Description

Thesis

AGYS is an emerging leader in the IT solutions industry.  Competitive advantages, excellent management and $170ml in net cash provide the opportunity for significant upside and eliminate the potential of a permanent impairment of capital.  The shares are worth $27 (mid-point of my range) now, offering 50% upside, based on a sum-of-the-parts analysis.  Additionally, as the company executes on its strategy, AGYS shares have the potential to appreciate into the mid-50’s over the next 3-5 years.

Business Description

Several brokers (Sidoti, Thomas Weisel, Raymond James) have put out notes that do a good job describing the business, so I will keep the business description down to bullet points that summarize the business and the transformation that has been happening.

History

• AGYS was founded in 1963 as Pioneer Standard, an electronic components distributor.
• In 2002, AGYS initiated a strategic review with Stern Stewart to maximize shareholder value.
• As a result of the review, AGYS began to improve its return on capital through improved working capital management and margin enhancement.  However, AGYS lacked scale in the distribution business to compete long term and exited the business through following transactions:
• In January 2003, AGYS sold its Industrial Electronics Division to Arrow for $285 million in cash.  At the time, IED generated $700 in revenue, accounting for 44% of consolidated AGYS sales.  IED was a broad-line distributor of semiconductors, passive and electromechanical components and power supplies.
• In January 2007, AGYS sold its Keylink Systems Group to Arrow for $485 million in cash.  At the time, KSG generated $1.2 billion in revenue, accounting for 73% of consolidated AGYS sales.  KSG was a distributor of enterprise computer systems (primarily IBM).
• AGYS has used the proceeds from these divestitures and $240 million in cumulative free cash flow from 2003 to:
• Paid down $180 million debt.
• Redeemed $143 million in preferred equity.
• Spent over $120 million to acquire several VAR’s and successfully integrated them.

Post-Divestiture Agilysys

·         AGYS emerged from the Keylink sale as a value-added reseller and solutions provider.  The Company also offers proprietary software in the hospitality industry.

·         AGYS’s business exited CY2006 with about $470ml in annual revenues, 25% gross margins, a debt free balance sheet and $440ml in cash.  AGYS laid out the following goals:

·                     Upon closing of the KSG sale, AGYS would initiate a tender offer for 20% of its outstanding shares.  Directors and management own 10% of the company (via options and stock) and committed not to sell into the tender. 

·                     Grow its revenue base to $1.0 billion in 2 years and $1.5 billion in 3 years.  Acquisitions targeting new industry verticals will account for the bulk of this growth.

·                     Target gross margins in excess of 20% and EBITDA margins of 6% within 3 years.

·                     Operate with a debt-to-capital ratio of 25-35%.

·                     Generate a 15% ROIC.

·                     AGYS intended to incur $2 million in restructuring costs to lower its SGA base by $12 million over the next 12 months.

·                     Out of the box, AGYS was estimated to run at 2.0-2.5% EBITDA margins due outsized SGA expense that the management expected to grow into.

Agilysys Now

• In the last 8 months, AGYS has begun to execute on its plan:
• AGYS has spent $232ml making 5 acquisitions, adding $362ml in revenues.
• AGYS realized the targeted expense reductions ahead of schedule.  Further expense reductions will be executed as acquired companies are integrated.
• In September, AGYS offered to buy 6ml shares (19% of shares outstanding) via Dutch auction with a price range of $16.50-18.50 per share.  Only 4.8ml shares were tendered at the top of the range.  AGYS also has an open market repurchase program in the amount of $2ml shares.
• AGYS’s business mix is now about:
• 66% hardware resale (low margins).
• 22% services (moderate margins)
• 12% proprietary software (high margins)
• Supplier diversification has increased with Sun accounting for 30% of sold products, IBM at 25% and HP at 20%.  In addition to being a top reseller for the aforementioned companies, AGYS is also a top Cisco and EMC reseller.
• AGYS is a leading player in software applications for the retail and hospitality industries.
• AGYS owns a 20% stake in Magirus, a European distribution company and solution provider.

AGYS Acquisitions

($ figures in ml)

Strategic Advantages

AGYS possesses several advantages that should enable the company to grow its business and attain an attractive return on invested capital.

With clients

• Most VAR’s generate more than 90% of their revenue selling the products of one hardware or software company.  AGYS has developed a business that has expertise across a variety of product suppliers and service offering.  This should help the company grow its share of clients IT budgets.
• AGYS also is expanding its national footprint that should give it an advantage in growing services to large enterprise clients.

With suppliers

• Hardware, software and distribution companies are all looking to drive efficiencies in the channel.  Channel consolidation will improve operating efficiency, bolster joint marketing programs and, perhaps most importantly, reduce credit exposure to small, high-risk VAR’s.

