February 22, 2010 - 10:05am EST by
2010 2011
Price: 15.68 EPS $2.00 $2.40
Shares Out. (in M): 9 P/E 7.8x 6.5x
Market Cap (in $M): 134 P/FCF NA NA
Net Debt (in $M): -20 EBIT 27 34
TEV ($): 114 TEV/EBIT 4.2x 3.4x

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I am recommending the purchase of ePlus (PLUS), which should be well-known to VIC members having been posted five times between 2002 and 2008, most recently by zach in June 2008 at $10.80.  PLUS has two business segments it reports:  (1) a value-added reseller (VAR) business that sells a wide range of IT equipment to mid-sized businesses, and (2) a financing, leasing and life cycle management business for the same IT assets.  Although not broken out separately, the Company also owns proprietary software for enterprise supply management, including procurement, spend management, asset management, document management and product content management software.  This business is not material but does occasionally produce license income from third parties, including $3.4 million in the current period that appears in the income statement as “Patent license and settlement income”.  This $3.4 million resulted from a settlement of patent litigation, which is ongoing against one party, and is offset somewhat by legal fees.


The VAR business is very straightforward.  Basically, the Company works with companies that have $25 million to $2.5 billion in revenues to architect and engineer their IT systems and then sells them the equipment for such systems (e.g., routers, servers, storage, computers etc), taking a modest markup on the sale of the equipment.  PLUS usually sells products that are shipped directly from its distributors or suppliers to the customer location, which minimizes the Company’s inventory investment (inventories were $11.6 million at 12/31/09 on quarterly VAR revenues of  $163 million).  PLUS sells through 30 regional offices, with strong positions in the Mid-Atlantic, Northeast, California and Texas.  The VAR business is highly fragmented.  The largest industry player, CDW, was taken private by Madison Dearborn and Providence Equity in a $7 billion LBO in 2007, representing over 13x EBITDA.   The best current public comparable is Insight Enterprises (NSIT), a multi-billion dollar revenue VAR with a total enterprise value of approximately $700 million that trades at 6.5x trailing EBITDA and 18x trailing earnings.


PLUS’s leasing and financing transactions generally fall into one of two categories:  direct financing and operating leases.  Direct financing transfers all the benefits and risks of equipment ownership to the customer.  All of the Company’s operating lease transactions (basically anything that isn’t direct financing) are net leases with a specified non-cancelable lease term, a fixed amount of rent and a requirement that the lessee pay all expenses associated with the use of the equipment.  As the expiry of a lease term approaches, the Company initiates a remarketing process whereby it seeks to re-lease, resell or rent the leased equipment so that it can recover or exceed the original estimated residual value.  PLUS historically has realized a premium over its original recorded residual assumptions or the net book value.  At 12/31/09, PLUS had a net investment in operating lease equipment of $21.2 million and in direct financing leases of $107.6 million.


To fully appreciate PLUS’s leasing business, cash flows and balance sheet, we need to take a brief detour into how the Company finances and accounts for its direct leasing book.  As indicated above, PLUS currently has a net investment in direct financing leases of $107.6 million; however, PLUS has financed approximately 60% ($64.6 million) of this lease book through “non-recourse notes” with third party financing sources.  The Company described these non-recourse financings as follows in its fiscal 2009 10-K:


Non-recourse financings are loans whose repayments is the responsibility of a specific customer, although we may make representations and warranties to the lender regarding the specific contract or have ongoing loan servicing obligations.  Under a non-recourse loan, we borrow from a lender an amount based on the present value of the contractually committed lease payments under the lease at a fixed rate of interest, and the lender secures a lien on the financed assets.  When the lender is fully repaid from the lease payment, the lien is released and all further rental or sale proceeds are ours.  We are not liable for the repayment of non-recourse loans unless we breach our representations and warranties in the loan agreements.  The lender assumes the credit risk of each lease, and its only recourse, upon default by the lessee, is against the lessee and the specific equipment under the lease.  [emphasis added]


This treatment of non-recourse debt has important implications.  First, databases erroneously treat it as recourse debt included in the calculation of total enterprise value (TEV).  Capital IQ, for example, reports PLUS’s TEV as $168 million, consisting of (i) a $129 million equity market cap plus (ii) $121 million of total debt ($62 million of short-term debt plus $59 million of non-recourse notes) minus (iii) $82 million of cash.  This treatment overstates the Company’s TEV by $59 million or over 50% relative to the real TEV of $109 million. Moreover, it presents the Company as having real leverage when in fact it has net cash. (As an aside, PLUS’s recourse debt is a short-term working capital facility that ebbs and flows with working capital movements and is not long-term funded debt.)  When we discuss valuation below, we will adjust TEV to exclude the non-recourse notes.


