EasyLink Beats Expectations, Supports Idea of Low Interest Rates to Stock Valuation

Jun.10.11 | About: EasyLink Services (ESIC)

EasyLink (NASDAQ:ESIC), a provider of cloud-based messaging and e-commerce services, reported its financial results for the fiscal third quarter of 2011 (ending April 30, 2011). Earnings and revenue beat expectations, and ESIC skyrocketed 75 cents yesterday to close at $4.73.

This was a very important quarter for ESIC because it was the first real opportunity to assess results of the major acquisition it made late last year. I have described this transaction in earlier articles but, essentially, ESIC acquired an operation at least as large as itself and financed the acquisition with relatively low interest rate debt.

The result is a much larger operation with increased cash flow but also increased interest expense. It has been my thesis that one of the impacts of ultra low interest rates will be to enable cash for stock acquisitions to accelerate so that the acquiring company increases its total and per share cash flow, because the cash flow of the additional operation added in the acquisition exceeds the additional interest rate expense of the debt used to finance the acquisition. EasyLink is a good test case for this proposition because the acquisition was a cash for stock deal and we can now monitor the company's financial progress.

ESIC generated $47.8 million in revenue (an annual rate of $190 million which is higher than the $180 million I recently projected) and recorded earnings of $4.3 million or 13 cents per diluted share. I calculate recurring cash flow by adding depreciation, amortization and other recurring non-cash expense items to income and subtracting capex. For the third quarter, I get $7 million in recurring cash flow, which fits nicely with balance sheet trends. In the third quarter, balance sheet cash increased by some $6.7 million to $27.9 million. Debt is at roughly $116 million and the effective average interest rate at the end of the third quarter was 4.45%.

Comparing the company before and after the acquisition by comparing the third quarter with the third quarter a year ago shows that the acquisition has enhanced the company's revenue and profits. Compared with a year ago, revenues increased by $27.1 million, gross profit increased by $16.3 million, net income increased by $2.35 million and earnings per share more than doubled. Interest expense increased by $1.3 million but this was swamped by increases in revenue and income and the result was a big increase in the bottom line.

Because the earnings yield of the acquired operation was so much higher than the interest rate on the debt used to finance the acquisition, the company was able to take a major stride forward.

ESIC should be able to pay off its debt with cash flow at the rate of roughly $30 million per year and, with a $28 million head start, can probably be debt free in about three years. As the debt is paid off after tax interest expense will decline adding roughly 15 cents a share to earnings. Using the third quarter earnings of 13 cents and adding 15 cents per year, a debt free ESIC would earn 67 cents per share. Factoring in some cost savings through synergies and some modest growth, it should not be implausible to see ESIC ramp up to 72-80 cents per share in earnings over the next three years. Taking the mid point of this range and applying a multiple of 15 for a debt free company, ESIC could very plausibly trade at $11 a share. I am using very conservative projections of growth; if growth continues to surprise on the upside, a much higher price could be achieved.

This stock remains one of my highest conviction long positions.

Disclosure: I am long ESIC.