USA Technologies Inc (USAT)

[FUNMAN]

Time to revisit USAT - FUNMAN USA Technologies: Special Situation With 100%+ Upside With New Management And Multiple Catalysts

Aug. 14, 2020 8:00 AM ET

Read it here for a better "view" of the charts, even though all of the info is still clear below:

https://seekingalpha.com/article/4368355-usa-technologies-special-situation-100-upside-new-management-and-multiple-catalysts

Summary

* Following a lengthy activist campaign, USAT has been taken over by an impressive new team.

* Special situation dynamics including an imminent relisting to Nasdaq and forced index buying provide intermediate-term downside support.

* Underappreciated, fast-growing SAAS asset likely justifies the entire EV, suggesting that the payments business is available for free.

* Near term price target of $12.50 at 5x sales would be a notable discount to comps and fail to capture the impact of new management.

* Longer term, if new management can execute their plan a $20-$30 target is reasonable.


Elevator Pitch
By way of introduction, I would like to start by pointing out that when USAT was last written up on www.valueinvestorsclub.com in the summer of 2018, the comment thread centered around the perceived failings of existing management and their inability to properly manage the business. These concerns were prescient, as only months later an accounting scandal unfolded, which led to the company being delisted from Nasdaq and a ~75% decline in the stock price.

Fast forward to today, and consider that after a lengthy activist battle, the company is now Chaired by Douglas Bergeron, whose fund owns ~17% of the equity. Bergeron is one of the most successful payments industry executives globally, having previously taken payments company Verifone (formerly PAY) from an EV of $50M to $5B while growing sales 6x, expanding internationally, executing strategic M&A, and making himself a reported half-billion dollars, some of which he used to take over USAT.

Additionally, while previous VIC writeups on USAT were derided as being better suited for "growth investors club," the thesis is now underpinned by a very believable cost cutting and operational improvement story, and the special situation dynamics that will surround USAT's imminent re-listing to Nasdaq and subsequent index inclusion. Not wanting to completely abandon the growth crowd (growth has worked pretty well for the last few years if you haven't noticed!), I would also note that while not broken out within the GAAP financials, within USAT there is a zero churn SAAS business that I estimate has been growing at ~37% a year, which by itself would justify the entire EV and then some based on SAAS comps, suggesting that the core payments business is available for less than free.

Enterprise Value (000s)


Notes:

Shares

64,557

3.31.20 10-Q cover


+ HEC Proxy Payment Shares

636

+ Option & Warrant Shares

2,492


+ Cnvt PFD Shares

0

$11 Redemption Option


+ Unpaid PFD dividend shares

0


Gross Shares

67,685

- Treasury Method Shares

1,985


Net Shares

65,700

note: 3.31.20 10-Q Wtd Avg = 64,096.778


Price

$ 7.16


Market Cap

$ 484,623


- Cash

25,894

as of 3.31.20 10-Q


+ Debt

12,678

as of 3.31.20 10-Q


+CNVT PFD Shares

4,896

10-K - 445.063 shares @ $11 redemption


+Accrued Unpaid CNVT PFD dividends

20,800

as of 3.31.20 10-Q


+Sales tax and related liabilities

18,200

Conservative? Assumes full payment


EV

$ 515,303




The Business

In brief, USA Technologies (OTCPK:USAT) provides a complete suite of solutions to the vending and other unattended retail industry that allows vending machines to accept cashless payments, and allow vending machine operators to more efficiently run all aspects of their business. While historically the financials have not been segmented as such, in my view the business is best thought of in two parts: Payments and Logistics.

Payments
The Payments business enables vending machines to accept credit cards and alternative payment means like Apple Pay etc. Customers pay a monthly fee as well as a percentage of revenue. Historically the company called this revenue "recurring" and the monthly fee does appear to be truly recurring. It is more of a stretch to call the revenue cut truly recurring, as we learned during COVID, when people stopped leaving their homes, which is a prerequisite to using a vending machine. That being said, vending demand is generally recurring and recession-resistant (although clearly not pandemic resistant) as people who are hungry or thirsty will still spend a buck or two on food and drink regardless of the economic backdrop. I say recession-resistant rather than recession proof because the location of the machine obviously matters. If it is located in a factory and the factory closes during a recession, that machine will not perform well. However, if it is located in a school or hospital etc., the machine should perform well regardless of the economy.

