NCR: Room To Run, But End In Sight

| About: NCR Corporation (NCR)

NCR is a global provider of ATMs, point-of-sale equipment, self-service kiosks, and other software in four major verticals, namely: financial services, retail, hospitality, and travel. The company has performed very well of late and has been on a 5-year upswing under the stewardship of CEO and president, Bill Nuti, who helped transform the ailing, 100+ year-old company into an innovative market leader. Despite the 12-month run up in the stock, there are a number of reasons why NCR is still relatively attractive, though data and analysis suggest there's not a lot more room to run.

In ATMs, NCR is the world's largest manufacturer and has an effective duopoly in the U.S. market with Diebold (NYSE:DBD). The company also controls a high percentage of the ATM market in India, has a strong duopoly franchise in Europe with Wincor, and has significant market share in China and Brazil. Globally, the company has an installed base market share of 30%.

More significantly, NCR has made a strategic shift over the last several years to move from a hardware-focused company to a more diversified firm with a higher margin, recurring, and faster growth software as a service business. One major part of the shift was the acquisition of Radiant Hospitality in 2011. Radiant provides POS terminals and kiosks for restaurants, movie theaters, sports venues, and hotels. Prior to the acquisition, NCR had 4% revenue growth, 22% gross margins, and 7% operating margins. Radiant brought 20% revenue growth, 45% gross margin, and 12% operating margins to the table.

This month, NCR also completed its acquisition of Retalix, a leading retail platform based in Israel that serves many blue chip companies including Tesco, Target, and Tiffany & Co. The combined unit should reap some operational and administrative efficiencies due to joint synergies. NCR should also be able to cross-sell existing products and share R&D best practices. More importantly, the move is added evidence of NCR's commitment to being the #1 player in each of its businesses.

Another area in which NCR is well-positioned is the U.S. ATM upgrade cycle, which is only 50% complete. Many regional banks such as M&T (NYSE:MTB) are still suffering from regulatory and compliance uncertainties surrounding Dodd-Frank, but should improve in the near future given healthy balance sheets and stronger cash flow generation (though interest rate pressures may persist for several years and dampen large-scale spending efforts). Large, diversified financial services firms like Chase (NYSE:JPM) have already upgraded ATMs that boast NCR's innovative Scalable Deposit Module technology, the first of its kind in 2011, which allows customers to simultaneously deposit cash and checks through one slot into their accounts.

There's also a retail upgrade cycle that has already begun and which represents a $1 billion dollar opportunity. Last year, NCR announced a key $100 million POS contract with Wal-Mart (NYSE:WMT) for 10,000 self-checkout terminals to be installed in 2013. Expect the trend to continue in the coming years. IBM, among others, is also involved in the space and holds agreements with CVS to provide self-checkout terminals.

NCR is also forging ahead with innovations in small business through its NCR Silver platform, a POS solution that moves beyond simple transactions and allows business owners to measure sales, market to customers, and track inventory, all on an i-Phone or i-Pad. Users would pay a monthly fee for the service, again illustrating NCR's high degree of operating leverage in frontier products.

Finally, the stock is still trading at an attractive valuation. Following strong fiscal year 2012 earnings, the company is currently trading at 8.8x 2014 adjusted EPS, which is a 3.2-point discount to its historic five-year average multiple of 12x and a roughly 4-point discount to its peer average of about 13x (Diebold, VeriFone). (One should note that NCR is becoming diversified enough that peer valuations become thornier). A major reason the company had been trading at a depressed multiple was because of a former $1.3 billion pension liability issue, the result of heavily-weighted investments in equities prior to the 2008 financial crash. NCR addressed the massive overhang in Q3 2012 when the company exploited record low rates and issued debt to pay down $500 million of the pension liability. The company also offered a lump sum payout in Q4 2012 that effectively shaved off another $300 million.

