|Shares Out. (in M):||46||P/E||0||0|
|Market Cap (in $M):||2,059||P/FCF||0||0|
|Net Debt (in $M):||472||EBIT||0||0|
|Borrow Cost:||General Collateral|
I am recommending a short of Cardtronics (“CATM” or the “Company”) with an anticipated return of ~25%. The short can work for a variety of reasons that are not adequately discounting by the current stock price including: i) a low ROIC; ii.) largest single source of revenue will soon disappear; iii.) main source of revenue mix has been and will likely be subject to further scrutiny and vulnerable to legislative pricing risks; iv.) highly-acquisitive strategy is lower quality growth; v.) elevated competition; vi.) longer-term secular industry decline; vii.) quality of earnings is questionable
The need for cash has declined substantially as it has been increasingly substituted by alternative forms of payment. The prevalence of compelling alternatives for consumers to pay and access banking services has made cash and therefore ATMs less relevant. In the U.S., the U.K., and other developed markets, more people are opting for electronic forms of payment for in-store purchases versus paper-based forms like cash and checks. Many merchants offer its customers cash back at the point-of-sale for free, thereby providing in-store customers an incentive for using their debit card. Quick service restaurants have historically been a popular venue for consumers to use cash but cash transactions have been losing share to non-cash forms of consideration. For example, major chains like Starbucks and Taco Bell are driving a strategy of on-line ordering and pick-up that encourages non-cash payment. It wasn’t so long ago that taxis didn’t accept credit cards because of the cost and time to process the transaction. Now, and especially to compete with Uber, taxi cab drivers have little choice and mobile POS devices have made it much easier to accept cards. Technology advancement has made digital payments simpler and there’s little reason that ongoing penetration and usage won’t continue to accelerate. According to the Nilson Report, cash transaction counts declined from 32.6% of all payment transactions in 2009 to 26.5% in 2014.
The continued growth in electronic payment methods is likely to drive a reduced need for cash in the marketplace and consequently a decline in the usage of ATMs. According to the Federal Reserve Payments Study, ATM cash withdrawals declined by a CAGR of 0.9% from 2009-2012 (note: the next triennial report is expected to be published during December 2016). On a per capita basis, the decline is closer to 2%. A study by the U.K. bank Halifax showed that cash was used in just 17% of consumer transactions. According to data from the LINK ATM network in the U.K., cash payment volumes have declined by almost 30% during the past decade and a steeper decline is anticipated in the next decade, fueled primarily by debit, contactless and mobile payments. The Company cited a negative rate of growth in cash withdrawal transactions across its ATMs in the U.K. during the past 12-24 months. CATM’s number of same-store cash withdrawals has been declining.
The government has been increasingly pushing for a cashless society. By having a paper trail for all transactions, the notion is there would be less crime, money laundering, and tax evasion. France’s finance minister recently said that he would “fight against the use of cash and anonymity in the French economy” to prevent terrorism and other threats. In Sweden, it is said to be impossible to buy a ticket on the Stockholm metro with cash, retailers are legally permitted to refuse coins and notes, and both street vendors and churches have embraced the Swedish trend for the increasing preference of card and phone payments. Cash payments comprised barely 2% of the value of all payments made in Sweden last year and more than half of all Swedish bank branches no longer keep cash on hand or take cash deposits. Even the Abba Museum, despite being a shrine to the 1970s pop group that wrote “Money, Money, Money,” considers cash so-last century that it does not accept bills and coins, wrote Liz Alderman in the New York Times. Although the short thesis is not predicated on a “cashless society”, the evolution of improving non-cash, alternative forms of payment is and will continue to be a growth headwind confronting CATM.
Cardtronics provides automated consumer financial services through its network of ATMs. The Company is the world’s largest retail ATM owner, providing services to ~190,000 devices at the end of 2015 throughout the U.S., the U.K., Germany, Poland, Canada and Mexico. Also, the Company operates the largest surcharge-free ATM network, called Allpoint, within the U.S. At year-end 2015, Allpoint had ~55,000 participating ATMs. Allpoint provides surcharge-free ATM access to customers of approximately 1,300 participating financial institutions in exchange for either a fixed monthly fee per cardholder or a set fee per transaction that is paid by the financial institutions who are members of the network.
The Company conducts its business through three distinct arrangements: Company-owned ATM placements (~59,000 devices, ~31% of total devices), merchant-owned ATM placements (~18,000 devices, almost 10% of total devices), and managed services and processing (~113,000 devices, ~59% of total devices). Since 2012, Company-owned units increased by 23,000, a significant majority of this increase having been acquired by the Company. Almost all of CATM’s owned ATMs are located in the U.S. (~66%) and the U.K. (~27%). The company is currently located in 8 of the top 10 retailers that have ATM programs. The Company will typically pay a merchant a fee for allowing CATM an exclusive right to place its ATM at their location. During 2015, merchant commissions represented over 30% of ATM operating revenues.