Enabling a vending machine to accept cashless payment is a no-brainer (with one major - but fleeting - exception, discussed below) for vending machine owners as it comes with multiple benefits including allowing people without cash to buy items, incremental pricing (can charge $1.25 for a soda instead of $1.00 w/o having to worry if people have the extra quarter in their pocket), higher average ticket, and the ability to stock higher cost items. To quantify, industry research suggests that average consumer spend is 35% higher for a cashless enabled machine vs. a cash-only machine, and it is estimated that only about half of the industry has gone cashless to date.

Cashless payments for vending are a competitive space, but competition is based on price and service, and as the largest player USAT is well positioned to compete on both fronts. Additionally, USAT is the merchant of record for transactions which involves a fair amount of complexity tied to integrating with the other elements of the payments ecosystem. What this means in practice is that for a vending machine owner that partners with USAT, USAT handles all elements of cashless transactions - then USAT takes a cut, and then seamlessly sends the balance back to the vending machine owner, along with a statement showing all the details. This is not an impossibly high hurdle by any means, but my conversations with former Cantaloupe (discussed more below) employees suggests that a big part of the reason that they sold to USAT was that they could not get their cashless/merchant of record system up to the same level of quality as USAT.

Back to price and service - service appears to be the more important element - if the card reader is broken or the merchant of record system has a kink, the vending machine is just a really, really, really big paper weight - and our diligence suggests that USAT has historically excelled at service, at least for the larger vending groups. Smaller vending groups seem to never be satisfied with service, and even for the larger groups service has suffered in recent quarters as the old management team was distracted by their self-inflicted failings. Despite this decline in service and tons of negative press around the company, churn for the company was approximately zero during a very difficult period.

On the price side, pricing among competitors appears rational for the most part, with slight wrinkles among plans. However, as USAT has the largest installed base (70% market share according to one former executive), they have the most transactions, which means USAT can realize favorable terms with credit card processors allowing them to be the low cost provider. However, USAT does not flex this cost advantage with customers. Rather, in the recent past, they have taken to subsidizing the cost of the hardware that is required to enable a machine for cashless service, giving them an advantage in terms of total cost of service. It should be noted however that one criticism new management has of old management is that the old team pursued growth in connections above all else - perhaps meaning that old management was too quick to subsidize hardware. The new team has indicated they will be taking a more holistic view of growth, with an eye toward "the rule of 40."

Logistics
On the logistics side, the company offers a cloud-based vending management software suite through its SEED platform, which was acquired in November of 2017 when USAT purchased Cantaloupe. This SAAS product is best thought of as enterprise software as it enables a vending group to run all elements of their business. Notably, it allows vending machine owners to remotely monitor inventory, connect inventory to accounting, efficiently schedule routing for restocking, monitor cash collection needs, and change prices remotely, as well as manage more back office functions like payroll etc.

Remote monitoring and efficient inventory management is a game-changer for vending operators. Rather than blindly driving all over town like a madman from machine to machine just in case something needs to be restocked, SEED gives them the power to only go to machines that need attending to, and only re-stock items that have been depleted. This maximizes efficiency, and the company estimates this reduces customer operating expenses by 30-40%.

Putting it All Together

As mentioned previously, the company historically has not split the business into the above-mentioned segments, although the new management team has committed to increasing disclosure, so that may change. At present what I call Payments and Logistics is reported together as "Transactions and Licensing," which is effectively monthly service fees plus a blended transaction rate on dollar volume sales at vending machines. Together, Transactions and Licensing represents ~80% of revenue. Importantly, pairing payments and logistics allows the company to approach customers with an end to end solution that drastically improves both sides of their business through both increasing customer revenue and reducing customer costs, creating a win-win-win dynamic.

The remaining 20% of revenue is tied to hardware, which the company can help finance through unrelated equipment financing partners. As mentioned previously, more recently the company has been taking a loss on hardware in order to gain access to the recurring revenue from the license and transaction fees. This appears to make sense as the average life of a vending machine is approximately 12 years (estimates vary), and the economics are such that it doesn't really make sense to switch cashless providers once you have established a machine with one provider. More specifically, the hardware and install can cost a few hundred bucks, yet service fees are ~$10 per month, so even if a competitor knocked 20% off of their pricing in exchange for switching to their product, it would still take years to cover the cost of the retrofit.

