Billing Services Group BILL LN
January 19, 2006 - 12:07pm EST by
jmxl961
2006 2007
Price: 92.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 414 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

I originally wrote the following at the end of Oct for my application to join VIC. I have left it mainly unchanged (a couple of minor corrections on syntax and added a reference to European Goldfields). Note in particular that references to prices/valuations have not been updated - but I think that that does not change the fundamental story. I will make updates in a second part.
(At the time of writing the stock was at 89.5p - it is currently at 92.5p)

Disclaimer - we own a position in this company and reserve the right to change that position at any time without notification.

Summary:
I believe that Billing Services Group (BSG) is an undervalued company with a dominant market share, secular growth and high barriers to entry. Due to it having floated in the wrong place by the wrong broker at the wrong time I believe that it has been overlooked by the market and deserves a valuation at least 50% more than its current price.

Description:
What it does:
The core business of BSG is third party intercarrier mediation. This is also sometimes described as a billing and settlement clearing house. In this it has an 89-95% market share in its core market.

What is ‘third party intercarrier mediation’?
Consider the following – you are a Verizon customer and you ring a friend who is a Qwest customer. Money needs to be transferred between the telecom operators – this is known as ‘intercarrier mediation’. Consider that there are about 1,200 telecoms operators (some estimates are as high as 1,800 but some are different brands with the same underlying company) in the US and each needs to have a relationship with each of the others. Furthermore there may be multiple tariff arrangements (eg different prices based on volume or type of traffic or location of origination or delivery). In addition a telecom operator will have to make tax filings in every state it operates in (usually monthly). Large operators such as Verizon will have departments (of hundreds of people) focussed on this.

For a small telecoms operator this is a significant burden – this is where BSG operates – it sits in between the operators so now an operator needs to have only one relationship with BSG which will invoice the appropriate counterparty, transfer monies and make the appropriate state filings.

Approximately 25% of the US market (in terms of number of Local Exchange Carriers (LECs)) is outsourced – and in this BSG has an 89-92% market share (data suggested 89% for 2004, management estimates are 92% in 2005). Of the two other players in the market one specialises in ‘adult entertainment’ phone line services (an area BSG does not get involved in) – this company has a 3% market share and we have reason to believe it actually uses BSG’s service ‘under the hood’. Hence arguably BSG’s market share is 95%.

We believe that there are high barriers to entry in this business because a dominant player has an advantage of scale – as a clearing house BSG has relationships with all 1200 LECS; it has 300 - 400 customers and customer retention is in the high 90s percent (it usually only loses customers due to them closing or being acquired). It is also expensive for a LEC to switch as BSG retains some cash for upto 6 months post receipt as security to allow for consumers who question their bill. A startup competitor would need relationships with all 1300 LECS whether it has 1 customer or 100.

As will be seen from the above example of Verizon and Qwest most of BSG’s revenue will be from long distance calls (ie calls that traverse between operators); however it also is involved in operator assisted calls, collect calls, calling card calls, enchanced service calls (eg voicemail, callerid, conference calls) and it offers outsourced billing management to some operators (ie to bill the operator’s own customers as opposed to just the intercarrier element).

In addition smaller carriers have at times been financially stretched so BSG provides a factoring service for bills. This may sound risky but is not. Consider if carrier X has $1m of payments it has due to it from another carrier – it will receive the majority of this money over 60-90 days, but some of the monies will take upto 6 months. BSG will offer an advance against this as long as BSG is doing the clearing for the carrier and so BSG will be doing the collection anyway and have experience it can use to estimate the bad debts etc of that particular carrier. (And for $1m of payments it might only advance $800k).

Everything described above is what we have classified as BSG’s ‘core’ or historic business – based in the US and orientated to fixed line carriers.

In July 2005 BSG acquired EDS Interoperator Services GmbH (EDS IOS) – this is Europe’s leading independent mobile clearing houses – thus BSG expanded its geography and its knowledge base to mobile. This business has been renamed BSGCS (BSG Clearing Solutions) (Note that this was very soon after float and management had indicated that they were looking to acquire at the IPO). Recently the company has confirmed that T-Mobile (Germany’s biggest mobile operator) has renewed its contract with BSGCS.

The purchase price was in two tranches – an initial payment and then a further payment on renewal of the T-Mobile contract. The acquisition was funded by a combination of equity and debt. Hence the cost was $165m made up of an initial payment of $125m, a further $30m on signing of the T-Mobile contract and $10m of costs. This was paid by $80m of equity, $55m of initial debt and then a further tranche of $30m of debt. For 2006 the company estimates that the acquired businesses will generate an EBITDA of $23.8m of which $3.4m will be from T-mobile. Thus the acquisition was on a EV/EBITDA ratio of just below 7x.