Taking account of the non-recourse note is also critical for understanding the Company’s cash flows and real economic investment in its lease portfolio at any point in time.  For example, if an investor looked only to the asset account “Investment in leases and leased equipment”, he might think that PLUS had only modestly grown its investment in its lease portfolio in the first three quarters of fiscal 2010 (March year-end) from $119.3 million at 3/31/09 to $124.7 million at 12/31/09.  In fact, the Company nearly doubled its investment in its lease book during this time frame. 


PLUS’s true economic investment in the lease book consists of the lease investment asset account described above less the non-recourse notes payable liability.  As you can see from the figures below, PLUS has made a substantial incremental investment in its lease book during the current fiscal year.





Investment in leases



Non-recourse notes



Net economic lease investment




This substantially increased investment in its lease book also largely explains why PLUS’s cash balance has declined by approximately $25 million in its current fiscal year.  With the credit crisis, lease economics (spreads) improved substantially, and PLUS management decided to deploy some its cash (otherwise not really earning anything) into leases.  The lease book generally is very high credit quality as it is secured by equipment that is critical to the function of the lessee’s business.  This capital deployment has also allowed the Company to opportunistically generate additional lease income during a period when its VAR business was cyclically weak. 


The strong momentum in the lease business should continue into the current quarter, the Company’s fourth fiscal quarter while the VAR business is about to lap its weakest quarter.  PLUS has increased sequential VAR revenues for three consecutive quarters with the December quarter down less than 5% yoy.  Moreover, the Company noted the following in the MD&A in its recent 10-Q:


At December 31, 2009, we had an unusual amount of orders from our customers that were not fulfilled by our vendors in their normal time frames.  This increase of approximately $20 million of open orders was due to a supply shortage of certain products by manufacturers….In addition, we had an increase in deferred revenue of approximately $10.0 million at December 31, 2009 related to bundled hardware and service arrangements that were not completed by the end of the quarter, compared to December 31, 2008.  We will recognize revenue on multiple deliverable revenue arrangements when service is completed.


It is clear that PLUS has substantial momentum in the VAR business while it will be lapping an exceptionally weak quarter at the same time that it will continue to generate strong yoy increases in earnings from its lease book.  The market doesn’t seem to appreciate how strong earnings and momentum will be when PLUS reports its fiscal year-end numbers.  We believe that PLUS will report Q4 EPS of approximately $0.50 (vs. $0.09 prior year when the VAR business produced  a loss), bringing full year EPS to approximately $2.00 excluding non-cash goodwill writedown.   Excluding the Company’s  $9.59/share of cash, at a $16 share price PLUS is trading at less than 3.5x current earnings and at an even lower multiple of normalized earnings in fiscal 2011 and beyond.  We think PLUS can earn $3/share in a few years with only modest overall economic growth while generating very substantial cash flows and continuing to grow book value (which has nearly doubled in the past six years).  At even modest multiples of earnings and cash flow, PLUS should be worth over $30 in the next few years.  Moreover, the Company’s tangible book value—consisting predominantly of cash, net working capital and lease investments—is $19.51.  Thus, PLUS trades at a discount to liquidation value despite having considerable going concern value, thereby providing exceptional downside protection while we wait for value to be realized.


An obvious question is what management intends to do with the Company’s substantial excess cash.  They have been repurchasing stock consistently, albeit in modest overall amounts.  They have also been looking for acquisitions, and the Company has a track record of doing disciplined deals (hence the lack of deal activity in recent years).  This is a conservative group with substantial stakes in the business (insiders own just over 50%, including 26% held by CEO Phil Norton), and we are confident that they will not squander the cash.  If they cannot find a value-creating use for the cash, we believe they will return it to shareholders through buybacks and perhaps a special dividend.  Lastly, Hovde Capital owns 15% of the Company, and Eric Hovde serves on the PLUS board, which gives us comfort that a successful financial services investor with a big equity stake also is looking after shareholders’ interests.



Increased earnings, share repurchases, special dividend

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