To attempt to quantify this dynamic, consider that for FY19 the company added 141k new connections, which generated about $20M in Equipment revenue, and negative $5M in gross margin. This equates to a loss of about $35 bucks on hardware per new connection. At the same time, the company earned about $40 in gross margin dollars per average connection (simple average YE 18 and 19), which basically means that for each new connection, the company sacrificed 1 year of net gross margin in order to position themselves to receive 11 more years of gross margin contribution per machine.

This appears to make sense, yet new management has opined that there is definitely room for improvement in the margin structure of this arrangement, and that while prior management cared about connections above all else and were thus willing to take large losses on the hardware, the new team will be taking a more holistic view of the transaction and relationship.

How Did We Get Here?
In brief, there are multiple old ValueInvestorsClub, Seeking Alpha, and sell side reports that can basically be boiled down to, ~"this company has real potential, but the potential is unlikely to be realized under current management." That view was crystalized beginning in Sept 2018 when the company announced an accounting restatement and ultimately delisting from Nasdaq which caused shares to trade down from $16 to below $4.

Enter activist investor Hudson Executive Capital ("HEC"), whose list of grievances was initially laid out in an October 2019 filing, and can be summed up as: the existing board and management had been terrible for a long time, including failure to complete an audit, raising capital at disastrous terms, failing to hold management accountable for repeated failures, etc etc. Not surprisingly, the company responded that they disagreed with HEC's assertions, and then the two sides traded filings back and forth for several months. If you like this sort of thing, I would actually recommend going through it all because it was really bizarre, including old management claiming that shareholders seeking new board representation would be a change of control and necessitate a control premium being paid, and an obscure provision of Pennsylvania law that would allow the company to clawback any profit made by HEC if they did take control of the board. In any event, the activist battle was unusually drawn out and created a mountain of paperwork, HEC eventually ran a proxy, the preliminary results made it abundantly obvious that they would win, and the old board is now gone and HEC's slate is now in control.

We have all seen instances of activist investors who can solve all the world's problems with excel spreadsheets despite having limited operational experience. That does not appear to be the case here. In fact, the opposite may be true.

The principals at HEC are Doug Braunstein, former CFO of JP Morgan (JPM), and Douglas Bergeron, former Chairman and CEO of Verifone (formerly PAY). Googling around and pulling old proxies from JPM and PAY paints a picture that suggests Braunstein and Bergeron walked away from their prior roles with several hundred million dollars each. It is my understanding that their personal fortunes are the foundation of HEC. At the very least, the fact that they have skin in the game is a big step up for shareholders of USAT, but the fact that their real world experience and domain expertise seems to dwarf that of the previous team suggests that HEC is uniquely qualified to understand the opportunity at USAT.

For Braunstein, in addition to being former CFO of JPM, he is presently on the board of Cardtronics (CATM), which operates the largest network of independent ATM machines. This is relevant to USAT not only because of the obvious relationship between ATMs and payment networks but also because servicing a fleet of ATMs has similarities to servicing a fleet of vending machines, which likely gives Braunstein insight into the thought processes of USAT's customers.

Bergeron has assumed the role of Chairman at USAT, which puts him in the driver's seat in terms of re-shaping the organization. This is not new territory for him, and this article from his time as Chairman and CEO of Verifone can provide some insight into his leadership style. In brief, when Bergeron took over Verifone in 2001, the company was completely dysfunctional and bloated, which seems to rhyme with the situation at USAT. At Verifone, Bergeron acted quickly to eliminate underperformers, create a culture that rewards success, and give P&L responsibility to local managers, all of which enabled him to take a cash burner, and it turn it into a massive success.

Among the first moves that HEC made was bringing in a new CEO, Sean Feeney. Feeney has a PE background and has previous experience across various technology, software, and payments companies. He had been essentially retired but still acting as a board member immediately prior to joining USAT. Feeney is also a West Point grad, and spent 6 years active duty. If you google around and/or talk to him, you will note that his military experience informs his leadership style, especially as regards the importance of culture. This is likely a positive at a company like USAT, which had previously suffered under a poorly performing management team and has recently been through a lengthy restatement and activist battle, neither of which could have been good for company culture or morale. Feeney was granted options on 1M shares with a $6.30 strike, which properly aligns him with shareholders.

