“By prevailing over all obstacles and distractions, one may unfailingly arrive at his chosen goal or destination.”- Christopher Columbus
Needless to say, it has been an incredibly tumultuous environment. The economic outlook, despite a few specks of light in a dark sky remains quite bleak. Despite this, I have been encouraged by valuations, by the tape action, and by the prevailing sentiment that continues to express doubt in the strength of this rally.
For today’s thoughts, I would like to focus on the tech sector. Tech stocks, in my view, are beginning to discount a recovery and unlike the tech bubble of the turn of the century, generally constitute reasonable business models. Many of these companies have substantially improved their manufacturing footprint to lower cost geographies. Many enjoy recurring revenue models. Many enjoy strong reputations and decent customer loyalty. However, in a climate of falling capital expenditures by their customers and the experience of building inventories, and falling prices for commodity products, the industry has generally been swift in its response by cutting employment and focusing on cost control.
Real tech spending fell at almost a 24% annualized rate in the fourth quarter (according to Ned Davis Research), the biggest drop since 1990 and in fact, much larger than the 18.6% drop in Q2 of 2001, when the tech bubble burst. As a percentage of GDP, tech spending fell to just 3.6% of GDP down 0.3% Q4/Q3 and down from a peak about two years ago of just over 5%. The quarter over quarter drop in tech spending to GDP exceeded the drop in the 1973-75 and 1981-82 recessions.
The industry responded by cutting production and employment. Capacity utilization in the industry went from just over 80% to 59.9%, a record low.
It is important to keep in mind that many of these trends are quite long in the tooth, in many cases having portended the industry recession. We may well be near the end of the downtrend in this industry. For example, new info tech orders declined for 28 months post tech bubble… Currently, we are in the 34th month of decline in this metric. The semiconductor book-to-bill ratio declined for only 13 months post tech bubble… Now, we are in the 31st month!
Earnings expectations have weakened substantially. The 2009 median expected growth rate has dropped to about -10% from expectations in early 2008 of about +20%. Though growth expectations post tech bubble bottomed at -26% in September of 2001, this coincided with the bottom in these stocks. From a valuation standpoint, price-to-book and price-to-sales ratios are below the 2002 troughs. The current price-to-book ratio is at 2.5 times as compared to the September 2001 trough of 3.3 times. The price-to-sales ratio is currently at 1.5 times as compared to the prior 2.1 times.
As you can see from the screen, there are many cheap stocks from which to select, in many cases with excellent balance sheets.
One subsector within technology that I believe has been ignored is the ATM sector. As one can imagine, at a time when banks are more concerned about retaining capital to ensure their solvency in a deteriorating credit environment, there should be little propensity to spend on ATMs. Investors remain concerned that increasing bank failures, potential nationalization, and general credit concerns will severely impact the operating performance of the ATM manufacturers.
Yet, some of this concern may well be overblown. During the S&L crisis of the 1980s when almost 1500 banks failed, the ATM manufacturers experienced rising sales as new banks emerged and surviving banks increased their focus on efficiency and innovation to reduce their costs.
The global market is dominated by Diebold (DBD) and NCR (NCR). Demand for self-service solutions has been steady from the large national banks that have rolled out deposit automation and bulk checking products. Roughly two thirds of ATM demand is replacement driven. Replacements are driven by regulatory and technological changes as well as aging of the equipment which has a useful life of six to eight years.
In a recent broker conference, NCR’s CEO Bill Nuti described the recurring nature of his business:
I think we also have a fairly stable revenue stream inside the Company. When you look at our revenue stream, approximately 40% of it is services, annuity-based services maintenance, which has contracts that stem from a year to five years in length, and a fairly stable revenue stream.
Another 10% of our revenue is in consumables. That tends to be fairly stable. This would be purchasing of paper rolls for point of sale or two-sided thermal paper technologies and printers. Another 20% or so comes in the year vis-a -vis backlog. Backlog coming into the year that we expected to turn in the year.
So, you've got about 70% of the revenue stream that's relatively reliable, strong revenue stream. The rest, of course, comes from success within the year.
I think large banks in the US will continue to roll out deposit automation at a fairly aggressive rate in 2009. We have a very good position in that particular segment of the banking market.
One of the important technological developments in the ATM industry has been the direct deposit taking ATM where the money is deposited immediately as opposed to an envelope-taking ATM.
Nutti describes the advantages of this technology:
A return on investment has been nothing short of outstanding for the banks that deploy deposit technology. In fact, today, the reason why in this environment you're seeing banks roll out deposit technology as aggressively, is because they're being, basically, the departments of the banks that are rolling this technology out are being told by the leadership of retail banking, we need to get X tens of millions of deposits out of the branch and automated onto a machine because of the cost savings.