At year-end 2015, CATM’s contracts with its top five merchant customers (based on 2015 pro forma revenue) accounted for ~37% of the Company’s pro forma revenue and had a weighted average remaining life of 2.6 years (3.7 years excluding 7-Eleven, which expires in July 2017). As will be described in more detail later, the loss of the 7-Eleven contract, the Company’s largest merchant customer and representing ~18% of pro forma 2015 revenue, is a significant headwind that will likely lead to lower earnings in 2017 and 2018. This change looms large starting mid-year 2017 and although already known, it is a significant earnings gap to fill on an organic basis. Since a relatively large portion of CATM’s expenses are fixed in the short-term, the deleverage impact of lower revenue will have a larger impact. After 7-Eleven, the Company’s next four largest merchant customers (together comprising 19% of pro forma revenues during 2015) were CVS, Co-op Food, Walgreens, and Speedway.
CATM’s renewal rates are impressively very high but there is an increasing risk of merchant customer losses and significant risk that pricing will be compromised to retain customers. CATM is especially vulnerable as the Company is losing its largest merchant source of revenue and earnings. Although I am not ascribing an issue with CATM’s performance in the field, the competitive environment has intensified as industry participants fight for an addressable market that is slow growth, at best. Competitor Financial Consulting & Trading International (“FCTI”) has cited aggressive pricing for new deals and FCTI is well-equipped to be aggressive pursuant to taking the 7-Eleven business away from CATM.
During 2015, ~69% of total revenue was generated from North American operations and ~31% from European operations. ATM operating revenue (~95% of total revenue, other ~5% from ATM product sales) is derived primarily from a combination of surcharge (~41% of mix), interchange (~37%), branding and surcharge-free network (~15%), and managed services (~7%). Surcharge fees are paid by consumers and interchange fees are paid by card-issuing banks. Also, some banks pay CATM for putting their brands on its devices and/or to offer surcharge-free withdrawals to their banking customers.
Surcharge fees, the Company’s largest source of revenue mix (at 41%), are vulnerable to legislative risk. Since being introduced in 1996, these fees have received substantial scrutiny and been challenged by consumer advocacy groups. According to the Company, eighty-five percent of U.S. consumers consider convenient surcharge-free ATM access to be essential or very important. As part of the Dodd-Frank legislation to reform the banking industry, Senator Tom Harkin sought to cap ATM fees at fifty cents (this would represent an almost 90% cut from the average ATM fee that consumers paid in 2015). Although his efforts were unsuccessful, ATM fees remain a topic that is likely to garner increased scrutiny during the next administration. During an interview in 2015 on the Colbert show, Hillary Clinton described her plans to reform the financial system and characterized ATM fees as “usurious”.
As an attractive consumer alternative to paying surcharge fees when in need of cash from an ATM machine, the Company owns Allpoint, the largest surcharge-free ATM network. The Company acquired the surcharge free network through its acquisition of ATM National in December 2005. Allpoint is an attractive asset for Cardtronics to combat the challenges of its core business but ultimately Allpoint could cannibalize the Company’s surcharge-fee ATMs. Revenue per total transactions has declined from an average of $1.26 to ~$0.88 in 2015 as surcharge fees per transaction have decreased by more than 40%.
The Company does realize some operating leverage from increasing ATM transaction counts (through interchange revenue) because Allpoint transactions are routed over Cardtronics’ own switch. Since consumers will increasingly gravitate toward “free” ATM access, the Company might benefit from increased transactions at Allpoint but not enough to compensate for the loss of those same consumers and others who are seeking a free ATM access point instead of having to pay the “usurious” fees when in need of cash from an ATM. Also, if the Company is to sustain a leadership position in this category, it is likely that CATM will be required to spend more in capital as banks demand higher functionality ATMs with enhanced software capabilities.
Management’s goal is for Cardtronics: “To be the ATM network of choice in every neighborhood and for every business around the world.” However, management doesn’t speak of the Company’s return on invested capital and perhaps not surprisingly given how low it is, at less than 5.5% (on average) for the last four years (from 2012-2015, ROIC ranged from 2.7-7.5%). Return on assets averaged just 4.2%.
In an effort to drive growth and mask the deterioration of the core business, CATM is highly acquisitive. However, a majority of the Company’s acquisitions seem to provide less impact. In each year 2011-2015, ATM gross profit per unit has been lower from the pool of ATMs acquired. Excluding managed services, gross profit per ATM per month has declined from 2011 to 2015 by ~10%. At year-end 2015, it was $427 (this excludes depreciation, accretion, and amortization).
Competition exists on multiple fronts. On a direct basis, CATM competes with financial institutions and other independent ATM deployers (“IAD”). On an indirect basis, CATM competes with other approaches to payments which includes checks, credit cards, debit cards, stored-value cards, and mobile payment options like Square, Apple Pay, and Venmo.