As an acquirer

• CFO Martin Ellis was brought from Stern Stewart and, as could be expected, looks at the from EVA perspective.  While the risk of GIGO is always present, at least AGYS management is focused on the factors that truly drive shareholder value.
• AGYS has a certain arbitrage advantage in pursuing acquisitions.  Since most of the VAR’s generate all their revenue via one product maker (e.g., Microsoft, HP, EMC, etc.), there is fair amount of business risk with each VAR that is reflected in the price paid.  Consequently, AGYS can pay a low multiple for these businesses; however, each acquisition lowers the business risk for AGYS as the combined revenue stream becomes more diversified.
• Lastly, AGYS has a significant amount of “inside” information on the universe of potential acquisition targets.  Through its divested Keylink business, AGYS has data on the companies to which it was a supplier and creditor. 

As an employer

• AGYS has been adding front-end sales people over the last six months.  AGYS management has commented that they have been attracting highly-qualified candidates for several reasons: 
• the diversified product and service capability means that sale people can increase their commissions by having more product to sell; 
• the diversified revenue stream decreases the employment risk that the typical VAR worker faces (e.g., an employee at a HP-focused VAR is dependent on HP not missing a product cycle or losing market share to a competitor); and
• AGYS can offer better benefits than smaller private companies.

Conventional View on Risk and Variant Perception

• Most brokerage reports address the change in strategic direction and the integration issues as major risks.  I think this is being greatly over-estimated from both a business and valuation perspective.
• First, the far greater risk for AGYS was continuing on its path as a hybrid distribution/VAR business because AGYS was at a HUGE disadvantage to much larger distributors and was competing with its VAR clients at the same time.  The move to focus on solutions did not magnify the business risk…rather, it swapped competitive and conflict-of-interest risks (that were insurmountable and worsening) for business integration risks (that AGYS is experienced in handling).  Net-net, the business risk facing AGYS is now LOWER.  AGYS has shed the business where it was an also-ran and is growing the business where it has sustainable competitive advantages.
• Secondly, the change in strategic direction is not new.  It has been going on since 2003.  The spate of acquisitions announced this year does not reflect rash buying.  AGYS knows the companies well and in the case of Infogenesis passed on buying the company in 2005 at a higher price.
• Third, AGYS management has a strong track record as an operator and was able to enhance returns on capital on its Keylink business prior to divestiture.  I would argue that was a more difficult challenge than the integration risks the company facing presently.

Valuation

Given the new direction of the company, the recent acquisitions and the temporarily elevated level of SGA, it is difficult to arrive at a precise estimate of value.  However, it is possible to bracket a range of $23-30 per share, significantly higher than the current market value.  In addition, AGYS shares offer significant upside if management can execute on its plans.  Before delving into what AGYS is worth, I will first look at how it’s now being priced.

Current Valuation

The table below summarizes AGYS’s current valuation, ignoring the temporally elevated SG&A levels and all the other wrinkles that are disguising the true value of the company.  AGYS is trading at 6.7x EV/EBITDA and 0.31x EV/Sales, a discount to the valuation CDW placed on another VAR, Berbee, (0.45x EV/Revenue and 8x EV/EBITDA, based on LTM figures) when it acquired the company in Q4 2006.

AGYS CY 2008 (Reuters estimates)

Revenue=$1,020ml

EBITDA=$46.7ml

Share Price=$18.00

Shares Out=26.8ml

Market Cap=$482ml

Net Cash=$170ml

Enterprise Value=$312ml

EV/Revenue=0.31x

EV/EBITDA=6.7x

Now on to estimating a range where AGYS should be trading.

Lower End of Range

To estimate the low-end, I aggregate cash and securities at book value, recent acquisitions at cost and AGSY’s pre-existing business at the revenue multiple paid by CDW in it acquisition of Berbee.  This multiple is conservative given AGYS’s higher level of proprietary services and software in its revenue mix and the resulting 400bp gross margin premium versus Berbee.

Net Cash=$170ml

Magirus=$7ml

Acquisitions @ cost $232ml

Pre-existing AGYS=$212

TOTAL VALUE=$621ml

Per share=$23

Upper End of Range

I estimate the upper end with more granular approach.  Obviously, the valuation of cash remains the same.

Rather than use book value for the stake in Magirus, I attempt to estimate market value.  AVT recently acquired the hardware distribution of Magirus.  Although price paid was not disclosed, most Street estimates are in the US$80-120ml range.  Assuming US$100ml purchase price, that AVT paid no more than 2x book and a 25% capital gains tax, results in net proceeds of about US$88ml.

