Unisys: A Cheap, Successful Turnaround

| About: Unisys Corporation (UIS)

Unisys (NYSE: UIS) presents a compelling investment opportunity for patient value investors that could double based on current prospects or triple from current levels if management allocates capital wisely. Investment highlights follow:

  • Extremely cheap: At its current share price of ~$20 and market cap of $870M, UIS is trading at less than 3 times its pretax profits. This is ridiculously cheap, especially when considering its net cash position of $367M.
  • Successful Turnaround: Under CEO Ed Coleman's 3-year turnaround program, Unisys has dramatically improved its operations, and achieved its goal of $350M in annual pretax profits.
  • Strong Balance Sheet: Impressively, Unisys has paid down $1 billion in debt since 2008 and now boasts a strong cash position of $659M against debt of only $292M.
  • Hidden Assets: Unisys has over $2 billion in potential net operating loss (NOL) carry forwards to offset future taxation. These deferred tax assets will become more valuable as its operating profits continue to improve. Also, as today's super-low interest rates normalize to higher levels, the overhang of Unisys' pension obligations will diminish. In effect, Unisys stock has an embedded hedge against rising interest rates.
  • Catalysts: As Unisys continues to demonstrate its pretax earnings power of $7 per share is sustainable and that its pension obligations are manageable, the shares should rise to $35. Legislative relief on pension funding requirements will help too. If the company uses its cash hoard to buy back its super cheap shares, Unisys could even triple to $60. Given CEO Ed Coleman's history of selling Compucom and Gateway, we would not be surprised to see a sale of Unisys to an IT firm or private equity.

Company Overview

Unisys is an information technology pioneer with roots dating back 139 years. The company's predecessors, Burroughs and Sperry, were stalwarts of the mainframe era that merged in 1986 to form Unisys. Soon afterwards, however, the mainframe computer industry began a long-term decline. In response, Unisys began a shift toward high-end servers (such as Windows NT) and IT services. However, supporting and upgrading the company's mainframe platform, known as ClearPath, has remained a lucrative business. By the mid-1990s, services and solutions became the company's largest business. This would eventually form the core of Unisys' IT outsourcing and systems integration businesses.

The period from 2000-2008 was a troubled period for Unisys. As its technology business shrank and even its services business stagnated, the company reported massive losses, which were further aggravated by the recession. In mid-2008, an activist investment firm named MMI Investments with over 9% of Unisys' shares was able to get two positions on the company's board of directors to clamor for changes, including the divestment of its government business. The CEO, Joe McGrath, was ousted in September 2008, and a new CEO, Ed Coleman, came to the helm.

Coleman brought an impressive turnaround track record in the technology industry. Most recently as CEO of Gateway, he prepped that struggling PC maker for sale at a nice premium to Taiwan-based Acer. Before that, as CEO of the leading IT reseller Compucom, he oversaw that company's transformation from a product pusher to a services provider and then sold the company to a private equity firm. (As management consultants in the high tech industry, the writers of this article became familiar with Compucom's operations and its successful transformation).

Coleman's tenure at Unisys began in October 2008 as the global economy was cratering, The market had left the company for dead, knocking the company's market cap down hard. The company announced cost reductions of over $200 million to staunch the cash burn, and indicated that it would concentrate its investments and resources in fewer, more profitable IT segments (later articulated as security, data center transformation, end user outsourcing, and application management).

By mid-2009 signs emerged that the company's efforts had averted catastrophe and Unisys returned to slight profitability even as sales plunged. Amid the credit crisis, the company was forced to refinance its debts at loan-shark rates. The company also began a divestment program to raise cash and pay down debt, including the sale of its Medicare IT business to raise cash.

In late 2010, the company formulated a business turnaround plan with the following goals:

  1. Pre-tax Profit: Increase annual pre-tax profit to $350M in 2013, excluding any change in pension income/expense from 2010 levels
  2. Operational Efficiency: Consistently deliver 8-10% services operating margin
  3. Revenue Growth
    1. Grow IT outsourcing and system integration at market rates
    2. Maintain stable Technology revenue
  4. Debt Reduction: By year end 2013, reduce outstanding debt by 75% ($625M)

These were bold goals - to simultaneously improve profits and revenue, even while drastically de-leveraging the balance sheet. Not to mention a period of economic uncertainty and public sector austerity. But fast forward to today (mid-2012), and the company has achieved all of these goals ahead of time. The execution has been remarkable.