With the company's 2015 projected EPS of $3.65 to $4.25--and having beaten analyst estimates for the past 10+ consecutive quarters--there's some confidence in using the projections as a ballpark approximation, although the figures are definitely aggressive and may overstate the case. At its five-year historic average of 12x earnings and projected earnings on the lower end at $3.65, the company would be valued at $43.80 by 2015. Subtracting $3 a share for the remaining pension liability, the base case scenario for the stock is $40.80 by 2015.

However, relying on 2015 estimates is burdened with risks given the distant time horizon. Using current non-GAAP estimates for full year 2013, which range from $2.65 to $2.75 a share based on 9-11% constant currency revenue growth, is a more conservative measure. Using the higher end of that value given NCR's recent history of consistent earnings surprises yields a current forward multiple on 2013's earnings of about 9.8x. If the stock increases to its 12x mean over the course of a year, the stock would be worth $33. Factoring in the pension liability issue, the the price drops further into the low $30 range. At around $27 as of this writing, the stock is already trading at 12.5x non-adjusted GAAP EPS estimates for 2013.

There are other key risks to the picture. The U.S. has 1300 ATMs per million people, while China has 100 and India has 50. On its face, low ATM density in NCR's key international markets seems like a boon that may presage exponential growth. However, intensifying developments in mobile banking and a general long-term move towards a cashless, virtual money society raise questions as to whether India and China may bypass the ATM generation by a high degree in the coming years in the same way much of Asia skipped building telephone lines (one should note that ATM growth in Asia is still strong and was over 14% in 2010). Counterbalancing this threat is NCR's burgeoning strength in mobile banking solutions (APTRA), including pre-staging ATM withdrawals via mobile apps. Contingencies like these make NCR a wily and well-capitalized player.

Another issue for NCR is the longer-term shift in retail from brick-and-mortar to e-commerce channels, which may lower point-of-sale and self-service checkout demand. However, the recent Walmart deal and gross savings for retail companies from lower general and administrative costs mitigate these concerns. Moreover, in 2008, an NCR survey highlighted by showed that "72 percent of shoppers are more likely to shop with a retailer that gives consumers the flexibility to interact easily via online, mobile, and kiosk self-service channels, versus a retailer that does not." Data like that, though self-serving, adds credence to the story that retailers will increasingly be relying on self-checkout options in the future.

Yet another problem lies in the ever-present domain of industry competition. The recent troubles for VeriFone suggest near-term volatility for the industry. The company's potential displacement will likely only intensify fierce competition from Diebold. Furthermore, large, established firms with deep pockets, high R&D spend, and even higher pressures to show yearly growth like IBM and HP (NYSE:HPQ) are in the mix too. Other concerns for NCR lie in the macro arena abroad, particularly in emerging nations, where the possibility of cooling momentum in India, China, and Brazil may affect the company's growth. This is an area that seems less of a concern in the short-run (1-2 years) than in the medium-term (3-5 years).

There are also questions about NCR's recent quarterly performance. Buried under excellent annual results, the company reported a year-over-year gross margin decline of 3.8% from 24% to 20.2% in the last quarter due to rising costs. CEO Nuti has also been selling a large number of shares, and there have also been a slew of high volume dispositions over the last two months by other officers. While a few sales don't necessarily indicate anything, the onslaught suggests that the smart, inside money is exiting at least a good portion of vested capital. What's more, David Einhorn (a big NCR believer since 2010) and SAC Capital also reduced positions in the past quarter, albeit slightly.

Overall, NCR is an innovative market leader with a solid balance sheet, lots of cash, and a diverse, growing set of business divisions. The question is whether the company's growth and aggressive earnings targets are sustainable relative to price appreciation. The stock is more of a hold or weak buy at this point, and without any major catalysts, it's best to reevaluate the position at the end of the year. Given strong growth prospects, I expect NCR to trade in the low $30s within the next 8-12 months, where it will be at a more stable valuation.

Disclosure: I am long NCR. 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.