Large moat that will get bigger as the company grows.
Low capital requirements.
High growth business (>20%) that is scalable with no debt.
Tax credit lowers the effective P/FCF to ~14x.
Blackhawk Network Holdings (NASDAQ:HAWK) (NASDAQ:HAWKB) came to my attention because of the Safeway (NYSE:SWY) buyout and merger. I learned that the remaining shares of Blackhawk were to be spun off to existing shareholders of Safeway, along with some other stuff, to help pay for the buyout. I did not really understand what Blackhawk did from the brief company description, so I downloaded the 10-K and began to study the company. It became apparent to me that Blackhawk was a unique company in a special situation.
Brief Company Overview
The company is engaged in selling prepaid products (mainly gift cards and prepaid credit cards) and collects fees on these sales. I have decided to divide the business into two segments by customers, consumers and businesses.
For the consumer segment, the company enters into a contract with retailers (distribution partners) that allows Blackhawk to place products within their store. The distribution partners get the majority of the commission while Blackhawk takes the remainder. The products are sourced from other businesses (content providers), such as Apple (NASDAQ:AAPL). Typically, the contracts with distribution partners are 3 to 5 years with an exclusivity agreement. The contracts with the content providers are about the same length, usually with an exclusivity agreement through the channels they distribute through.
The business segment provides corporations with prepaid products from content providers. Again, Blackhawk receives a fee for the products it sells. Businesses could use these for customer rebates and loyalty programs or for employee rewards and incentives. The business segment, for the most part, was acquired in 2013 and is in its formative years (i.e. much smaller).
What is so Good About this Company?
This business is a toll bridge business, meaning it takes a small piece of the pie in exchange for a value adding service to all involved. The business essentially has two relationships, one with suppliers (content providers) and the other with customers (distribution partners and businesses). For the content providers the company provides a cost effective way to incrementally increase sales as well as increasing brand awareness. For the distribution partners the company also provides about 2/3 of the commissions as well as increased foot traffic into their retail locations. The area dedicated within the distribution partners stores are usually one of the most productive areas. For businesses that Blackhawk supplies prepaid products to, they provided a wide offering of solutions in a more cost effective manner than traditional methods.
I liken Blackhawk to a credit card company; follow me on this one. What makes a credit card company valuable are its relationships with acquiring banks and merchant banks. As long as a credit card company has a relationship with both banks (as well as the infrastructure) the credit card company can process the transaction. This allows the bank to be a bank and not need a relationship with other banks domestically or internationally. In exchange for this arrangement the credit card company takes a small fee while the lion's share goes to the banks. As the network becomes larger it makes less economic sense to leave. The increasing size of the network will attract more and more people to the network. Much like a black hole getting larger, its pull also gets stronger.
Blackhawk maintains relationships with content providers and distribution partners. This allows the content providers and distribution partners to continue to do what they do best. Blackhawk allows the content providers and distribution partners to not need a relationship with one another. In exchange for this arrangement Blackhawk receives the smallest fee of the three participants. As the pool of distribution partners becomes larger it makes less sense for a content provider to decline this service or go to a competitor. As well, as the pool of content providers also becomes larger it makes less sense for distribution partners to decline this service or go to a competitor. It is a very virtuous cycle.
The retention rate of distribution partners and content providers in the consumer and business segment is in the high 90% range. The business segment, although very young, is even stickier. In a recent conference call management noted that ~68% of the Fortune 100 uses their services with a nearly 100% retention rate. Within the consumer segment Blackhawk dominates the grocery stores (distribution partners) in the United States, having almost all of the market share. Internationally, the industry is much less developed (which is good for Blackhawk's future).
The company has negative working capital with relatively little net fixed assets. The returns on invested capital are extremely good. For example, in 2013 Blackhawk had -$142 million in WC and $80 million in NFA. Total common equity was $221 million. FCF in 2013 was ~$76 million.
Hopefully, I have convinced the reader that Blackhawk is a unique company with a moat that will get much larger with time.
High Growth Business
It is my belief that it is very hard to accurately quantify growth opportunities for companies in general. I highly recommend doing your own research and coming to your own conclusions especially and particularly about growth. Nevertheless...
The mid-point guidance for next year's adjusted operating revenue growth is 26%. Adjusted operating revenue CAGR was 26% from 2009 to 2013. Adjusted EBITDA CAGR was 28% from 2009 to 2013.
With the completion of the spinoff, Blackhawk will be able to pursue avenues previously unavailable, because of Blackhawk being owned by Safeway. One example is Wal-Mart (NYSE:WMT). Growth opportunities for Blackhawk are abundant both domestically and internationally. The total addressable prepaid market is estimated to be about $221 billion for 2015 in load value and the market is growing. Load value is the amount stored on a prepaid card or product. Blackhawk has about $10 billion with most of that being in third-party gift cards. Major avenues for extremely high growth will probably come from prepaid telecoms, incentives and rewards, third-party gift cards internationally, and general purpose reloadable gift cards. Knowing this and Blackhawk's business model, I believe that Blackhawk's best days are actually ahead of it.
This is just speculation, but I believe that as Blackhawk grows, the bottom line will grow at a faster pace than the top line. This is because of Blackhawk's ability to effectively scale its business.
Tax Benefit and Valuation
If the merger between Safeway and Albertsons is consummated Blackhawk will probably receive a tax credit of about ~$30 million for 15 years. Doing a quick DCF at 10% equals a PV of ~$4.35 per share. This effectively lowers what you are paying for Blackhawk to (assuming $24.35 share price) $20.
The EPS or net income is not really indicative of Blackhawk's earning power. Luckily, the operational cash flow is indicative. Before changes in WC, Blackhawk brought in ~$106 million in operational cash flow in 2013. CAPEX was ~$30 million therefore, FCF was ~76 million. Dividing FCF by shares outstanding gives us ~$1.46 per share in FCF. This is a good proxy for real earnings.
Taking a share price of $24.35 and subtracting the $4.35 PV of the tax credit gives us an effective share price of $20. With FCF at $1.46, P/FCF is ~14x (13.7x if you want to be precise).
What should the multiple be? I have no idea, but I am pretty sure 14x is about as low as you are going to get for this high quality and high growth business.
Risks to the Investment
- The moat I described could be an illusion and therefore the business could materially degrade.
- Tax credit could not materialize therefore raising the purchase price of the business.
- Growth could not materialize or at much lower rate (<5%).
- Dilution of shares could adversely impact the per share value of the business.
- I could be totally missing the boat with this analysis.
This is a high quality business with an incredible amount of growth potential. The price you are paying for the business is actually cheap for what you are getting. The risks for this investment are very low. Even if the growth is just an illusion, 14x for a high quality business is still fair in my opinion. Crucially, this investment is a "compounder" and will require a long time horizon (3-5 years at least).
Disclosure: I am long HAWKB. 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.