While USAT shares are probably ~50%+ higher than HEC's average cost today, I think it is likely that HEC entered this position and subsequent proxy battle with multi-bagger intentions, not a quick flip. Additionally, the rest of the board which they have assembled is unusually well qualified for a company of this size.

Operational Improvement Opportunity

With 5 CFOs in 5 years and a theoretical margin expansion / operating leverage opportunity that was never executed upon, it is not hard to believe that prior management was running this business poorly. At the same time, the current board and management is unusually well qualified for a company of this size, and they have made it clear that they believe the opportunity is real. Of particular note, credit card processing fees are a major element of the company's cost structure. It is thus notable that one of the board members recruited by Braunstein and Bergeron is Michael Passilla, who was formerly CEO and Vice Chairman of Chase Merchant Services, the global payment processing division at JPM. It is likely that Passilla knows as much about transaction processing as anyone on the planet, and is uniquely positioned to opine on if there is an opportunity to improve gross margins through negotiating with Visa/Mastercard over interchange fees, and with the company's transaction processing partner, who perhaps not coincidentally historically was.... JP Morgan Chase Merchant Services. However, in what may have been a parting shot by old management at HEC, as of March 2020, USAT began transitioning to First Data (FDC) for transaction processing. It is difficult to quantify these opportunities from the outside, and new management has not provided specific guidance, although previous management indicated a target of 40-45% gross margins for Licensing and Transactions, up from mid 30%s in recent years.

In addition to the possibility that gross margins could be improved through negotiation, it seems likely that they will naturally move higher over time. First, as the company gains scale and increases the number of transactions that are processed, fees will naturally come down. Second, disaggregating interchange fees into component parts reveals a fixed fee, as well as a percentage of revenue fees. The trend in vending has been toward higher priced items, which exerts leverage on the fixed portion of the interchange fee. For example, in 2009, industry average cost of a snack sale was $0.70, and a drink sale was $1.00. As machines have transitioned from the sale of 12-ounce cans to the sale of 20-ounce bottles, and as snack portions have grown larger, the average industry sale grew to $1.71 in 2019. As more machines are upgraded to 20-ounce bottles etc., the average sale will continue to move higher.

While every little bit helps, the trend toward higher ticket items is surely less important than the changing mix of the company's revenue. New management has been clear that prior management did a poor job integrating and cross selling the Cantaloupe acquisition, which comes with gross margins that are much higher than those tied to transactions. To quote CEO Sean Feeney:

"Given my software and platform background, I'm focused not just on increasing the number of connections in our base, but also on recurring software revenue and gross margins in order to drive profitable growth. more to come on that topic on the [next] call."

-Q3 2020 conference call (6/24/20)

Needless to say, shifting the revenue mix increasingly toward software to make it less dependent on transactions should widen gross margins further.

Moving down the income statement, the accounting restatement and proxy battle generated a host of costs that can be easily eliminated. These costs go beyond the obvious and extend to an army of consultants that have basically been managing the company's accounting functions on a day to day to basis. Here is Bergeron on this topic:

"the company was overly reliant on paying professional services firms $700,000 or $800,000 a year per head for people that could be hired […] for $150,000. And you start multiplying those times a big number, and you get to obscene numbers that you see in these financial results."

~Q3 2020 conference call (6/24/20)

Eliminating those costs should be very straightforward, but there is additional opportunity as well. Feeney has indicated that there are real opportunities for automation throughout the company's internal sales and accounting process, as well as on the customer service side. For example, at present, for a customer to order hardware, there is no simple online portal where that customer can just identify what they want, hit enter, and then wait a day or 3 while USAT's back office seamlessly generates a purchase order and notifies the warehouse to ship a unit. Rather, my research suggests that the simple act of ordering the hardware requires 3 or 4 USAT employees to manually handle the order, which can sometimes take more than a week before the item is even shipped.

This opportunity is, of course, difficult to quantify, but prior management had indicated a target of having SG&A at 15-20% of revenue vs ~33% in FY'19, and mid-20s% prior to the accounting debacle and associated costs. Our conversations with former employees validate this target, and current management has stated that by just automating a few functions, current headcount can support a much bigger organization, which of course implies significant operating leverage.