So, the cost savings are phenomenal for a bank to take someone who was once depositing checks in a branch vis-a -vis a teller now onto a machine. And so you're seeing tremendous cost savings.
I've got one customer who recently was requested to move more rapidly with deposit automation because they need 60 million checks that were normally deposited in branches to now be deposited vis-a-vis deposit-taking ATMs. So, that's one customer. And you can imagine, you could put any number, any dollar savings you want against the 60 million checks and come up with a pretty good ROI given the cost difference.
The difference is discernible to customers as well, spending only seconds rather than waiting in line in a branch for a teller. The bank would far rather employ a person as a salesperson, selling additional higher margin services and establishing customer relationships rather than depositing checks in a drawer.
For NCR, there is also exposure to the airline industry and its self-serving kiosks. NCR is the number one provider of these devices to the airlines with an 80% share. According to the company, to check in by waiting in a queue at the airport costs about $3.15 per transaction. Checking in by kiosk runs $0.14! That is a tremendous cost savings.
The company anticipates that it will generate free cash flow in 2009 despite needing $200-$250 million to fund its pension plans. Currently, the company has $403 million in cash and investments per share (roughly $2.50 per share) net of debt.
The company launched over 50 new products in 2008, the highest number in more than a dozen years, including the launch of the industry's newest and most innovative ATM family, NCR SelfServ.
In the retail industry it introduced a next-generation self check-out solution, 5.0, and other point of sale solutions that have captured significant market share. NCR is gaining significant traction in expanding its self-service strategy into new industries including the entertainment industry that promise to open up future avenues of growth for NCR.
For Diebold, some 50% of its revenues are service oriented, consisting of annual maintenance, servicing and monitoring contracts. In North America alone, the company has over 120,000 annual contracts to service the installed ATM base with a renewal rate of well over 90%. The company has generated about $250 million-$300 million in EBITDA annually whereas capex has run around $40 million. A concern is that DBD has been the subject of an accounting investigation by the SEC relating to revenue recognition practices. From a corporate governance standpoint, last March United Technologies (UTX) offered to buy DBD for $40 per share which the company rejected as inadequate. Recently, the company allowed a poison pill provision to expire. Back in 2005, the board dismissed most of its senior management because of poor internal controls and controversy about its election systems division which represents about 5% of sales.
The company has made significant strides in cost reduction since the 2005 disaster. As per its most recent conference call:
More than just squeeze cost out of the old process, they identified best practices that were new to Diebold and implemented them successfully. As a result of the success of this initiative in 2008, we expanded the effort to eliminate an additional $100 million of cost out of the Company by the end of 2011. Key to the next 100 million, we expanded our relationship with Minlo, our logistics partner in the supply chain area. They assisted us in reducing our finished goods warehousing footprint from 89 company operated facilities down to three Menlo operated logistics centers. One center located in Greensboro, North Carolina is a flexible delayed product configuration facility serving market in North America and Latin America. This helps us improve lead times to customers while reducing costs.
We also improved manufacturing footprint. We have 85% of our production in low-cost geographies. By increasing production in low-cost geographies, we are also manufacturing our ATM products closer to our key customers in growth regions in Asia and eastern Europe. In addition, we consolidated security manufacturing facility in Ohio, with existing facility in North Carolina. To further streamline our operations, we expanded our vendor managed inventory system. We continue to leverage our relationship with Ariba implementing best practices and direct indirect procurement processes.
NCR trades at merely 2.6 times trailing EV/EBITDA reflecting $1.5 Billion in equity market cap, $333 million in debt and over $700 million in cash or an enterprise value of $1.1 Billion.
DBD trades at 7.6 times EV/EBITDA with $1.5 Billion in equity market cap as well, but $620 million in debt and $360 million in cash or an enterprise value of $1.7 Billion.
Here is a look at the quarterly progressions of working capital management, capital intensity, and ROIC for these companies.
In conclusion, I believe that there are many opportunities within the tech sector that are worth further exploration and investigation. By prevailing over the many distractions, focusing on value, and relying on recurring revenue models, investors can earn significant long term returns with some patience. I believe that the ATM industry in particular represents an unappreciated sub-sector in tech.
Courtesy of Seeking Alpha, I have been privileged to have been introduced to an exciting new research product called Gridstone Research. Gridstone is a new research platform that combines financial data, operational data, and unstructured textual information about a company into a structured useful form.
As I become more proficient with its use and application, I will be incorporating Gridstone into my financial models.
For now, a very basic look at NCR versus DBD's profitability over the last several years.
Disclaimer: I, my clients and family may have a current position in securities mentioned in this blog post.