Magirus’ remaining business is a Pan-European solutions provider that generates US$400ml in revenue.  At an EV/Revenue multiple of 0.20x, that business is worth US$80ml.  The combined value would be about US$168ml, implying that AGYS’s 20% stake is worth US$33ml or $1.25 per AGYS share.  Given the lack of financial information on this private company, I apply a 20% haircut to the estimate and arrive at a value of $26ml or $1 per share.

I then separate AGYS’s VAR business from its software business given the starkly different economics of each segment.

AGYS’s software business has a $100ml revenue run rate.  The most comparable companies (Micros and Radian) trade at EV/Revenue multiples of 2.8x and 2.3x.  I use 2x revenue to value the segment, implying a discount to the comps and a slight discount to the 2.14x EV/revenue AGYS paid for Infogenesis.  This is also in line with the average 2.0x multiple paid on the US enterprise software acquisitions since 2002.

AGYS’s VAR business has a $762ml run rate.  Based upon management comments (which I am happy to discuss in Q&A), AGYS should be able to run at a 6% EBITDA margin now if it chose to pursue only organic growth (i.e., reduced corporate overhead).  This results in an EBITDA level of $46ml.  At 9.0x EV/EBITDA (a slight premium reflecting the higher component of proprietary services in the business mix), the VAR business is worth $414ml.

Cash=$170ml

Magirus=$26ml

Software=$200ml

VAR=$414ml

TOTAL VALUE=826ml

Per share=$30

Long Term Upside Potential

However, this estimate does not fully capture the potential upside.   AGYS also targets a 15% ROIC and debt-to-capital ratio of 25-35%.  Assuming that AGYS drew down fully on its $200ml credit line and it ran at a 33% debt-to-cap, implies that the company should generate $90ml in NOPAT on $600ml in invested capital.  Assuming a 40% tax rate, this level of NOPAT implies an EBIT level of $150.  Assuming an effective 8% interest rate on the credit line and a 3.3ml reduction in the share count (2.0ml current outstanding repurchase program + 1.3ml not tendered via the Dutch auction), results in an estimated $3.42 in EPS.  At P-E of 15x, this would work out to a valuation of $52 ($51 + $1 in Magirus) per share.  Assuming that this level of earnings and valuation were achieved in 5 years, AGYS shares currently offer a return of 24% per annum.  At my target price of $26 per share, AGYS shares would offer a 15% CAGR over 5 years to get to $52.

This analysis implies that there is significant margin upside in the business.  I have vetted these numbers with management.  I think AGYS management realizes that it is going to take some time to build the business and reach its targets; hence it does not want to set expectations too high too soon. 

Other Considerations

• Given the large scale of the divestitures and acquisitions, as well as the “new” direction of the company, I think many analysts are exhibiting several of the behavioral fiancé biases that often cause inefficiency in the pricing of securities.  As an example, the analyst at Raymond James upgraded the stock to Buy on the news of the KSG divestiture.  In typical Wall Street Style, the report carries the closing price from the day ($17) before the announcement, even though the stock traded at $19-21 on first possible day of trading.  The analyst downgraded the stock to Neutral at $23 explaining the price reflected “near-flawless execution” (ed., that was quick!!!).  Then with the stock at $18 in early August, Raymond James reiterated its Neutral on the stock, despite the fact the management was executing on the announced strategy.
  
  I would refer you to Whitney Tilson’s November 2005 presentation on Behavioral Finance to get a laundry list of the biases that I think are causing a mispricing of AGYS stock
  
  
• Stock repurchases are an empirically robust indicator of future stock performance.  AGYS recently repurchased 15% of its shares via Dutch auction at the top of the price range.  This was about 78% of the total offered to buy.  I think both the price and participation rate are good indicators of the potential in the stock.
• There is a high level of insider ownership at the company.  Insiders own about 12% of AGYS stock and did not participate in the auction.  The former CEO of the company owns about 3.5%; however, I do not know if he tendered his shares into the Dutch auction
• Interestingly, AGYS may be a casualty of the quant fund carnage of July and August.  As of June 2007, shareholders included:
  
  Dimensional      2.6ml shrs          8.3%
  Barclays             2.3ml                 7.5%
  Highbridge        453k                  1.4%
  Black Mesa        274k                  1.0%
  Caxton              269k                 0.9%
  Citadel              250k                  0.8%
  Renaissance          34k                  0.1%
  D.E. Shaw          32k                  0.1%
  TOTAL             6.2ml shrs         20%
  
  Forced selling on the part of these quant shops may be creating an opportunity for fundamental investors to acquire the shares cheaply.

Risks

• Integration issues.
• Overall IT spending environment.
• Value destroying acquisitions.

Catalyst