The ATM industry confronts multiple challenges. According to the 2015 U.S. Independent ATM Deployer Survey, the five biggest concerns regarding the health of the ATM industry are as follows: i.) declining transactions; ii.) ATM saturation; iii.) keeping up with changing technology; iv.) fraud risk; and v.) consolidation/competition. In regards to legislative/regulatory concerns in the ATM industry, the five biggest concerns are as follows: i.) EMV migration drives increased spending; ii.) reductions to interchange revenue stream; iii.) difficulties imposed by financial institutions to operate cash funding accounts; iv.) EMV migration and shift of fraud liability to ATM owners; and v.) government changes. Some of these concerns are described more below.
By October of this year, ATM owners in the U.S. have to replace or upgrade their machines to accept chip cards or else accept the liability for certain types of fraud. Owners of ATMs that don’t move to accept the chip technology (called “EMV”) will become liable for any counterfeit fraud that’s perpetrated on the machines using MasterCard. In October of 2017, Visa will start enforcing a similar rule. According to a Senior Vice President at MasterCard, only ~20% of ATMs in the U.S. had been adapted to accept the chip cards at the end of June. In general, costs to upgrade an ATM’s hardware and software range from $300-$3,000. According to the Aite Group, some 410,000 ATMs have to be upgraded, and ATM owners will have to clean the new chip-card reader at least once every couple of weeks. The cleaning kit costs another $1.50 a pop. According to a Vice President at ATM manufacturer Triton Systems, he anticipates that as much as 10% of retail ATMs (i.e., non-bank) will be shut down versus being upgraded/replaced because the return on doing so cannot justify the additional capital and operating expense. CATM management expects EMV will have caused the Company to incur an incremental $35-50M of capital spending to upgrade its Company-owned ATMs.
Among the potential catalysts for the short thesis are changes that could be made to interchange fees. The Company is vulnerable to such changes and any change is likely to be made with little influence from CATM (i.e., a potential negative surprise earnings revision). Investors should accord such risk in how CATM is valued and my assertion is that this risk is not adequately discounted by the current valuation. During 2015, interchange fees represented ~37% of CATM’s ATM operating revenue. Interchange fees are set by the various EFT networks and major interbank networks through which transactions are routed. In the U.S., almost 5% of Company ATM operating revenues are subject to pricing changes where CATM has no ability to offset such changes with lower payments to merchants. Furthermore, ~20% of the Company’s total ATM operating revenue in 2015 was derived from interchange revenues in the U.K. where the significant majority of interchange revenues are based on rates set by LINK, the major interbank network in that market. LINK sets interchange rates using a cost-based approach that incorporates ATM service costs, generally from two years back. While management thinks this approach has generally enabled the Company to recover its costs and earn a reasonable profit margin, large increases to costs within a particular time period could adversely impact CATM’s profitability in the U.K. since interchange rates are fixed on a calendar basis. Also, in addition to LINK transactions, some card issuers in the U.K. have issued cards that are not affiliated with the LINK network, and instead carry the Visa or MasterCard brands. Transactions conducted on CATM’s ATMs from these cards in the U.K. comprised ~1.5% of annual withdrawal transactions in 2015. These interchange rates set by Visa or MasterCard have historically been less than the rates established by LINK. If any major financial institutions in the U.K. were to leave the LINK network in favor of Visa or MasterCard, this would likely further reduce the interchange revenues that CATM receives in the U.K. The number of EFT networks has declined significantly and is now concentrated with Visa and MasterCard, giving them more bargaining power in setting rates.
Despite the clarity that materialized during July 2015 that CATM would no longer work with 7-Eleven in the U.S. (when the stock declined by over 16% to below $31 on July 7, 2015 pursuant to the market learning of the contract loss), the stock has rebounded by over 45% since that announcement. I believe the market is not adequately discounting that the Company's largest source of revenue, profitability, and FCF will be eliminated, beginning as early as July 2017. In July of 2015, 7-Eleven chose not to renew its contract with Cardtronics in the U.S. and instead executed an ATM Placement Agreement with Seven Bank’s subsidiary FCTI to install and operate ATMs at 7-Eleven on an exclusive basis beginning in July 2017. Since Seven Bank is 46% owned by 7-Eleven’s parent company, Japan-based Seven & i Holdings, the fact that Cardtronics is losing this business to Seven Bank’s subsidiary FCTI is not too surprising. It is also worth noting that during October 2015, Seven Bank/FCTI established a subsidiary in Canada. CATM’s business in Canada with 7-Eleven is across more than 500 ATMs.
During 2015, the U.S. 7-Eleven business represented approximately 18% of CATM's pro forma revenue. This business comprises a larger percentage of profitability. The 7-Eleven ATMs are much more productive (at least 2x) than the Company average. As described by the Company, "Because of the scale of this relationship and the volume of transactions on ATMs in 7-Eleven stores (which are higher than our average in the U.S), we currently believe the loss of this merchant in 2017 will most likely have a higher negative impact (in percentage terms) on our income from operations relative to the revenue impact."
