Transition To Mobile Provides Opportunity In XRS Corp.

| About: XRS Corp. (XRSC)
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(Editors' 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.)

Key takeaways

  • XRS Corp. (NASDAQ:XRSC) trades at a discount to its closest competitor as the transition to mobile results in temporarily lower revenue.
  • However, investors are "missing the forest for the trees" given that the new mobile, SaaS model should provide a high-margin, recurring revenue stream and significant free cash flow. The recent reversal of five years of net losses is an encouraging sign, especially as it means the ~$40 million of NOLs should no longer be valued at zero.
  • The combination of upcoming federal regulations requiring electronic logging devices as well as the multiple tangible benefits of its solutions result in demand being less cyclical and more inelastic or even countercyclical.
  • A debt free balance sheet with $10.4 million in cash limits the downside while the 69% insider ownership means they have a greater interest in a successful transition than anyone.

Company overview

XRSC offers compliance and fleet management solutions to the commercial trucking industry in the U.S. and Canada, including >1,300 customers representing >110,000 subscriptions. The two core solutions include:

Mobile

The XRS solution launched in 2013 consists of a mobile app and a small in-cab device attached onto the truck dashboard that taps into the engine control module. Data is transferred via Bluetooth to the driver's mobile device as well as to a web-based system via cellular network for data collection and analysis. The features include electronic driver logs, driver vehicle inspection reports, automated fuel tax filings, driver/vehicle performance reporting, GPS tracking, two-way structured forms, fault code monitoring/reporting, alerts and scheduled stops reporting.

Legacy

XataNet is a fleet optimization and compliance solution consisting of a traditional on-board computer, integrated communications and SaaS platform.

MobileMax is a communication platform using an on-board computer system that is integrated with back office systems.

High market share + multiple demand drivers + product that sells itself

XRSC used the first mover advantage (it was the first company to provide completely paperless electronic logs and exception-based management reporting) to build a unique combination of strategic assets (e.g. management, technology, customer base, key partnerships) to gain a dominant market position over its almost 30 year history.

However there is still room to grow for two reasons. First, the high market share is small relative to the size of the overall market (there are 7.1 million trucks according to FMCSA). Second, XRSC can steal market share as customers (especially small and mid-sized fleets) increasingly demand a holistic solution due to increasing operating complexity. Moreover, customers can integrate a single module (for compliance purposes) with existing third-party solutions, which may result in gaining more "wallet share" as customers see the unique features and benefits.

However the future is even brighter than the past due to the following dual demand drivers.

Increasing regulation. The need for a compliance solution due to increasing regulation is the single greatest demand driver. For example, in June 2012 Congress passed a bill requiring the use of an electronic logging device ((NYSEARCA:ELD)) to track hours of service by 2015. XRSC even assisted the task force in developing the technical specifications. The FMCSA estimates that 3.1 million commercial trucks will be affected. However, only 500,000 vehicles are currently using ELDs, which means there is a significant growth opportunity to gain market share from the remaining 2.6 million commercial trucks.

In addition, XRSC can replace the current paper-based method of filing required driver vehicle inspection and international fuel tax agreement reports through an electronic and automated process.

"Everything else". While the other benefits pale in comparison to compliance, they are significant nonetheless including reduced fuel costs* (by minimizing idling and speeding), increased labor efficiency, improved equipment utilization (through vehicle monitoring, weigh station bypass), lower maintenance costs (through proper inspections and fault code monitoring) and fewer crashes.

*This is the single greatest operating cost for fleets - even greater than driver wages and benefits.

Skating to where the puck is going: The transition to mobile

The CEO recently compared the transition to mobile to digital downloading for the music industry. While the trucking industry is not traditionally viewed as high tech, this is precisely the reason there is such a significant opportunity. For example, the cab industry is being disrupted by Uber, whose success is largely the result of its mobile strategy.

There are many incentives to transition including no upfront costs, no costly and time consuming installation (almost immediate ROI), seamless automatic updates to comply with changing regulations (with no action required on the part of drivers/fleet owners) and the fact that many new features are simply unavailable on traditional on-board computers.

The transition has already begun and should reward those companies willing to make the short term sacrifices (e.g. lower revenue) in order to build a newer and more sustainable business model. Given that the technology graves are filled with companies who failed to recognize change (or simply refused to accept it), the market should give the benefit of the doubt (in the form of a higher multiple) to forward thinking companies with a history of successfully managing past similar transitions (e.g. from traditional hardware-based on-board computers to in-cab devices and dealing with constantly changing regulations).

In FY13 mobile software revenue rose 20% as XRSC signed 322 new customers including Allied Automotive Group, one of the largest transporters in North America. Investors should focus on this recent sign of success (along with the following four key takeaways) rather than the 10.9% decline in revenue due to lower hardware revenue as customers switched to the no upfront hardware mobile solution.

First, the lower monthly subscription price compared to some of the legacy solutions is more than offset by significant margin expansion. For example, overall gross margins rose 900 basis points in FY13 as software accounted for 81% of revenue compared to 50% in FY09 while hardware only accounted for 17% (the remainder is services). Meanwhile, the software gross margin of 72.9% is ~55% higher than that of hardware.

Second, its Turnpike customers (first generation XRS solution) historically operated under month-to-month contracts however beginning in FY13 XRS customers began to enter multi-year agreements. As a result, XRSC should enjoy a growing, high-margin/high visibility, recurring revenue stream.

Third, the significant cash flow growth is being ignored as the market has been slow to recognize the transition. For example, in FY13 operating cash flow rose to $9.5 million from -$0.9 million while free cash flow rose to $5.6 million from -$3.8 million. Part of this cash flow was used to eliminate all debt.

Free cash flow should continue to grow for four reasons. First, the elevated R&D spending to support the transition to mobile should decline as most of the infrastructure is built. Second, there should be a lack of transition-related restructuring and impairment charges (e.g. workforce reduction, inventory write-off) going forward. Third, the XRS SaaS solution is cloud based and highly scalable with significantly lower maintenance costs. Fourth, the recent improvements in working capital should continue given the new "asset light" business model (e.g. no hardware, monthly subscription).

Fourth, the recent reversal of five years of net losses increases the possibility of a significant reduction in the full valuation allowance against the $39.7 million of federal NOLs that expire in 2032. XRSC reported four consecutive quarters of net income in FY13, which rose to $0.6 million compared to -$10.2 million.

Valuation

The high mid single-digit multiple that appears full from an absolute standpoint must be viewed in context as the ongoing transition is temporarily depressing EBITDA. While its closest pure-play competitor deserves to trade at a higher multiple due to its higher margin, the current "spread" is too wide (e.g. margin ~2.3x higher but multiple ~3.4x higher). The spread should narrow as investors see more progress in the transition to mobile with each passing quarter.

Risks

  • The transition to mobile is expected to result in short term revenue declines.
  • The recent focus on small and medium-sized fleets presents new challenges given the higher cost of customer acquisition and retention.
  • The market is highly competitive and fragmented with some providers offering simpler products such as basic ELDs while others offer advanced mobile satellite communication and information systems.
  • Existing offerings must be continually updated due to the changing nature of technology (e.g. mobile, cloud, wireless) and regulations.

Conclusion

The target price is based on a 10x multiple, which is more than deserved for the reasons mentioned above.

A stop loss should be placed below the recent support at ~$2.65. The time frame is 12-24 months given the longer time required for the transition.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.