Tier Technologies, Inc.: A Turnaround Is Afoot

| About: Official Payments (OPAY)

Share Price: $5.00

Intrinsic Value: $10.26

Buy Below: $7.18

Business Description and Background: Tier Technologies, Inc. (NASDAQ:TIER) provides biller direct electronic payment solutions to federal, state and local government, as well as to educational institutions, utility companies and other public sector clients in the United States. The company's solutions include multiple payment options, including consolidation of income payments, bill presentment, convenience payments, installment payments and flexible payment scheduling. Its solutions also offer its clients a range of online payment options, including credit and debit cards, electronic checks, cash and money orders and alternative payment types. In addition, Tier Technologies' solutions provide processing for Web, call center and point-of-sale environments. Further, it offers a front-end platform designed for the biller direct market with a single source solution that simplifies the management of electronic payments. The company's client base includes the U.S. Internal Revenue Service, 27 states, the District of Columbia and approximately 3,800 local governments and other public sector clients. Tier Technologies was founded in 1991 and is headquartered in Reston, Virginia.

Source: Yahoo! Finance

Thesis: Tier Technologies, Inc. is a microcap stock whose intrinsic value will likely be realized through divestiture, aggressive cost cutting, or acquisition facilitated by its new management. Such radical changes will be needed break from its history of losses and negative cash flows. Once the company's operations are made profitable, it will benefit from continued organic growth and an upswing in payments sizes made to government entities.

Drastic change is needed: TIER has had poor performance over the past five years. Its annual earnings have been consistently negative since 2005, with an average annual loss of 59.4 cents per share. Similarly, over the past five years free cash flows were negative, with a yearly average of -$1.5 million. What's worse, sales peaked in 2006.

TIER currently manages payments through least three separate information technology platforms. This redundancy is expensive , and makes TIER's SG&A expense high relative to the industry average. This difference is the primary reason why TIER's negative 4.9% net margin is much lower than the information technology industry's average net profit margin of 5.8%.

It seems like TIER ' s management was seduced by the allure of scale and synergy arguments. Imagine how convincing the following might seem: Let's focus on growth first, and systems later. Synergies will easily be realized once we reduce SG&A expenses with the elimination of two redundant IT systems. Merging their data will be as easy as stapling sheets of paper together, right?

Wrong! Combining two information technology systems is tricky, like trying to stitch two spider webs together. TIER tried to combine their platforms in 2009 and gave up:

" In 2009, we made the decision to consolidate our operations onto a single technology platform over time. The goals of the consolidation were to facilitate our ability to develop, sell and implement new and enhanced product offerings, improve margins by spreading fixed platform costs over a growing number of transactions, simplify our operations and reporting structure and make it easier to integrate potential future acquisitions. While we have made some progress in the consolidation efforts, we have found that completion of the development of a consolidated platform and the migration of our approximately 4,000 biller direct customers to that platform would take longer than originally anticipated. Our original plan was to complete development during calendar year 2010 and complete customer migration in calendar year 2011. We are continuing to evaluate the platform consolidation. At this time, we have postponed all migration plans for current customers. Our immediate focus is to strengthen our present platforms and make the necessary investments to provide competitive products on each of our existing platforms." (TIER 2010 10-K Filing, p. 20)

TIER discovered that restructuring is a painful, difficult process. Not only has TIER stopped trying to consolidate IT operations, but the firm has been unable to make meaningful progress in reducing headcount. Management expressed the need for layoffs, but TIER ' s employees and contractors grew from 222 to 243 between 9/30/2009 and 3/31/2011. Clearly, change will take years, not months.

Once actual change is made, TIER s operations will benefit from growth in the market for government payments based on increasing nominal salaries, real estate values and levied taxes. TIER will benefit from higher tax bills because some of its service contracts calculate fees as a percentage of the tax bill. These percentage-based fees have been reduced by the economic downturn, which has lowered average payment size. For example, lower tax-assessed real estate values yield smaller property tax bills, and thus lower percentage-based fees were paid to TIER for processing them. Smaller tax bills reduced revenues from TIER’s two largest customer segments: Federal/IRS tax-collecting and real property tax-collecting government entities, which contributed 20.5% and 32.0% of revenues over the year-ended 3/31/2011. TIER’s average per-payment fee has dropped at an annualize rate of 14.5% per year, from an average fee of $17.37 in 2004 to $6.80 in 2010. This trend is likely to reverse as inflation, economic recovery and tax-rate hikes increase payment sizes.