Despite the lack of precision regarding what this leverage might look like, it is not difficult to believe that this is the first time this company is being run by a focused, experienced, properly incentivized professional management team, and thus margins should improve with time. I expect this opportunity will be quantified and guided to in the coming months.

Growth Opportunity/Operating Leverage/Pricing Power
Starting at the vending industry level, it is estimated that only ~50% of vending machines in the U.S. have been upgraded to accept cashless payments, suggesting substantial runway. This may seem odd given the clear boost to sales that comes from switching to cashless. There are a few simple reasons that adoption has not been more immediate: 1) machines that are nearing the end of their useful life do not justify the expense of a retrofit, 2) the time needed to have a technician do a retrofit over a fleet of machines, 3) just simple laziness by mom and pop owners, and 4) some portion (estimated at 10-15% by industry contacts) of the vending fleet will never justify the expense required to maintain a cashless system because they are located in very low traffic areas.

In addition to these factors, at this point, I think the real problem is that mom and pop vending machine owners are reluctant to tie the entirety of their revenue stream to something that the tax man would have full visibility on. However, this dynamic is rolling off as it would be insane to replace an existing machine with a machine that is not cashless enabled, and slowly but surely mom and pops are aging out of the business and either 1) selling to bigger players who are not interested in cheating on their taxes or 2) passing the business to their children who are much more likely to prefer the convenience of the cashless experience.

Bigger picture, there are other verticals such as laundry, gas station air machines, parking etc. etc., which leads the company to identify their TAM as 15M connections vs. a current 1.25M penetration (up 16% YoY, despite several management-led debacles that have surely slowed growth). Additionally, the company believes there is an international opportunity as cashless payments abroad - especially for small ticket items - is less prevalent than it is in the U.S., and Bergeron has experience leading international expansion. However, this is more of an intermediate or long-term goal.

Beyond the obvious such as vending, laundry, parking etc., it seems clear that there will be an increasing trend toward unattended retail as operators seek to cut labor costs and increase efficiency. The most high profile example of this is, of course, Amazon Go, but the idea of "intelligent cabinets" that can largely replace the traditional retail experience of selling things like sneakers or electronics or jewelry is gaining speed, and moving from something that started in airports to more mainstream locations. This model has the dual benefit of reducing employee overhead and reducing shrink, and any move in this direction will presumably be accelerated by COVID. Who knows - but perhaps the mall of the future is mostly unattended? If it were, studies show that this would largely be inline with consumer preferences to avoid pushy salespeople etc.

This is all well and good, but the real low hanging fruit is with the company's existing customers. At present, the company estimates that their customers manage a fleet of more than 3 million machines, yet the company has only ~1.3 million connections, suggesting ~40% penetration. Further, of the ~1.3 million connections, only 50% are using the company's logistics suite. This under-penetration represents potential growth that should come relatively easily as the company already has a beachhead, and vending companies are likely to prefer the convenience of using one vendor for cashless pay and the same vendor for logistics (although smaller players have less need for a dedicated logistics suite). Importantly, this growth should be high margin because the existing sales infrastructure should not need to be expanded to cover existing accounts, resulting in operating leverage.

Additionally, the structure of the vending industry should naturally benefit USAT. We believe that approximately 50% of the U.S. vending industry is controlled by ~15 organizations, and the other 50% is made up of thousands of smaller players who own a few dozen, a few hundred, or a few thousand machines. Acquisitions in the space are extremely accretive because essentially all fixed costs (building, back office, management, etc.) can be removed, to the point that an acquisition is really just buying the route, and eliminating all other costs. As such, the industry will continue to naturally consolidate over time, eliminating those smaller players who are reluctant to upgrade to cashless systems for tax reasons.

New management has commented that they are reorganizing the sales team to a more focused approach and using incentives to create the results they want. Whereas formerly the focus was increasing connections above all else, the new approach is to behave more as a platform software company and work with partners to ensure seamless integration of adjacent products to best suit customer needs. In this vein, new management has commented that in their eyes the SEED side of the business is the real prize. Whereas previous management offered pricing concessions on SEED to just drive connection growth, new management has suggested they think there is actually pricing power on the SEED side. However, they have also been clear that they have no intention of trying to flex this power in a COVID world, and realize that they have to improve customer service before attempting to flex pricing power. It was suggested however that by 2H calendar 2021 they anticipate they will be in position to flex.

