USA Technologies Inc (USAT)

[FUNMAN]

USAT: Growth, But At What Cost? 40% Downside To Fair Value

This is a sobering article about what's happening as USAT.


Read this online to see all of the charts and graphs:

https://seekingalpha.com/article/4097817-usa-technologies-growth-cost-40-percent-downside-fair-value?app=1&auth_param=7kokn:1cor5a5:a396a9ee1ba791e0333a60c4fd1da6f4&uprof=45


Aug. 11, 2017 7:30 AM ET

Summary

* While USAT has produced solid revenue growth, gross margins have plunged by 1,350bps over the past three years, thus profitability has remained elusive.

* Either revenue growth will slow or margins will continue to compress, either of which, we believe, will lead to multiple compression.

* Management's compensation incentives have little to nothing to do with creating long-term shareholder value, partially explaining why margins have been allowed to plummet.

* C-Suite turnover has been extremely high, with four CFOs in the past two years.

* At 25x forward EBITDA, a ~150% premium to higher-quality peers, USAT has 40% downside as forward profitability estimates come down.


USA Technologies (NASDAQ:USAT) is a provider of credit card readers to the unattended retail space, primarily vending machines and other applications such as laundry and parking. In my initial thesis (“USA Technologies: Undervalued, Under-Followed And At An Inflection Point”) I argued that USAT was at a profitability inflection point, and would produce significant amounts of free cash flow on a go-forward basis. The key tenants of the thesis were:

-75% of USAT’s revenue is recurring and therefore high-quality. As recurring revenue increased with a larger installed base, so too would profitability and free cash flow

-USAT operated in an under-penetrated market, providing a long runway for growth

-Profitability was being masked by prior sale accounting, an aspect that would reverse as USAT transitioned to a new sale process

-Quick Start, the company’s new sales program, would accelerate adoption and lead to faster revenue growth

With two years in the rear-view mirror I am reassessing the thesis, and have concluded there is significant downside to the current share price. While my revenue and unit adoption theories have come to fruition, the company had to sacrifice margins to meet and exceed those expectations. Moreover, based on comments made by USAT’s CEO on a recent conference call, I do not believe the recurring revenue portion of the business is high-quality, and likely produces little cash flow. With margins compressing on the equipment sale side of the business, and little cash flow from the license and transaction segment, I assess the likelihood of a significant cash flow inflection to be low. The stock is currently trading at 25x 2018E EBITDA, a 150% premium to larger, more established payment peers. I believe there is roughly 40% downside to the stock as forward EBITDA and free cash flow estimates are revised down and/or revenue growth slows.

The capital structure of USAT has evolved over the past two years. In 2015 there were 36M shares outstanding, with an additional 4M warrants that struck at $2.61. Those warrants were executed and converted into common shares, and the $10M of cash went onto the company’s balance sheet. Debt has been relatively steady, inching up from $6M to $9M, and the accrued value of the preferred equity has increased to $18.4M. As a reminder, the preferred equity accrues value every year, but only pays out in the case of a return of capital to shareholders. If there were to be a cash dividend or buyout, the preferred equity would rank senior to the common shares and would be made whole. This was the state of the capital structure until earlier this month when the company announced an unexpected secondary equity offering. The stock closed at $5.25 before the offering was announced, and the goal was to raise $40M. To be sure the offering was a surprise. Why would a company that has net cash on its balance sheet and is supposedly on the cusp of generating significant free cash flow need to raise ~20% of its enterprise value in equity? There wasn’t an acquisition announced in conjunction with the offering, and the use of proceeds were for “general corporate purposes and working capital to support anticipated growth”. With debt as cheap as it is, and for a company with a solid balance sheet, the equity raise seems like a peculiar decision. Nonetheless, the equity offering was completed at $4.50, raising a total of $43.1M by issuing 9.58M shares. The result is the following capital structure:


One of the primary points of my initial thesis was that revenue was set to accelerate because USAT had adopted a new sale structure (Quick Start), whereby a third party financed the transaction for operators, allowing USAT to offload the terminals from its balance sheet. This alleviated two issues: 1) USAT’s growth was no longer constrained by its balance sheet, and 2) operators had a third option financing option that didn’t force them to purchase the equipment up front at full cost. Throw in an underpenetrated market with solid ROI’s for the operator and you had the blueprint for accelerating revenue growth. This is exactly how the situation played out, and USAT has generated revenue close to or slightly above my initial estimates.