In 1984, 7-Eleven was the first convenience retailer to offer ATM services and their stores offer the largest ATM network of any retailer in the U.S. When Cardtronics acquired the 7-Eleven business in 2007 for $135M, management estimated the business was generating $164M of revenue (including ~$19M of nonrecurring fee revenue) and ~25% EBITDA margin (about 600 basis points better than CATM’s margin then) across 5,500 machines.
The consensus EPS estimate (non-GAAP) for 2017 shows a $0.17 decline being anticipated next year and although I agree with an EPS decline being most likely, the magnitude of such materializing next year from the 7-Eleven business is difficult to discern since the key ingredient is the timing of FCTI’s implementation. They can begin as early as mid-year 2017 so CATM would at least benefit from the 7-Eleven business during the first half of 2017 and perhaps longer until FCTI successfully transitions the ATM operations. The main point is that 7-Eleven will soon disappear and the earnings impact and loss of FCF will be meaningful. I focus my attention as if all the 7-Eleven business in the U.S. (CATM will likely lose Canada as well) is gone as of 2018.
During July 2015, management disclosed that 7-Eleven U.S. should generate ~$210M of revenue in 2015 across its 7,850 ATMs and that margins are “somewhat” above the corporate average. During 2015, CATM reported ATM operating gross margin at 36.4% (exclusive of depreciation, accretion, and amortization) and an Adjusted EBITDA margin of ~25%. Assuming “somewhat” above the corporate average is 150 basis points, the 7-Eleven U.S. business contributed ~$80M to CATM’s EBITDA last year (over 25% of the Company total). Since management noted depreciation expense of ~$8M, one can estimate an earnings impact of over 35% (based on 2015 non-GAAP earnings) and FCF of ~$45M. Although there have been some recent acquisitions that will likely contribute to earnings in both 2017 and 2018 plus value from ~40% of the newer EMV-ready units at 7-Eleven that can be redeployed, I do not think the market has fully-discounted the magnitude of the pending 7-Eleven lost.
There are more 7-Eleven units operated globally than any other convenience store, retailer, or food service provider. Less than 20% of those units are in North America but that is likely to change as 7-Eleven’s parent focuses on making 7-Eleven “ubiquitous”. Approximately 25% of the U.S. population lives within one mile of a 7-Eleven store. More than 6M people stop by a 7-Eleven in the U.S. each day. Three years ago, Seven & i Holdings communicated its plans to more than double North American outlets to 20,000-30,000. As 7-Eleven expands its footprint to become more ubiquitous in the U.S., FCTI will place ATMs in those stores. The loss that CATM will incur from 7-Eleven is more than just the immediate loss of the current portfolio of ATMs operating at 7-Eleven. As 7-Eleven’s footprint grows, the ATMs there will serve as an additional alternative for ATM usage relative to other merchants where CATM has ATM real estate. It’s difficult to quantify such but an additional competitive issue to highlight. This is just anecdotal but within one mile of my zip code, CATM currently has six alternatives where I can use their ATM and two of those happen to be at 7-Eleven. Within three miles, CATM currently has twenty-nine alternatives and six of them (a lower percentage but still over 20%) happen to be at 7-Eleven.
The fact that Seven Bank is focused on driving ATM market share in the U.S. with the commitment of a company the size of parent Seven & i Holdings is a formidable competitive challenge. Seven Bank acquired FCTI during 2012 for $52M (FCTI generated ~$42M of revenue during 2011). Seven Bank and FCTI currently manage over 27,000 ATMs worldwide and their management has said they want to expand FCTI’s business in the U.S. (currently ~6,500 ATMs) as evidenced by their comment that follows, “As regards the U.S. ATM business, we believe that the execution of this agreement will result in the expansion of business as well as better cost competitiveness and profitability, which will further accelerate the growth of the business.” FCTI’s current focus is to smoothly transition their operation of the ATMs inside ~8,000 7-Eleven stores in the U.S. FCTI’s outlook for its fiscal year ending March 2017 is for ~6,700 ATMs with EBITDA of $5M. By the end of 2018, FCTI will have doubled its ATMs in the U.S. through the 7-Eleven arrangement. FCTI has already demonstrated a willingness to outbid CATM for acquisitions and once FCTI implements the 7-Eleven business, assuming they do so smoothly, they intend to drive their share.
The market might not be adequately discounting these and other risks for CATM but some insiders might be anxious about the current and ongoing challenges that CATM confronts. During the past two years, insiders have sold ~$11M of stock. Directors and executive officers as a group owned just 1.5% of the Company as of the most recent proxy statement. In addition to substantial insider selling, there are some senior level executives that have or will soon be leaving the Company. This includes the President of the North American Business Group, the General Counsel, the CFO, and the President of Global Services. Current management dismisses these high-level departures as normal course of business with regards to some reorganization including the Company’s redomicile to the U.K. I believe these departures reinforce a sense of the challenges that loom ahead for CATM.
