- Company has turned the corner to profitability; limited debt and total liquidation preference limit the downside risk of the Preferred security.
- Accumulated liquidation preference is already ~83% higher than the current USATP price, but non-compounding cumulative dividends result in an unusual IRR calculation.
- If the company is bought out before mid-2023, you can earn a 10+% IRR over the holding period, however, longer holding periods result in lower rates of return.
- If you believe USAT is likely to be bought out sooner rather than later, the Preferred shares may be a better bet than the common--with less downside risk.
Much has already been written about USA Technologies (NASDAQ:USAT) from the perspective of the common stock. However, I believe that the publicly traded preferred stock (USATP) may offer a better risk/reward trade-off--but only if you believe the company will be acquired at some point over the next 9 years.
The basic structure of the USATP shares is that they have an initial liquidation preference of $10/share, with an accruing cumulative non-compounding preferred dividend of $1.50/share/year. The dividend accrues in two semiannual installments of $0.75/share, but all of the liquidation preference and accruing dividends are only paid at the time that the company is sold. What makes these shares interesting, at present, is that the market value of USATP shares is only $20.63 relative to a per-share liquidation preference of ~$37.68 ($16,690,456 total preference / 442,968 shares outstanding, according to the 10-Q for the period ending 3/31/2014) (I could not find a more reliable source for the exact preference outstanding per share--which would need to be of the form $10 + $0.75 * n where n is a positive integer).
While there is an optional conversion feature to the preferreds, its value is, for all intents and purposes, 0; the conversion price is >400x the current price of the common ($1000/share)! As a result, this write-up looks at the liquidation preference of the preferred shares under the assumption that the holder will not make use of the optional conversion feature.
USAT had approximately $5 million in debt, as of 3/31/2014, and the aforementioned liquidation preference--requiring the first ~$22 million of proceeds of a sale to go to the lender and preferred shareholders before the common participates. As the company is profitable, and the $2.10 price of the publicly traded common stock implies a market cap of ~$75 million, it is unlikely that the company would be sold for less than $22 million. As a result, the downside risk to the preferred shareholders, barring a substantial deterioration of the business, is low.
Bolstering the case for limited downside is the company's recurring revenue business model. For the quarter ending 3/31/2014, ~$9.0 million of the company's $10.4 million in revenue was "recurring license and transaction fee revenue." Recurring revenue businesses are less likely to see large short-term swings in revenue, and are generally better able to forecast future revenues. The company's outlook still seems optimistic, and they have not made any comments that suggest the company's profitability will erode. In fact, management's press release from 5/30 implies that recent performance "leave(s) us very encouraged about the business."
It is worth noting that the company has increased its line of credit and entered into a sale-leaseback transaction subsequent to the end of Q1. However, even with the additional debt, the preferred would still seem to have relatively low downside risk.
If you believe Northland Capital Markets, that the company may be acquired in a reasonable time horizon, the Preferred shares offer considerable upside. Below is a table of gross returns and IRR by holding period, assuming preference continues to accrue on schedule and the full preference is paid upon the acquisition.
Holding Period (years)
As you can see from the table above, the lack of compounding causes the IRRs to drop for longer holding periods. Thus, a 10+% IRR can only be attained if you believe that the company will be acquired at some point over the next 9 years. However, this returns table, given the limited downside, may appear attractive to many investors. Junk bonds, with more downside risk, for companies of lower credit quality than USAT, are unlikely to be yielding 9.80% on a sub 10-year duration.
This returns chart also seems attractive relative to the company's own common stock. The common is buried under the debt and preference; furthermore, it would need to increase by a percentage equivalent to the gross return in the table above merely to keep pace with the returns to the preferred shareholders. Only if the company remains independent, and does not put itself up for sale in a reasonable time horizon, is the preferred highly likely to underperform the common. However, given the active M&A environment we find ourselves in, it is probably more likely than not that the company is sold at some point over the next decade.
Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
Additional disclosure: I am long USATP (the preferred shares). I do not own the USAT common shares.