Other material points:
– BSGCS has signed a strategic relationship with China Mobile’s equivalent mobile clearing business unit and this is likely to lead to additional revenue
– the company is developing a product called ‘Enabill’. In essence Enabill will provide the same functionality as Paypal but allow payment via your phonebill. This is interesting because of the issues of trust, convenience and cost (see comments on the web re the expense of Paypal).
– The company is close to BT (the UK’s main telco operator) – eg Phil Dance who is in charge of BT’s ’21 CN’ programme (to upgrade BT’s entire network to an IP backbone) is on the board of BSG. This is important because we believe BSG could be on the verge of winning orders (for 21CN) from BT (they have signed an MOU) and that this will be a precedent for other major operators who upgrade their backbones. It is also important because it will show that IP based networks still require billing and clearing houses (indeed the problem gets more complex with IP networks than with voice networks because an operator needs to bill according to the type of service eg voice, video, file transfer and customer eg corporate, residential and priority eg a corporate may pay a premium for guaranteed bandwidth).
– The company has a wireless LAN clearing solution for wifi hotspots – this may gain transaction going forward
– Management owns about 18% and the only sale they have made is to pay taxes (a tax event was created by the IPO)

The secular story:
As mentioned above only about 25% of US LECs (local telecom operators) use BSG. However this is a business in which scale is an advantage and the customers (ie LECs) operate on shrinking margins – we therefore believe that more LECs are likely to switch to BSG in the coming years. As shown by the above example of BT’s 21CN we also believe that as operators offer more complex services more LECS will find it easier to outsource than use in house systems. Similar sentiments apply to mobile. We believe it is reasonable that one major US wireline telecom operator may outsource to BSG some of its intercarrier billing in the next year.

Visibility
Because it signs upto 3 year contracts with its customers and due to the high switching costs, at any time BSG has high visibility to its next 12 months revenue (eg by February 2005 it estimated that it had visibility for about 90% of the revenue it was hoping for the whole of 2005).

‘The wrong place, the wrong broker, the wrong time’?
BSG – despite all its business at the time being in the US – chose to float in June in London on the AIM market. As a result it faced an investor unfamiliar with US telecom billing practises (there are some significant differences).

Second it chose as its broker Evolution Securities. Though this house is of good repute, at the time of float a company it had previously brought to the market (‘Regal Petroleum’) was undergoing a lot of turmoil (overstated oil reserves and corporate governance issues) and hence investors were very wary of any new floats Evolution was bringing to the market. Also at the time of the float there were market rumours of a liquidity crisis at a large London hedge fund and so investors were very reluctant to commit money to new floats – hence the wrong timing. [Read on VIC re European Goldfields which also suffered due to Regal Petroleum connections.]

Furthermore Evolution at that time was not particularly associated with either technology / IT services related companies nor US based companies so investors were very sceptical about BSG. Usually the bank does floats which are smaller than £100m yet the initial plan was to raise upto £220m at the IPO of BSG – the bank had insufficient placing power and had to scale down the float – hence the wrong broker.

So why did the company not float on NASDAQ?
The company is very frank and open about the rationale for this:
1. Sarbanes Oxley – as one of the management said – 90% plus of his net wealth is tied up in the company and he will do his damnest to ensure good corporate governance. But he does not want, one day before he retires, to find that five employees at a very junior level have colluded and committed a fraud of $1m say, and as a consequence the company has filed inaccurate statements with the SEC. His comment was he wants to be able to sleep at night and not worry that under Sarbanes Oxley he could be personally liable and hence lose his personal wealth.
2. Cost of Sarbanes Oxley – given the complexity of the billing that the company does it feels ensuring full compliance with Sarbanes Oxley would cost it upto $5m per year and management frankly felt that it would make accountants rich and not shareholders (the senior management are all big shareholders in the company). $5m would be a significant percentage of its profits.
3. Ease of raising funds – the EDS IOS acquisition was done by a book build process in London in literally a week. Given the company wishes to grow by acquisition it felt it would have faster access to cash in the London market with less regulatory hurdles than in the US.
4. Future growth – the management believes that the European market in particular is very open to its services (consider you have even more complexity with multiple languages) and Europe is progressing faster to IP networks. By listing in Europe it is more likely to be considered a ‘local’ rather than an outsider when bidding for contracts.