It is worth noting that the CFO, Edward West, was previously CEO/CFO of Education Management Corp. He was CFO from 2006-2012 and became CEO in 2012; he resigned his leadership from Education Management during August 2015, four months after eight directors resigned in a restructuring when creditors gained majority control of the company for cancelling over $1.3B of debt. Education Management was never profitable under his leadership and during November 2015, an almost $100M settlement was announced by federal and state authorities resolving a case in which the company was illegally paying recruiters based on the number of students they enrolled. Attorney General Loretta Lynch said that Education Management Corporation has been “operating essentially as a recruitment mill” and the company’s actions “were not only a violation of federal law but also a violation of the trust placed in them by their students, including veterans and parents, all at taxpayer expense.” Lynch said prosecutors did not seek to make the company pay the full $11B (!!!) that the government believed Education Management defrauded the government because they considered the company’s “ability to pay”. Although I believe the issues that Edward dealt with might have largely been inherited as part of the broad-based, for-profit education scam among the publicly-traded sector at least, one should question his judgement for being there nine years and consequently he deserves some blame for the questionable activities that existed at Education Management during his tenure. Given his position at Education Management, West’s experience showed he was willing to interpret the rules in a flexible manner (or “compromising manner”) or perhaps he was incapable of discerning when questionable business activities were happening. On July 7, 2016, West received a promotion at CATM to fill the combined role of CFO and chief operations officer and assume responsibility for global operational effectiveness and profitability.
The Company frames its performance through numerous adjustments, almost more than any company I have ever evaluated (note: I never evaluated Valeant!). Since the management team is influenced by “adjusted” performance for incentive payments, they appear more focused on framing as many adjustments as possible as opposed to driving intrinsic value creation through attractive investments as measured by ROIC. It has recently been highlighted that GAAP and non-GAAP earnings have diverged more than ever and it’s impossible to know if/when the market will care about GAAP earnings when evaluating a company’s valuation. Since 90% of companies use non-GAAP numbers to explain their financial operations, I am not calling CATM out specifically for the use of non-GAAP but I think the magnitude of adjustments at CATM warrants mentioning as I think management’s efforts of improving the cosmetic appearance of the company’s performance is too large to ignore and should raise red flags regarding earnings quality.
During 2015, CATM’s adjusted EPS was 95% more than GAAP EPS. The magnitude of adjustments between GAAP and non-GAAP has indeed improved from 2013 and 2014 when the difference was 271% and 194%, respectively, but still highly questionable at the current magnitude and further reinforced by a low ROIC and negative FCF generation (when acquisitions are included as described later). For context, note that during the first quarter of 2016, non-GAAP earnings were ~29% higher (versus ~20% in the prior year period) than GAAP earnings for 19 of the DOW 30 that report both earnings numbers. During the first half of 2016, CATM’s non-GAAP EPS was 91% more than GAAP EPS. With regards to CATM, the three largest adjustments are amortization of intangible assets, acquisition-related expenses, and stock-based compensation expenses. Goodwill comprises more than 40% of total assets, intangible assets and goodwill comprise more than 50% of assets and tangible book value is negative. Stock-based compensation expenses have grown by more than a 25% CAGR in the past two years.
Despite the recurrence of acquisitions, almost $70M of acquisition-related expenses has been characterized as “adjustments” since 2011. There are in fact expenses that should be deemed as non-recurring but the magnitude of adjustments for an acquisitive-driven company raises a red flag regarding the quality of earnings. It is notable that at the beginning of each year, during the discussion of Q4 results from the preceding year, that management provides its annual outlook and within such guidance they provide an estimate for acquisition-related expenses to be included in their framing of Adjusted EBITDA and Adjusted Net Income. The striking issue is that from 2013-2015, management provided a total estimate of $17.5M but by the end of those years, the total adjustments for acquisition-related expenses actually amounted to more than $60.5M. I suppose they needed to jam other stuff into that category to keep within the cosmetic arena of achieving their EBITDA outlook. Based on their incentive structure, they were motivated to find those adjustments. Since the adjustment is not GAAP, it is subject to much flexibility and management appears to be abusing it. I don’t know if the market will ever care but it does reinforce a quality of earnings issue.
It is also worth noting that during 2013 and 2014, the Company generated “Adjusted EBITDA” that exceeded the midpoint of management’s initial outlook by $13.3M and $14.4M, respectively. Those same years, the difference in acquisition-related expense adjustments that were ultimately framed versus management’s initial outlook amounted to $13.4M and $12.6M, respectively. Perhaps a coincidence that CATM beat its Adjusted EBITDA outlook roughly by the same amount by which the magnitude of acquisition-related expense used was a similar amount more than the original outlook? For this year, management did not include any acquisition-related expenses in their initial outlook but has already modified such to be $2.5M. I suspect it will ultimately be more.
