EasyLink Services: Solid Quarter - Long Thesis Intact

 |  About: EasyLink Services International Corporation (ESIC), Includes: PG
by: Philip Mause

EasyLink Services (NASDAQ:ESIC), a company in the on demand messaging and supply chain messaging businesses which closed Thursday at a price of $4.18 a share, just issued its financials for the first quarter of its new fiscal year. There was a modest sequential uptick in revenue, margins improved and ESIC continued its rapid debt pay down. ESIC made a very large debt financed acquisition last Fall and year over year numbers are not really comparable because, for the comparable quarter a year ago, ESIC was a smaller company.

I have been reviewing sequential quarterly numbers and it appears that top line revenue is growing slowly and the company is following through on its plan to pay down the debt incurred for the acquisition rapidly. In the nine months ending October 31, my calculation is that net debt (total debt minus cash) decreased by some 24 million dollars or at an annualized rate of roughly 32 million dollars. Since the company doesn't pay dividends and did not make acquisitions or buy back stock during this period, the net debt pay down is a good measure of cash flow available to the creditors and owners of the enterprise.

In future quarters, cash flow should be enhanced by expense reductions associated with synergy and lower interest expense as the debt is paid down (the effective interest rate is in the 4.5-5.0% range and so the interest expense reductions should be about $1.5 million per year). On the other hand, tax loss carry forwards and large depreciation and amortization deductions are currently reducing cash outlays for taxes and cash tax expense will likely increase at some point in the next two years.

The latest quarter (and the quarter right before it) are generally the seasonally weakest quarters because of a slowdown in business activity in the Summer and so an uptick should be manifested in the next quarter. The next quarter will also probably be the first opportunity to make a meaningful year over year comparison.

I think two possible scenarios will emerge over the next two or three quarters. It is possible that decent top line growth will be achieved and this should also increase cash flow. The United States GDP is achieving nominal growth of between 4 and 5 per cent a year and top line growth at that rate would amount to 8 to 10 million dollars a year (ESIC's gross revenue is currently forecast at roughly $190 million). Given ESIC's margins, $5 million or so should fall to the bottom line.

A steady trend of this kind of growth would make ESIC an extremely attractive stock with prospects to be debt free with free cash flow of over $40 million a year ($1.30 per fully diluted share) in two years. This could very plausibly produce a share price in the low teens -especially if 40 or 50 cents per share of the cash flow were used to pay dividends.

It is also possible that ESIC will struggle to keep gross revenue at about the current level (taking seasonality into account). In that case, you have a company paying off its debt (net debt of $71 million as of October 31) in a little more than two years. It would still have cash flow of roughly $30 million (assuming that tax expense is somewhat higher than savings due to synergy and the elimination of interest expense). Making these very conservative assumptions, the company would have roughly $1 per share in cash flow and no debt. At this level, assuming dividends of 25-30 cents a share, a price in the $7.50 - $10.00 range is a reasonable assumption.

It is not often that you can make very conservative assumptions and still produce a set of numbers suggesting that a stock will double in two years. I think that the $4.18 current price is the product of a number of factors extraneous to the accurate valuation of the company. In a real sense, this is a stock which has not yet "found its audience." It is not a surging growth stock. But it is also not Procter & Gamble (NYSE:PG). It still has a fair amount of debt and does not really have a big institutional following. At this price, I think it is a very strong buy.

Disclosure: I am long ESIC, PG.