Domicile
The company is looking to optimise its tax by moving domicile to a more advantageous tax regime. This may mean going forward the tax rate falls significantly.

The numbers:
(Note that we have converted everything into dollars but the listing is in pounds and a significant part of the revenues (via BSGCS) is in Euros. Numbers from 27th October 2005).
Share count: 253.3m
Share price in GBP: 0.895
Share price in USD: 1.60 (using exchange rate of 1.78)

Market cap in USD: 404m
Debt: 243m

Enterprise value: 647m

Due to the float in 2005, and the acquisition we think that 2006 numbers are better indicators of earnings for the company. Built into our estimates we have assumed a large US telco will subcontract to BSG – we get the impression that the company is actually in detailed talks with more than one. In addition we think that some CN21 revenue from BT will start flowing in 2006.

We focus on EBITDA and net income in our modelling of this company because gross billing revenues are meaningless (ie how much the company has billed on behalf of its customers) and net revenues are also meaningless because the fixed costs are relatively high but variable costs are low so the company actively seeks additional contracts which will fall through to the bottom line. Large contracts often have caps on total charges which BSG is comfortable with as the incremental costs are low for it so most of the incremental revenue falls straight to the bottom line. The company reckons its US infrastructure could cope with 2-3x the current level of transactions without significant extra costs.

For EBITDA detailed discussions with management lead us to estimate that EBITDA for 2006 will be around $80m thus giving an EV/EBITDA of 8x. However this is assuming that no debt is paid down during the rest of 2005 or in 2006. This may be too pessimistic. (2005 numbers were $41.7m; we are adding $23.8m for the acquisition and assuming $14.5m incremental growth in the US due to high leverage and a contract win and some revenues from CN21).

For 2006 we are modelling a net income number of $42.7m. On this basis the company is on 9.5 earnings. However it should be noted that we are modelling a tax rate of 30% but that the house broker is expecting the actual rate to be nearer 22% and falling going forward. In conversations management have also indicated that over a number of years by changing domicile they will be able to bring tax rates down.

Note that there is potential upside if Enabill were to take off.

It is too early to make any estimate of 2007 net income but we would observe that winning even part of T-Mobile and BT’s business in 2006 will put the company in a good position for 2007. It is important to note that BT acts as the benchmark for a lot of European operators. Additionally as cable operators roll out ‘triple play’ in the US it is likely that they may become a new source of business for BSG.

Competition and comparators:
The main competitors are:
Syniverse (SVR) – this company is listed in the US (market cap $1bn; EV $1.4bn) and acquired the US mobile clearing business of EDS in the past. (BSG is clearly frustrated that at the time it could not do the acquisition). This trades on 19.25x 2005 earnings; 16.4x 2006 earnings (IBES on Bloomberg).
MACH – private – owned by Warburg Pincus – largest global player in intercarrier clearing
United Clearing (UCL LN) – listed in London – small – market cap £22m. Has a good reputation and starting to win some contracts. At current price (124p) with broker estimates (one broker) of 4.15p and 6.36p (for 2005 and 2006 respectively) is on 30x and 19.5x earnings

To summarise the direct competitors:
Syniverse MACH United Clearing BSG
2005 19x ? 30x 12-13x
2006 16x ? 19.5x 9.5x

I would also include Amdocs, Convergys and Intec Telecom in any assessment of this market. Amdocs and Convergys are nominally software houses that provide CCBS (carrier care and billing software) ie software that produces bills for end consumers (as opposed to intercarrier billing) whereas Intec produces intercarrier billing software. However these companies have a varying degree of service element in them – most in Amdocs - and so in some ways are comparable to BSG.

The valuations (PE) are:
Amdocs (DOX) Convergsy (CVG) Intec
2005 17.5x 15.5x 18.8x
2006 15x 14x 13.6x

Target price:
We think that the PE for BSG can rise from the current 9.5x to 15x. Additionally as debt is paid down, if the EV remains even constant the market cap will have to rise. Some of the mezzanine debt is relatively high cost so as this is paid down the interest charges will also fall.

Catalysts:
I think the main catalyst is good results over the next few quarters from BSG. In addition I expect as debt is paid down the market cap will rise even if the EV stays constant. At around $750m I think it will start appearing on the radar of major investment houses and research notes will start being produced. I note that anyway major institutions (Capital, Gartmore, Fleming, Goldman Sachs Asset Management) have been buying.

In addition I think that a contract win with a major US telecom company could increase interest in the stock.

If the company trades down much more I would expect MACH or Syniverse to try to acquire it.

Catalyst

Start appearing on investors radar screen as it grows and wins contracts.
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