Ever since one reader brought up the potential risk of competition for Exela (XELA), we had always wondered: Is Exela really so vulnerable to competition? Today, we can finally answer this question. No. Exela has a substantial moat that protects it from competition, and this makes its bull case clearer than ever.
Why having a competitive advantage is important
Exela does not have a lot of flexibility because it has substantial debt due in 2023 and very little cash on hand. If a competitor entered the market and caused Exela to bleed cash for even a few quarters, it would be all over for Exela shareholders.
However, after doing our due diligence, we have discovered that Exela actually has significant competitive advantages. We believe these advantages are key to achieving the bull case and unlocking shareholder value, as they help in maintaining revenue stability and give more flexibility to management.
We believe Exela has substantial switching costs, intangible assets (brand and possibly IP), and low costs from efficiencies of scale.
We believe Exela has substantial switching costs as its solutions are frequently mission critical and highly integrated with its customers. According to Exela’s 10K, ~5000 employees work as customers in an onsite capacity. Many of its solutions also involve storing, processing and handling sensitive information and helping with other day-to-day operations. Some of the customers are in industries where switching can have a devastating impact on operations, such as healthcare.
Exela is also likely to have substantial intangible assets. According to the 10K, it has long-term relationships with many of the largest companies in the Fortune 100. This has led to stable and recurring revenues (from 10K 2018):
We have successfully leveraged our relationships with customers to offer extended value chain services, creating stickier customer relationships and increasing overall margins. Customers are increasingly turning to us due to a demonstrated ability to work on large-scale projects, past performance and record of delivery, and deep domain expertise accumulated from years of experience in key verticals. As a result, our stable base of customers and sticky, long-term relationships lead to highly predictable revenues.
Another major competitive advantage could be Exela’s intellectual property, which consists of proprietary technology and deep industry expertise. Exela protects its IP through NDAs (also from 10K, 2018).
We deploy a combination of internally-developed proprietary knowledge platforms, applications and generally available third-party licensed software as part of our scalable and flexible solutions and services. Our intellectual property is our competitive strength.
Exela’s extensive industry experience and specialized role means it tends to have lower costs than most of its competitors, which mainly consist of in-house operations. We believe this cost advantage is a major factor as to why Exela is so successful. Automation and innovation efforts may lower costs further and increase Exela’s value proposition in the years to come, further increasing this competitive advantage. From the Q2 2019 call:
Now let's turn to Slide number seven. Headcount is our largest cost component of our business. And the technology we used to provide automation to the business processes enables Exela to work towards a lower total variable cost.
Overall, we believe Exela’s competitive advantages provide significant barriers to entry for any upstarts and help to retain Exela's customers.
Interestingly, Exela’s scale and established status not only gives it credibility but also helps to mitigate many of the potential disadvantages of outsourcing, outlined in this article.
How the bull case plays out
The competitive advantages mentioned earlier help Exela to grow revenues steadily and give management great visibility into revenues. From the Q2 2019 call:
We have strong visibility into this revenue, which, in turn, will help us to prioritize our operations and focus on liquidity and cash generation.
This good visibility and strong competitive advantage gives Exela the ability to plan ahead without worrying about potential competition. Exela can therefore spend cash available to restructure the business and lower costs further without worrying about a shortage of cash.
This lowering of costs should eventually allow Exela to generate large amounts of FCF and start repaying debt. Heck, Exela is literally so confident about future cash generation that it has spent cash on buying back shares.
During the second quarter, we bought back 237,962 shares. Under our stock purchase plan, since inception, we have now purchased a total of 2,787,147 shares.
Under our projections, Exela could pay down most of its debt by 2023, giving it more leverage to seek a refinancing. The payment of debt by itself would be enough to create massive shareholder value. Honestly, the bull case is so clear-cut that it's quite shocking that the stock still trades at this valuation.
In our most optimistic case for Exela, it will be able to pay down debt through a combination of GM expansion to 35% and a reduction of O&R expenses. This should lead to shareholder value creation of at least $1 billion or more if the multiple expands. Assuming a diluted share count of 160 million, each share should be worth ~$7 in 2023, at minimum.
In our most pessimistic case, GM will only expand to 32% and O&R expenses will decline more slowly. Even in this scenario, Exela can pay down half its debt by 2023. Assuming a diluted share count of 170 million, each share should be worth ~$4.50 in 2023, at minimum.
Overall, Exela has a clear-cut bull case by taking these steps: lower costs, generate more FCF, pay down debt. With good visibility into revenues and strong competitive advantage, we believe this bull case has a high chance of playing out. It doesn't make sense for Exela to trade at this valuation, and we believe the multiple will expand once the bull case starts playing out.
Disclosure: I am/we are long XELA. 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.