. Management has indicated that in order to hit their F2017 exit goals, they would only need to add $1.5M-$2M of SG&A spend. If that were the case, my estimated SG&A costs would be $1M-$2.5M too heavy.
Below the line is relatively simple to understand. The company has $6.1M in debt that carries an average interest rate of ~5.5%. It also has about $120M in NOLs that will shield any pre-tax income for the foreseeable future. Other than that, the only other below-the-line item of note is the preferred share accrual, which is a non-cash item. Below is the resulting P&L:
The end result is the picture of a company that is right at the inflection point of generating significant amounts of free cash flow. This is a function of all the previously mentioned factors, including the switch from JumpStart to QuickStart and the fact that revenues are reaching a "critical-mass" level whereby SG&A is able to be significantly leveraged. The next step is to assign a valuation to the business.
Based on the significant free cash flow the company will begin generating starting in fiscal 2016, the best method of valuing this business is using a discounted cash flow model. I've created two DCF valuations, the first based on a perpetual terminal value and the other based on an exit EBITDA terminal value. The valuations indicate that the intrinsic value of the business lies around $6.00 per share:
Given that this exercise indicates the fair value for this company is roughly double its current price, and the fact that the value of the preferred shares is placing the probability of a take-out at almost 50%, I built an LBO model to see what the IRR would be, given a purchase price around the DCF valuation. What I found is that a private equity firm could purchase USAT today at $6.00 ($5.57 value to the common shareholders) and make 3x its capital with an IRR of 32% based on a four-year exit. Given that most PE firms will underwrite deals that are in the 25%-30% IRR range, I think it is highly likely that USAT ultimately gets acquired by either a financial or synergistic buyer.
Based on these return characteristics, I believe the 50% chance of a buy-out, indicated by the value of the preferred shares, is justifiable. It's not a perfect model by any means, for example, I'm not sure a financial buyer would be able to borrow at the implied debt/EBITDA ratio. In addition, the 20.6x EBITDA multiple is certainly rich, but remember the company has little in the way of interest payments and has $120M in NOLs, so cash taxes will be nil for the foreseeable future. Also, I'm only assuming $3M worth of synergies, and in the case of a strategic buyer, I would bet the savings from cost synergies alone would trump that figure based on an SG&A base of roughly $16M-$17M. Looking at a comparable transaction, albeit on a much larger scale, Oracle (NYSE:ORCL) acquired Micros for $4.6B net of cash, which translates to roughly 16x EBITDA and 22x free cash flow, compared to the transaction I'm proposing which would be 20.6x EBITDA and 23.4x free cash flow. Taking all these factors into account, I believe this LBO model validates the DCF price targets I calculated in the prior example, and indicates that USAT is undervalued by a significant margin. For reference, at my target price of $5.89, USAT would be trading at 22.6x F2017 P/E and carry 6.5% free cash flow yield on F2017E FCF (one year out, we're currently in F16), neither of which is out of line for a high-growth quality company. A key question here is why is this opportunity available? There are multiple answers, including the fact that this is a very small cap company with low trading volume and little sell-side coverage. Another reason is that it does not screen well based on its historical performance, which is largely a function of the mechanics of the JumpStart program. However, this company is right at the inflection point and will be a much cleaner and healthier (re: free cash flow) story going forward. Moreover, there is a big margin of safety with the projected free cash flow. Based on my $5.89 price target, I believe there is 104% upside to the intrinsic value of the business.
Additional disclosure: The information presented reflects the opinions and projections of Westpark Capital as of the date of publication, which are subject to change without notice at any time subsequent to the date of issue. All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. Please perform your own due diligence.
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