Revenue has increased at a CAGR of 33% over the past two years. This is impressive growth, no question, and should have led to significant operating leverage flowing through the P&L. USAT generates revenue through a per month license fee, and a percentage of every transaction, therefore the majority of the cash flow from the incremental installed units should have flowed straight to the bottom line. This was the underpinning of my original long thesis, which management communicated to me in 2015. And, to be fair, they have exceeded the goals for revenue and units. However, margins and profitability goals have fallen way short of prior expectations.

The primary reason for profitability falling short of expectations has been a significant deterioration in USAT’s gross margins. Gross margins have fallen from 39.2% in F2013 to an estimated 25.7% in F2017, a 1,350bps decline. This is an alarming decline, and indicates a lack of value-add and competitive differentiation. The decline hasn’t been confined to one segment, either. Equipment sales’ gross margins have fallen from 38.5% to an estimated 16.7% in F2017, while gross margins on the License & Transaction side have fallen from 39.4% to an estimated 32.7%. I believe there are three root causes for the declines. First, while the Quick Start program enables the company to accelerate revenue growth, it does so by sacrificing profitability. USAT is ceding a portion of the gross profit to the third-party financier, as a large portion of the monthly fee goes to the third party rather than USAT. Therefore, gross margins fall as a higher percentage of customers adopt the Quick Start program, which now makes up 75%+ of total equipment sales. If total unit sales from Quick Start remain at that level, or increase, gross margins are unlikely to increase and could continue to go lower. Secondly, based on conversations I’ve had with former employees, it is evident that competition in the space has intensified, which has pressured pricing and thus gross margins. Lastly, I believe that there is a certain aspect of gamesmanship occurring. Since USAT’s stock has typically traded up or down based on the reported and expected revenue growth, the company is incentivized by Wall Street to continue to pursue revenue growth at the expense of profitability. These three factors have put significant pressure on gross margins, especially in comparison to other hardware transaction processing peers.

The countervailing bull thesis to the gross margin deterioration is that USAT should sacrifice profitability on the equipment sales in order to get a greater number of units in the field. This is problematic, though, since gross margins are down 700bps on the License & Transaction revenue. In addition, I am increasingly skeptical that the company generates much cash flow at all on the License & Transaction revenue based on comments made by USAT’s CEO on the 2Q17 conference call:

Joshua Elving, Feltl: “And I guess, in looking at the license being up…about 22% in the quarter, and gross dollar volume being up I think closer to 40%, were you suggesting that your revenue yield or your processing revenue yield, perhaps, you had given up some pricing there, such that the kind of monthly service fee was maintained somewhat? Does that make sense?”

Steve Herbert, USAT CEO: “I think what Lee was referring to was the opposite. On the monthly service fee, sometime, strategically, we will make a decision to back off a bit on a monthly service fee with the customer. And again, it’s typically strategic in nature and so forth. So it’s actually the monthly service fee that we’ll sometimes give relief on for, to position ourselves for a longer-term gain. On the processing side of the equation, what we’re doing and what I mentioned, is that we’re actually taking, we’re taking that rate up with certain parts of our customer base so we’ll generating a little bit more revenue. We don’t make a lot on the transaction. We don’t make much at all but we’re going to squeeze a little more revenue out of the transaction side at the L&T line.” (Emphasis mine)

So, if USAT doesn’t make much on transactions, is making concessions on the license fee side, and clearly doesn’t make much on the equipment side with gross margins in the mid-teens, how is this company going to increase its profitability? One answer would be to leverage its operating cost structure as revenue ramps. However, this too seems unlikely based on the level of cash SG&A spend (Gross Margin Less EBITDA Margin). For example, USAT’s cash SG&A cost as a percentage of revenue have been hovering around 19%-22% over the past four years. By comparison Ingenico, the highest-quality company in the processing equipment space, runs at 22%-24% cash SG&A as a percentage of revenue, and Verifone runs at 26%-27%. The implication is USAT is already running very lean, and would likely need to maintain its cash operating costs as a percentage of revenue to support the company’s current trajectory.