New management has also suggested that subsequent to improving customer service and fixing some other internal issues, there will be a real opportunity for adjacent M&A. I suggest a grain of salt - perhaps more - but on the first conference call with the new team, Bergeron stated, "this could be a long-term 30% top line grower" and "if it can grow at 30%, 35% for a few years, should be a business 3 or 4x the size of what it is today. There is ample growth opportunity here." It seems likely that achieving that goal will be dependent on M&A to some extent, and that is the playbook Bergeron ran at Verifone.

Regardless of how many grains of salt should be taken with that long-term view, what seems clear is that in the near term COVID has increased the adoption of cashless payment technology. For example, surveys have shown that people don't even want to touch cash, Square (SQ) recently posted that prior to COVID, 8% of U.S. Square sellers were cashless, but by late April 31% of Square sellers were cashless. Additional headlines to consider revolve around an actual shortage of coins in the U.S. as consumers eschew physical currency. The vending industry has surely taken notice of these changes, which should benefit USAT.

Moving to margin, the company has not provided formal guidance, but Bergeron has said the result of the above-mentioned operational improvements and substantial growth should ultimately be "good double-digit 20ish operating margins at some point." In investor calls, management has also hinted at the possibility of 30% EBITDA margins at scale, but again, formal guidance has not been provided. At the very least, there should be ample opportunity to improve from trailing levels which are littered by one-time items, and it is not at all difficult to imagine that this new team is more capable than the prior team.

Stock Market Opportunity
Beyond the operational improvement opportunity and growth opportunity, there is a substantial "stock market opportunity." For starters, at some point in the next few months, the company is likely to be relisted to Nasdaq, which will, of course, open up the opportunity to a whole new world of buyers who are unable to buy OTC pink stocks. This effect should be compounded next spring when the company will likely be once again be included in the indexes, forcing ETFs and closet indexers to buy shares. The effect of forced buying is likely to be particularly pronounced here as volume in the stock has all but dried up following the uncertainty tied to the restatement and proxy battle, presumably because current owners know what they own, and potential buyers have not yet realized the substantial change that is taking place here. With a ~$500M market cap and a stock that often trades well less than $1M in market value per day, I would imagine that the forced buying of USAT stock will be measured in weeks of volume, not days of volume.

Beyond these structural factors, the changing narrative of "this is a company is poorly run" to "this is a company run by a team with skin in the game that is unusually experienced for a company of this size," is powerful. Even more powerful is the fact that CEO Feeney appears to know how to tell the story of "platform company," and "recurring revenue," while also telling the story around growing not just for growth's sake, but for the sake of building value and free cash flow. The new team - who is eager to shed light on their business - has already committed to increasing disclosure, and it seems likely that all the metrics that the market loves like CAC, LTV, recurring revenue, etcetera will be front and center for the world to see in short order. It is hard to believe that the shift from "this is a poorly run company" to a metrics driven, sexy, margin expansion / recurring revenue story will not result in multiple expansion.

The Hair
There are a number of issues in the rearview mirror that have the potential to have an impact on the present. First, the prior management team entered into a lending agreement with Antara Capital that could perhaps best be described as predatory. There is a $15M note outstanding earning 9.75% interest, and given the COVID related slowdown, in the most recent conference call management indicated they would be likely to trip covenants as of June 30th. However, they also expressed confidence that they could modify covenants, Antara has a significant equity stake which should facilitate negotiations, and June 30th has come and gone with no news, so presumably everything is in the clear. Importantly, if no agreement to modify can be reached, the company could re-fi. There would be some costs attached to this, but it seems obvious that the former CFO of JP Morgan should have better luck accessing debt markets on reasonable terms than the prior team, and management has indicated that "there will be a good ending [here]."

Second, according to the most recent conference call, prior to the end of the March Q, the company received a DOJ subpoena seeking records regarding prior financials periods. This is clearly backward looking, and the company recently passed a full accounting review to get current with their financials, but it is not impossible to imagine that there will be some costs here.

Third, as of June 30, 2019, the company disclosed potential sales tax and related interest liabilities that are estimated to total $18.2M. The company is working to evaluate these liabilities and the amount and timing of any payments which may be due. It seems likely that these liabilities are tied to the previously mentioned DOJ subpoena.