It also appears that management has inflated earnings by increasing the depreciable life of its assets. At CATM, most new ATMs are depreciated over eight years. This is significantly more than the five years used by publicly-traded Canadian peer DCPayments and five years applied by FCTI according to my source. Also, in conversations with selected ATM manufacturers, they confirmed that eight years is “highly aggressive” from a “useful life” for an ATM and especially in light of ongoing regulatory and technology changes (note: recognize that they are biased). Also reinforcing that CATM is likely overstating earnings through extended depreciation is the fact that capital spending has exceeded depreciation expense in each of the past six years. This might make sense if the Company were growing new locations organically and therefore buying new machines as part of that fulfillment but that’s inconsistent with a majority of ATM machine growth coming from acquisitions. Total capital spent in the past six years has exceeded depreciation expense by 40%. If CATM were a private company, I suspect management would manage depreciation to be higher for lower taxes but instead play the game to extend the life to prop earnings.
To foster potential growth, the Company has been highly acquisitive. During the past fifteen years, the Company has acquired twenty-six ATM businesses. Since 2011, CATM has acquired eight domestic ATM operators, two Canadian ATM operators, Cardpoint Limited (August 2013) to further expand in the U.K. and enable the Company to enter the German market, Sunwin (November 2014) to expand the Company’s capabilities in the U.K., Columbia Data Services (July 2015); as well as Locator Search and i-design group. A majority of ATM location growth has been derived from CATM’s acquisitions and for the years 2011-2014, the productivity of acquired ATMs (defined here as cash withdrawals per ATM, excluding managed services) has been dilutive.
Acquisitions are a core component of CATM’s strategy and therefore one should impute that cost when evaluating the Company’s free cash flow generation. When acquisitions have been the primary source of growth and occur relatively frequently, the use of cash incurred to make an acquisition becomes a substitute for the capital that might have instead been spent to grow organically. This is especially relevant with CATM where several acquisitions are tuck-ins that include ATMs owned and operated by the target being acquired. During the past five years, without the inclusion of any acquisitions, the Company generated ~$390M of total FCF but including acquisitions, the Company lost almost $285M of FCF with only two years of marginal amounts of FCF ($10-23M) generated relative to the Company’s market cap. Since the end of 2010, net debt has increased by $220M.
Assuming that the 7-Eleven business disappears as of July 2017, the optics of declining earnings that will occur in 2017 and 2018, in the absence of additional acquisitions, is undoubtedly driving management to fill the gap. Management continues to highlight a robust pipeline of M&A opportunities and it would not be surprising to see the Company acquire the NoteMachine Group which has reportedly been exploring a liquidity event for Corsair Capital. British-based NoteMachine is the operator of more than 8000 ATMs as well as Eurochange. The potential acquisition, believed to be at least $400M, would be the Company’s largest. Management has said they would lever the company up to ~3x Net Debt/Adjusted EBITDA. As of Q2 and based on the Company’s 2016 outlook for Adjusted EBITDA of $322M but pro forma for the loss of 7-Eleven (assuming the 2015 estimated EBITDA of $80M from 7-Eleven did not grow), current leverage is ~2x.
The Company pays a fee for renting the cash that is maintained in its ATMs. These fees are based on market rates of interest and CATM would incur additional expense if interest rates were to rise. To limit its exposure to increases in interest rates, management has arranged interest rate swaps for the Company’s domestic operations through 2020. The Company requires ~$2B of vault cash in the U.S. ($1.3B of which is hedged) and ~$1.5B in Europe. CATM does not hedge the U.K.-based vault cash since it regains the incremental cost in the following year through interchange revenue. During 2015, vault cash rental expense represented over 6% of revenues. As part of the Company’s initial 2016 outlook, management incorporated ~$0.08 of headwinds related to rising interest rates; this outlook was predicated on the interest rate futures curve exiting 2015. In hindsight, management was being conservative as the prospects for rising rates changed during 2016. This still remains a potential catalyst for lower earnings if interest rates were to rise in the future. Management estimates every 100 basis points of increased rates adds ~$9M of expense in the U.S.
From a valuation perspective, the stock (at ~14x 2016E non-GAAP EPS and ~8x 2016E EBITDA) doesn’t look too expensive. On a GAAP basis, and especially contextualized by the issues I noted, I believe the stock at ~23x is very expensive. More relevant than looking at 2016 though is the fact that 7-Eleven won’t be part of the Company’s results in 2018 and possibly for as much as half of 2017. If one frames 2016 EBITDA without $80M from 7-Eleven, then valuation on an EBITDA basis is ~10.5x. At 8x this pro-forma EBITDA, CATM would trade at $32.50. There are many ways to think about valuation and when I triangulate such in a variety of ways, including a DCF, I believe CATM’s stock price is inconsistent with its near-term challenges. I am certain the Company will engage in M&A to fill the looming earnings gap and an evaluation of such will be critical towards monitoring the short exposure.