One key question is why is management so willing to sacrifice gross margins, and therefore profitability, for the sake of growing revenue? Interestingly, the answer to this question could also help to explain why the company just diluted the share count by ~25% in a secondary offering. I believe the primary reason management is willing to pay so little attention to profitability metrics is due to the fact they have zero compensation incentive to do so. In fact, in certain cases management’s long-term incentives have no connection to financial performance at all.


The above list of metrics tied to executive compensation are at a minimum unaligned with the interests of common shareholders and have no impact on long-term value creation. First, notice that none of the metrics are on a per-share basis. Therefore, the fact that the company just diluted the total share count by 25% doesn’t affect management’s compensation. Moreover, why would management care about the economic viability of a sale when they are only incentivized to increase total sales? This also explains the recent secondary offering, as the company can acquire revenue and non-gaap net income without regard for the per-share economic value add. Looking at the long-term incentive compensation, “total number of connections” is particularly egregious. It’s worse than total revenue, since theoretically management has no incentive to care about the price or gross profit at which it sells the connections, only how many are in the field. These metrics have little to no correlation to creating long-term per-share value.

Despite USAT’s perpetual profitability disappointments, the market has handsomely rewarded the company for its impressive streak of revenue growth. The company’s stock has risen nearly 300% since revenue growth began to accelerate in F2015. However, although revenue has increased by roughly $60M over the past three years from $42M to $103M, EBITDA has only managed to increase from $5.9M to $7.2M, a $1.3M gain. The 2% incremental EBITDA margins are meager at best. Thus, the result of the stock price appreciation has left USAT trading at 25x forward EBITDA, a 150% premium to high-quality peers.

One argument for a nosebleed valuation such as 25x forward EBITDA is that USAT will grow into its valuation. I view this as unlikely for the reasons which I previously detailed regarding gross margins and cash operating costs. Another argument is there’s some inherent value in USAT’s business model, similar to the valuation methodologies ascribed to multi-tenant SaaS companies. The problem with that argument is the inherent value in a SaaS company is that it generates recurring revenue at a very high gross margin. Take any high-quality SaaS company (MIME, DATA, CRM, etc.), they all generate recurring subscription revenue at ~80%+ gross margins. The value in those businesses is that if you remove duplicative costs, a synergistic buyer could theoretically run those models at 40%-50% EBITDA margins. Circling back to USAT, with very low and decreasing gross margins, even on the “recurring” side of the business, this is not the case. Even if we were to assume that USAT could hold its gross margin ~28%, the leanest you could likely run the business would be at ~20% cash operating costs as a percentage of revenue (8% EBITDA margin). Taking it one step further, if we assume USAT continues to grow at 25% per year over the next two years, the company would be producing ~$160M of revenue in two years. Applying the hypothetical 8% EBITDA margin to that $160M of revenue would yield EBITDA of ~$13M. The resulting multiple is roughly 20x EBITDA for two years out in a best-case scenario, a >100% premium to peers.

Valuation

So, what is USAT worth? In my original thesis, I outlined a path for USAT to get to $5.80 per share, which is coincidentally where the stock traded to recently. However, at the time I assumed F2019 EBITDA would come in at $24.4M and EPS would be $0.47. Because of the massive drop in gross margins, and thus EBITDA and EPS expectations, in addition the 25% increase in diluted shares outstanding, my current estimates are more than 50% lower than they were two years ago. My current estimates for 2019 are for $11.6M in EBITDA and $0.14 in EPS. I believe these to be significantly below where street expectations are tod ay, and thus the multiple ascribed to the stock will come more in-line with peers are forward estimates are revised lower. Given the current stock price of $5.15, I believe that there is roughly 40% downside to fair value.

Disclosure: I am/we are short USAT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.