The Incident

In spite of the remarkable success of this turnaround, the market gives Unisys stock little respect. As mentioned above, the shares trade at merely 3 times the company's pretax profits. What is holding it back?

Well, macro conditions are playing a part. About 40% of Unisys revenue comes from public sector customers. As governments in Europe undertake austerity measures and the US federal government stand-off points the country toward a "fiscal cliff, there will no doubt be some turmoil. But at the end of the day, Unisys contracts are in non-discretionary areas. The company has achieved its turnaround goals in spite of winding down some big contracts such as the 2002 TSA deal which rolled off in 2010. Investor fear in this area seems overdone and should eventually subside.

Also, the market is unfairly viewing Unisys as a stodgy relic from a bygone era. Admittedly, the company's flagship ClearPath mainframe platform is still a significant factor in its business. But Unisys has done a nice job of porting ClearPath to modern server technologies such as Java. The company expects ClearPath revenues to be stable (though lumpy quarter to quarter) over time. Today, more than 90% of Unisys revenues comes from other sources, such as IT outsourcing, systems integration and business process outsourcing which are growing at a nice clip. Unisys is also creating strong capabilities in crucial new areas such as security and data center.

A more substantive overhang over Unisys shares is its legacy pension liability. While Unisys froze its pension plan years ago, it is still on the hook for vested beneficiaries and retirees. At the end of 2011, Unisys indicated its pension plans were underfunded by nearly $2 billion. At first glance this sounds really scary for a company with a current market cap of only $870 million. But as recently as 2008, Unisys' pensions were fully funded.

To understand this, it is crucial to understand that the projected payouts to retirees have not actually changed. Instead, the discount rate at which the series of pension payouts is made has plunged as central banks in the US and Europe have embarked upon zero interest rate and quantitative easing policies which artificially suppress long term bond interest rates. The US 10-year Treasury yield is 1.5%. Pension regulations demand that pension liability calculations use these long term bond interest rates as factors for their pension liability discount rates.

This accounting artifact has caused the "present value" of the pension payouts to explode over the past two years, even though the payouts themselves have not changed. (For this reason, we believe that Unisys stock is an excellent way to hedge against rising interest rates - it contains an embedded "short" of long-term bonds. Once interest rates normalize, the pension overhang vaporizes.) Management has stated for every 25 basis rise in their discount rates, ~$125 million of the pension overhang goes away. A 1.50% rise in rates eliminates a phantom liability equal to the current Unisys market capitalization.

Of course, this effect cuts both ways. If interest rates actually decline further from their already microscopic levels, this phantom pension liability could increase due to the discount rate effect. While this would not fundamentally impair Unisys' intrinsic value, some may perceive this as a risk as rates could be volatile in the near term. However, value investors who believe, as we do, that long term interest rates will eventually rise, ought to ignore short term volatility (or better yet, exploit it).

The Valuation

Given the pension overhang, how much is Unisys stock actually worth? Let's get back to basics and build a discounted cash flow model. As the baseline, let's make the following assumptions:

(i) profit before taxes and pension contributions of $350 million (they currently exceed this on a TTM basis) is sustained, but does not grow

(ii) pension contributions conform to the company's expected schedule under the current legislative environment, but we will conservatively assume there is a leftover annual payment of $170 million payment, forever

(III) tax rate of 30% (this is conservative given the largely untapped NOLs)

The resulting valuation of $35 per share is quite conservative. If long term interest rates increase, or Unisys refinances its debt at lower interest rates, or Unisys is able to better capture the value of its deferred tax assets, the value is much higher. If management pivots from a mode of fear-driven debt reductions and captures the potential value created through accretive share repurchases, the intrinsic value could exceed $60 per share.

The Catalysts

While we believe that value is its own catalyst, it is key to note that there are significant events that could re-price the stock up toward its intrinsic value:

What takes Unisys to $35

  • The US budget stand-off and European austerity don't cause the end of the world
  • Unisys continues to demonstrate sustainability of its operations and earnings power
  • Unisys management does a better job communicating to investors about how undervalued its stock price is

What takes Unisys to $60+

  • Management undertakes share buybacks at attractive prices (below $30 per share)
  • Long term interest rates eventually normalize to historical average levels
  • Unisys profit levels actually rise
  • Unisys unlocks value of its deferred tax assets (NOLs) as US business profits grow
  • Unisys attracts a buyout offer from a strategic buyer or private equity fund

KMF Investments may hold a position in the securities mentioned in this article.

Disclosure: I am long UIS.