With 11 days to cover, there are others that might have a similar perspective to my short thesis. In fact, Kerrisdale Capital framed the short opportunity in a comprehensive manner during May 2014 (the stock traded during that month at ~$29-38.50). Many of the same issues exist and the 7-Eleven catalyst has already materialized as a decision although the magnitude of financial deterioration has yet to be incurred. Given hedge fund challenges of late, there have been numerous redemptions which likely has forced some of the better short candidates (I think CATM qualifies) to be covered by struggling hedge funds. It is notable that the shares short at CATM have recently declined.
· Deteriorating profitability (on both a GAAP and non-GAAP basis) as clarity of 7-Eleven profitability loss develops
· Additional client attrition and/or worse renewal terms as competition intensifies especially from FCTI
· ATM surcharge regulation
· Reductions in ATM reverse interchange rate and/or increases in PIN network switching fees
· Allpoint and growth in surcharge-free ATM networks cannibalizes core ATM business
· Overstated earnings is subject to more market scrutiny
· Currency headwinds coupled with higher interest rates (i.e., vault rental expense)
· ATM usage at CATM portfolio declines as 7-Eleven more than doubles its footprint and FCTI gains such advantage
· Capital spending requirements escalate (EMV upgrade, banking relationships demand, regulatory requirements like Americans with Disabilities Act/National Federation of the Blind, new currency designs in the U.K. being introduced during June 2017)
· Longer-term secular ATM usage decline as alternative payment forms/technologies substitute for cash
|Subject||Reply to Nails|
|Entry||09/02/2016 01:38 PM|
Thanks for your questions. Based on their management presentation, organic revenue growth since 2011 has been the following: 8% (2011), 12% (2012), 6% (2013), 7% (2014), and 5% (2015). During 2013, management said they target longer-term organic revenue growth at 7-9%. They have adjusted their goal to 6-8%. On a same-store cash withdrawal basis, counts have been down during the past several quarters. Part of the decline in the U.S. is ascribed to the loss of a partnership with Chase. Regarding acquisitions, there are many transactions and most come with limited valuation discussion but the larger acquistions (Columbia Data, Welch, Cardpoint) are said to be at 6-8x EBITDA. There are some synergies and this can include leveraging existing personnel infrastruture (e.g., ATM maintenance personnel working across improved density of machines) and consolidation of processing. Several transactions have yielded some tax benefits as well. Many of the acquisitions have been to drive new merchant relationships and/or geographical expansion. The Company historically was focused solely on the national enterprise footprint and their acquisition of Welch ATM gave them a mid-market platform.
|Subject||Re: Re: Reply to Nails|
|Entry||09/02/2016 05:31 PM|
maggie + nails,
My 2 cents:
I was short CATM but covered short late last year after several positive results.
My reasoning was along the lines of Nails questions. My original thesis was that all the organic growth was coming from newly acquired ATMs. But they were over-paying for these machines and true organic growth (say, of machines owned 2+ years) was zero or slightly negative. But later results made me conclude that this was not true. There was true organic growth.
But how can this be given the macro picture that maggie accurately presents? I believe that even though cash is in secular decline, the closing of bank branches and bank-owned ATMs are in even greater decline. And thus CATM can grow even though the larger market is declining.
I do think the short works if FCTI (7-11 atm company) aggressively pursues other large contracts. Otherwise, scale is important and CATM is leader.
Hope this helps.
|Subject||Reply to Nails|
|Entry||09/06/2016 02:37 PM|
Nails, you asked three questions noted below to which I respond as follows:
|Entry||09/07/2016 01:11 PM|
Maggie1002, thanks for the thorough write-up. A few questions:
(1) Are the 7-11 ATMs all CATM-owned? Are only 40% EMV-compliant, and thus it's assumed there is zero value for the rest?
(2) How did the UK redomicile impact tax rates? What tax rate are you modeling going forward?
(3) To revisit your previous answers to the questions around organic growth. Parsing their organic transacting revenue growth (i.e. ex-managed services and processing) into: change in organic ATM count, revenue per transaction excl. acquisitions, and transactions per ATM per month excl. acquisitions (similar to Kerrisdale’s approach in their write-up), the growth in transaction organic volumes (9-14%) has recently been enough to offset lack of organic growth in ATM count (~0%) and revenue per transaction excl. acquisition declines (-2 to -3%). And so growth has really been volume and not unit-driven. Thinking of their core business along these unit economic growth drivers seems to suggest that the migration to Allpoint and the resulting increase in transaction volumes is more than offsetting declines in surcharge revenues and stagnant organic ATM counts. What alternative explanation would you offer for how the company is growing organic transacting ATM revenues in recent quarters?
