Short of a name change, it's likely going to take a long time before investors stop thinking of NCR (NCR) primarily as a manufacturer of ATMs and retail self check-out kiosks. After all, that's what we all see on a day to day basis when we go to the bank or a store. There's a great deal more to the story, though, as NCR has invested significantly in its services and software capabilities.
With the acquisitions of Digital Insight and Alaric Systems, announced on Monday evening, NCR has significantly accelerated that transition towards a service and software-oriented company. The deals are expensive in terms of multiples, but the potential from operating synergies, cross-selling, and addressable market expansion make them worthwhile. While there are areas of sluggishness in the financial and retail spaces that threaten near-term performance, I believe these shares of NCR remain meaningfully undervalued in a market that offers few of those opportunities.
Digital Insight - Will NCR Do Better Than Intuit Did?
The biggest part of Monday's news was the nearly $1.7 billion acquisition of Digital Insight from Thoma Bravo. Digital Insight, formerly part of Intuit (INTU), is a provider of web-based (SAAS) software to the banking industry. Digital Insight's customers are largely small and mid-sized banks, with a roughly 40%/60% mix between regional and community banks, and Digital Insight provides them with a wide range of software solutions covering functions like internet and mobile banking, electronic payments, funds transfer, online financial planning and so on.
This deal offers tremendous potential synergies for NCR, to say nothing of accelerating the company's drive to a less hardware-based, higher-margin revenue stream. Less than a third of Digital Insight's customers are current NCR customers, and likewise relatively few of NCR's 3,000 global mid-sized bank and credit union clients are Digital Insight clients. While larger companies like Fiserv (FISV) and Fidelity National Information Services (FIS) are partial competitors, they're actually more partners to Digital Insight than rivals. Most of Digital Insight's rivals are small companies that focus just on a particular offering (like electronic bill pay, funds transfer, or online statements).
I will be very curious to see what impact this has on NCR's legacy financial services business. NCR was already the largest ATM manufacturer in the world, and I don't see how Diebold (DBD) or Wincor Nixdorf (OTCPK:WNXDY) answer this, provided that bundling and integrating services does in fact make the hardware stickier.
The Market Raises An Eyebrow Or Two...
While NCR management was ebullient on the conference call discussing these moves, analysts seemed more skeptical and the stock sold off initially.
Now there are a few yellow flags here. First, Intuit wasn't able to do much with Digital Insight, as revenue didn't grow much at all in the last two fiscal years in which Intuit owned them. I blame some of that on Intuit not really having the market position or focus in banking to maximize the value, as well as the challenges in the banking sector in recent years where many banks were just as focused on surviving and shoring up their capital as building out their digital banking capabilities. In the hands of NCR, though, I believe that Digital Insight has an almost instant "in" with NCR's large bank/credit union client base (and vice versa). Moreover, with credit ratios at banks in much better shape and a serious drive to eliminate costs, I believe NCR/Digital Insight is now in the right place at the right time to deliver a host of automation and digital solutions for the financial sector.
I'm also a little curious as to why NCR paid almost $1.7 billion to Thoma Bravo when Thoma Bravo paid just over $1 billion to Intuit about four months ago. Management talked about Thoma Bravo having made meaningful progress with cost synergies and streamlining, but I think the question stands as to why NCR and Intuit didn't get together on a deal between themselves. I'll give NCR management some benefit of the doubt and go along with the idea that Thoma Bravo made some moves that enhanced the value of Digital Insight, but I struggle to believe that those moves were worth a 70% premium over just a few months.
I also believe that the market may be quailing a bit at the significant increase in debt that NCR is taking on to fund this deal. Given that net debt was already greater than shareholder equity, this too is a fair point. What I would argue, though, is that NCR has significant free cash flow generation potential just under the surface, and as their pension issues get cleaned up here shortly, a lot of that obscured FCF generation potential will come to the surface. Elsewhere, I believe the significant expansion/extension of the company's software operations (particularly through Digital Insight) will lead to significantly greater FCF generation in the coming years - things may be tight for a few years, but I think NCR's debt ratios will get back to less concerning levels quickly, and management indicated that they don't intend to launch any additional large deals in the near term.
Integration Is Not Much Of A Risk (To Me...)
NCR is paying a lot for Digital Insight - five times trailing revenue and nearly 16 times trailing pro forma EBITDA. Those multiples are in line with what NCR paid for Radiant and Retalix, and this deal will be every bit as transformative for NCR's financial services segment as R&R were for retail and hospitality.
What's more, NCR has a pretty good history of "under-promising and over-delivering," as the Retalix deal in particular has generated better revenue and margin synergies than management originally projected. Given NCR's existing capabilities and emphasis on bank branch transformation/automation, ATM hardware and software, and check/imaging solutions, this deal (meshed with the acquisition of Alaric and its fraud detection, payment processing, and ATM/card transaction software) gives NCR a wide range of capabilities and solutions for sub-national/super-regional banks with very logical complementary points of integration.
Trading Debt For Growth
This deal will roughly double the company's net debt, though management's comments on the call suggested they would secure relatively attractive pricing on the new debt needed to fund the Digital Insight deal. That certainly puts a spearhead against the back of management, encouraging them to make these deals work and generate meaningful rates of return, but also threatening bloodshed if there are shortfalls or missteps along the way.
I do believe NCR will generate strong synergies and growth from this newly enlarged financial services business. Likewise, I think investors may be underestimating just how large of a software and "FinTech" company NCR will become, as well as the margins and free cash flow leverage than should accompany the transformation. But it's not just a financial service story - there are still meaningful opportunities for NCR to grow its footprint in the software and services areas of retailing and hospitality, not to mention converting more users over to NCR Silver, NCR's mobile point of sale competitor to the likes of Square and Intuit's GoPayment.
I'm now looking for revenue to grow more than 6% over the long term, with Digital Insight, Alaric, and my own estimated cross-selling/synergies adding almost a point to the growth rate. Upon close, NCR will have more than a billion dollars a year in software revenue and not only will NCR emerge as one of the largest FinTech companies, it will be among the largest software companies in the country over the next three to five years. Should mobile payment technologies like Silver take off, and/or the company continue to gain share in hospitality software/services, it would only be gravy on top of those projections.
I am also now more confident in NCR attaining a double-digit free cash flow margin many years down the road. NCR's trailing EBITDA margin has been around 9%, but Digital Insight comes in with a margin above 30%. While SaaS companies have been somewhat notorious for underwhelming operating leverage as they scale up, they do nevertheless throw off good cash flow (double-digit percentages of revenue). I believe this shift towards software and services will help NCR move from a company with single-digit free cash flow margins into the very low double digits over the next decade, leading to a sharp 10-year CAGR - something the Street often pays up to get.
Even with the influx of debt to fund these deals, the improved growth and margin prospects result in a fair value of over $42 and into the high $40s' if you're willing to get more aggressive on the pace of the accretion, synergies, and margin improvements. While the next 12 months may not be so eye-popping in terms of performance, I believe the next three to five years will see significant operating leverage and consistently higher revenue growth rates.
The Bottom Line
I wish NCR had sold off a little more, as it would be even more compelling to free up some cash in my account to buy these shares. As it is, NCR is sitting at or near the top of my list of new stocks to buy. With appreciation potential of 30% to 40% and bank branch automation/transformation just starting to being in earnest, I think this could be a real winner and another example of a stock that rewards investors in the transition from "old tech" to "new tech."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. (More...)
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