Fourth, while Braunstein and Bergeron are very impressive executives, they are not without blemishes. Braunstein seems to have been the fall guy for JPM's London Whale scandal, and Bergeron seems to ultimately have been forced out at PAY after failing to realize the world around him was changing, most notably having called Square a modern pets.com. Additionally, the pair recently raised a $400M SPAC, which of course introduces the risk that they will be prioritizing other ventures ahead of repairing and growing USAT.

Lastly, while the company has indicated that the $25M in cash on the balance sheet is enough to get them through the next year, it is not impossible to imagine that they might choose to do an equity raise to really fortify the balance sheet should they choose to go into hyper growth mode and/or fund a full scale overhaul of the operating structure. However, given the substantial equity position of the insiders and obvious dilution that an equity raise would entail, an equity raise seems unlikely barring extreme COVID scenarios, and in any case would presumably not take place until after the relisting to Nasdaq, which will presumably goose the share price. Further, as we will see below, in my view the valuation is such that even in the unlikely case where there was an equity raise, the future potential is such that taking the dilution would be worth it.

Valuation
This isn't a sum of the parts story because the value of having the payments business and logistics business together is so apparent, but attempting to break them up can be revealing.

First, consider the logistics side, Cantaloupe, which was purchased in November of 2017 for ~$87M. Disclosure is limited, but the headlines are that run rate revenue at the time of the purchase was "mid $20s", the company was growing at "more than 20%" and they had 300k connections. Some finger in the air here, but the below seems reasonable:

Nov-17

Notes



Purchase price:
$86,610

$65 cash, $19.8 stock, $1.8 debt assumed



Run Rate Revenue

$25,000

"mid 20s" 11/17 con call



Connections

300

11/17 con call - gross of overlap



Growth Rate

23%

"more than 20%" 11/17 con call



Revenue per Connection

$ 83.33

Understated: based on ending connections



per month

$ 6.94

"



EV/S

3.46x



Fast forward to today, and again disclosure is limited, but the company does indicate that Seed is 50% penetrated with the company's total connections, which suggests:



31-Mar-20

Notes

Total connections



1,289

Q end



Penetration

50%

April 20 investor deck



Cantaloupe connections

644.5



Months Since Acquisition

29

Q end



CAGR

37.2%

implied trailing revenue



$ 53,708.33

@ $6.94 per month



implied revenue +1Y

$ 73,699.25

@ 37.2%


There is obviously some guesswork here and it's not really appropriate to extrapolate past growth forward considering that the company has been completely distracted with all of their problems, COVID, and new management has indicated they may choose to slow growth a bit to focus on price, but high level it appears that since the November 2017 acquisition, Cantaloupe's revenues have been growing at a high 30% CAGR which has led to something more than $50M in SEED revenue. Management has confirmed this is "directionally correct, but perhaps a bit conservative." I am not going to pretend that this is the best SAAS company ever - or even close to in that league - but for reference consider that there is still a long runway for growth here, and it is not unusual in today's market to see SAAS companies growing near 40% to garner a 20+ EV/Sales multiple.

So, given the increased growth rate since the acquisition, the increased scale, the better management team, zero churn, and the general expansion of software multiples since 2017, might the Cantaloupe part of the business be worth 6x a simple extrapolation of forward revenue? Consider that prior to the accounting debacle, the entire company traded at north of 5x forward revenue, and Cantaloupe likely deserves a higher multiple than the payments business, so 6x doesn't seem crazy... and if 6x is a reasonable multiple for Cantaloupe, then the entire payments side of the business is free to investors.

As for the business in its entirety, I'm not going to claim that unattended retail is the sexiest space ever, but I will note that fast growing payment / software companies can garner high multiples, with Square (SQ ~17x EV/Sales) and Lightspeed (LSPD.TO ~~17x EV/Sales) illustrating this point. I get it - those companies are all about the TAM, and while the TAM here is large it is not as large or as sexy, and the margin profile differs as well. At the same time, it should be noted that unattended retail is far more resilient than SMBs.

Moving away from the highflyers, Global Payments Inc (GPN) is a much larger company that is nowhere near as sexy as Square or Lightspeed that trades at ~9x EV/Sales while growing single digits organically.