(4) In response to Nails you said that “they are generating negative FCF if one includes their acquisitions strategy”. Could you provide your calculations? I show positive FCF over LTM basis after including cash for acquisitions. Curious what adjustments you might be making.
|Subject||Reply to LimitedDownside|
|Entry||09/09/2016 05:55 PM|
I don't have a good response for you and it's something that I have sought to reconcile with management but have not heard back from them. It might have something to do with them using data for non-Allpoint for one calculation and the inclusion of Allpoint for the other. It also might have some influence from acquisitions given the latter figures are inclusive but I don't have a good answer for you but will share anything if I get clarification.
|Subject||Reply to AtlanticD|
|Entry||09/09/2016 06:12 PM|
I don't know if all the ATMs at 7-Eleven are owned. The Company grew the base of the business from 7-Eleven that they acquired by 2350 machines as of last year and one would think that a majority of those they acquired in 2007 would have been replaced during the eight years. During July 2015, management said that it doesn't expect to incur a material write-down of 7-Eleven assets and that its ATMs there had a BV of $30M with annual depreciation of ~$8M. They also highlighted 40% of units being almost fully-depreciated, 20% at midlife with close to zero BV when the contract ends, and 40% being newer EMV-ready that can be redeployed.
In regards to the re-domicile, we recently learned that management expects moving to a GAAP tax rate with a booking of 25% in Q3 and 29% in Q4. In 2017 and 2018, expectations are for 30% and mid-to-high 20%, respectively.
On your third question, it appears you've answered it on your own. I believe cannibalization will materialize in substituting higher profitability with lower profitability transactions but time will tell.
|Entry||10/06/2016 08:49 AM|
Any thoughts on the acquisition?
|Subject||Re: DC Payments|
|Entry||10/09/2016 05:28 PM|
As you will note from the write-up, I expected the company to continue its acquisitiveness although I was anticipating they would be acquiring the NoteMachine Group. Although it remains possible that CATM might remain ambitious to pursue another sizeable acquisition, on a pro forma basis (for the loss of 7-11 and the inclusion of DC Payments), leverage is at ~3x. This is different from management's 2.6x pro forma based on the anticipated loss of 7-11 at some point starting next year. Based on any FCF generated until the loss of 7-11 and any growth of EBITDA in 2017 ex 7-11, leverage is of course somewhat lower but I assert higher than 2.6x as management's pro forma does not take into account the pro forma impact of the pending 7-11 loss (estimated to be $80M of EBITDA and $45M of FCF in 2015). Management has said they would lever the company up to 3x so it will be worth monitoring their willingness to do another meaningful acquisition that violates their own commentary pertaining to leverage. Moody's has placed CATM on watch for a potential downgrade. The magnitude of debt, almost $1B on a pro forma basis, adds to the longer-term risks that might confront CATM.
There is no change to my short thesis but one must of course be willing to acknowledge the market's positive reaction to increase CATM's equity by almost $200M for their $460M acqusition. I ascribe some to short covering by those focused on short-term dynamics and any change in price momentum. The short interest (based on days to cover) is currently at 15 and was 11 days when I wrote up the idea. One cannot argue with the strategic merits of the acquisition (e.g., geographic expansion, improvements to existing geographic density) but it is my own opinion that there are structural issues within the industry that are not adequately discounted by valuation. Those structural issues have not gone away and the acquisition is definitely motivated, at least partially, to fill the looming 7-11 gap.
I suppose the most disconcerting issue is that the acquisition provides additional "cookies" for the accounting "cookie jar" that CATM uses to manipulate their framing of adjustments. The market has clearly shown a willingness to embrace such adjustments and CATM's acquisition of DC Payments gives them additional fuel to continue doing so. Note that DC depreciated its ATM assets by five years versus CATM use of eight years so another point of "synergy" or accounting manipulation exists in that regard. As for synergies, CATM's management was not explicit about any magnitude although they said they envisioned such being done over 1-2 years and that their perspective of the valuation paid was less than the reported 7.5x EBITDA after potential synergies.
I never said I expected the short to work immediately and although there was an attractive generation of alpha for a few weeks, that has quickly been eroded, for the time-being, by the market's reaction to the acquisition. As for near-term catalysts, Q3 results will be released soon and the Federal Reserve should be releasing their triennial payments study in December. I also think it's worth monitoring the insider activity which hasn't materialized since mid-August in hindsight (presumably) based on the pursuit of DC Payments and now the earnings window. As you might have seen in last week's WSJ, 7-11 is focused on domestic unit expansion as I wrote up and that continues to be a longer-term competitive issue. We also have yet to learn of CATM's loss of the 7-11 business in Canada which presumably will be announced in the near future. Having been dislocated by Hurricane Matthew, I have yet to dig into the DC Payment rationale for selling, the competitive nature of the sale, and other relevant issues but will share any thoughts as those are collected.
It is worth noting that the market was valuing DC Payments at more than an 11% implied yield pre-acquisition and the valuation accorded to CATM is quite different. Based on the current valuation for CATM pro forma for the DC deal and the pending loss of 7-11, CATM is now trading at more than 10x 2016 EBITDA.