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It should be noted that the number of transactions facilitated by TIER has increased rapidly, at an astounding annualized rate of 41.4% per year since 2004. This growing number of transactions will be very valuable to TIER as payments and percentage-based fees increase.

For example, consider a hypothetical scenario based on TIER’s 2010 transactions and operations combined with taxes from a pre-crisis, 2007 economy. Taxes from 2007 were paid in 2008, resulting in the $11.38 average revenue per transaction collected by TIER. Multiplying this average fee charged by TIER times the number of transactions TIER facilitated in 2010 would give revenues of $213 million. With a gross profit margin of 24.5%, gross profit would be $52.2 million, up from the actual 2010 gross profit of $31.9 million. This increase changes the 2010 $6.2 million net loss to a positive $9.1 million net income.

Management and Stewardship: A management shake-up started with the appointment of payment industry veteran Alex Hart as CEO in August 2010. Mr. Hart has served as vice president of CheckFree, CEO of Corillian Corporation, and president of FleetCor Technologies (NYSE:FLT). His efforts at CheckFree and at Corillian Corporation were instrumental in making each an attractive target for acquisition. These two acquisitions are an impressive track record of increasing wealth for owners in the payments sector. Mr. Hart may be at it again, having already made dramatic changes to TIER's executive team. Since Mr. Hart's appointment, TIER has hired a new Product Management SVP, CTO, Sales SVP, and is currently seeking a new hire to fill the CFO position. Sweeping changes to the management team bode well for a turnaround.

Management is winding down operations that are unlikely to benefit TIER in the future. The firm is no longer soliciting new customers for their Voice and Systems Automation, Government Business Process Outsourcing, and Packaged Software Systems Integration businesses. Clearly, the management has the discipline to streamline operations by discontinuing or selling businesses segments.

The board has authorized the Executive Performance Stock Unit Plan, which will pay executive recipients when the market price of TIER has maintained a target share price ($8.00, $9.50, $11.00, or $13.00 per share) for 60 days. Currently, insiders own 5.3% of TIER shares and two directors, James Hale and Philip Heasley, have purchased additional shares of TIER in the past 12 months.

Valuation: Relative value metrics have limited use for TIER:

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Relative valuation for TIER is difficult because its negative free cash flows and negative earnings produce meaningless, negative Price/Free Cash Flow and Price/Earnings ratios. Furthermore, the Price/Book ratio is not very informative for technology companies. TIER's internally-developed technologies are not recorded on its balance sheet. What's worse, Price/Book ratio comparisons between companies are thwarted because the same patent or research would be recorded on a balance sheet if it was bought from another company even though its value would have been omitted from its developer’s balance sheet. These accounting conventions make the P/B ratio difficult to use for these companies. As a last resort, we see that the Price/Sales ratio of TIER is within the range of similar companies, suggesting that its market valuation is not an outlier in the industry.

A conservative turn-around scenario for TIER can be valued using a capitalized earnings model with a 5-year holding period. Analyst estimates for net losses will be endured in fiscal 2011 and 2012. Revenue growth will continue even as operations are unprofitable, as it has for the past six years, leading to a large revenue base. Revenue growth is conservatively estimated at the 20.9% growth rate experienced over the economic downturn. Earnings per share in year 3 is estimated at $0.67/share when net income margin is raised to the information technology industry average 5.8% and multiplied by the projected revenue. After five years TIER shares would then assessed or sold at a P/E multiple of 16.










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To achieve a 30% upside, we recommend buying shares at, or below $7.18.

Sources: TIER website, sec.gov company filings, Yahoo! Finance, Morningstar.com

Joe Escalada contributed to this article.

Disclosure: I am long TIER.

Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time.We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.