Lastly, looking at USAT prior to the accounting restatement, in the past the company traded as high as 5x EV/Sales when it was considered to be very poorly run, and when multiples in the space were broadly lower.

All of this is just to say that based on these comps and the company's own history, I don't think it is crazy to throw around a 5x revenue multiple, and at 5x T12M 3.31.20 Revenue USAT would be a $12.50 stock, representing ~80% upside from here (this includes the PFDs and accrued dividends in the EV, which could probably fairly be ignored, and excludes ~$350M in NOLs).

Moving past multiples of revenue and looking forward to a time when the new team has had a chance to repair and grow the business, we can think about FCF. Based on historic growth, industry trends, under-penetration with existing customers, management commentary regarding future growth and pricing power, the potential to layer on additional functionality to SEED, the general trend toward higher priced items in vending machines, and the potential for horizontal expansion, it is not unreasonable to think that connections could ~double in the next 3-5 years to 2.5M, and that annual revenue per connection could move to $125 from $115, resulting in $312.5M in L&T revenue. I would note that prior management, as well as one expert call suggested that the company could hit $500M in revenue in 5 years, so this seems reasonable.

At this larger scale and subject to successful streamlining of the business, the business could hit 20% EBIT margins, which they have soft guided too. Finger in the air add back $6M for D&A/capex (vs $4.4M capex in FY19), and this would result in $75M in EBITDA. Punitively assuming that for some reason the management team does not refinance the existing 9.75% loan despite hints that it will favorably refinanced, noting that with $350M in NOLs the company will not have much of a tax bill, and then subtract $6M for CapEx and this would lead to about $67.5M in FCF, vs. the current EV of approximately $500M.

I would argue that a fast-growing, software-centric, zero churn, recession-resistant business led by a very experienced team with a lot of skin in the game should be worth well more than 20x FCF, but at 20x USAT would be worth about $20/share, representing upside of ~200%. At 30x (not crazy compared to comps) it would be worth about $30, representing upside of ~350%.

These are big numbers (though much smaller than what Bergeron has soft guided too), and feel free to view them skeptically. However, why I think this investment is interesting is that right now investors get a free swing at those big numbers over the next year because it is very difficult to believe that the business won't improve under the new team, and very difficult to believe that the stock won't re-rate higher as the story is cleaned up, it rejoins Nasdaq, and is ultimately added to the indexes.

A year from now we can check in on operational improvements and index inclusion and update our views on 200-350% upside. Importantly, if it becomes clear that growth will not develop as envisioned, it is highly likely that the company will be sold to a strategic who can better exploit the margin structure of the business through scale. This view is informed by the fact that HEC owns too much to exit w/o a sale, Braunstein was formerly the head of Global M&A at JPM, Bergeron's former baby Verifone was acquired, and Feeney has experience with exits as well.

Given the multiples that other payments companies trade at and their size, accretion through multiple arbitrage would make buying USAT a very attractive proposition. For example, consensus suggests that SQ will have ~$10B in T12M revenue in 3.5 years. If growth at USAT severely disappoints and is only at ~$250M in 3.5 years, SQ (or others) could pay 3x revenue (~$11/share) and tuck in USAT's revenue stream while barely making a ripple, and enjoy better margins and a much higher multiple (17x?) on those revenues. Maybe it is silly to thus call $11 the downside case, but given the incentives for all parties involved, it seems to make sense.

In sum, I believe there is very little chance that an investment in USAT will lose money in the near term due to the special situation dynamics attached to a re-listing and ETF inclusion, and very little chance that an investment in USAT will lose money in the intermediate term because if the plan doesn't work, the board is incentivized to just sell to someone with more scale. Limited downside combined with multiple ways to win is an attractive setup.

Risks

As with any investment, there are a number of near-term and longer term risks to consider. In the near term, as mentioned previously the company still must tackle a backward looking DOJ investigation, potentially refinance their outstanding debt, and deal with the unknown impact of COVID. However, in my view, each of these risks is likely to be transitory. Longer term, while at present the company has a dominant market position, there is substantial competition that must be monitored. If it becomes clear that the company's competitive position slips, the thesis should be re-evaluated. However, this risk should not apply over the next ~9 months, at which point the company is likely to be re-listed to Nasdaq and included in the R2000.

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.

Additional disclosure: We may buy or sell shares at any time.