|Shares Out. (in M):||18||P/E||0||0|
|Market Cap (in $M):||265||P/FCF||0||0|
|Net Debt (in $M):||-27||EBIT||0||0|
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Information Services Corporation (ISV-T)
I believe ISV represents an attractive opportunity to invest in a regional contracted monopoly business (land title, personal property and corporate registries in Saskatchewan, Canada) with high margins and low capex requirements at ~ 8.8x normalized FCF. ISV unlikely shows up well in screens because it is a smaller capitalization name trading at a 15.5x forward PE. The FCF multiple looks significantly more interesting when one begins to account for ISV’s: 1) excess cash on the balance sheet (they just announced an acquisition last week so I will comment on that later in the write-up), 2) the meaningful deferred tax asset that will likely be used (lower cash taxes, higher FCF), and 3) FCF generation under a normalized land title registry activity run rate.
As well, a close study of a comparable business, Teranet (land title business in Ontario, Canada), will help provide investors with valuation goalposts and historical trough and peak business metrics likely applicable to ISV – especially since it was taken out in the height of the financial crisis.
Overview – ISV was originally created in 2000 as the province of Saskatchewan (Province) used ISV as a crown corporation to replace the existing Saskatchewan Land Titles Office. As the Province began to convert a paper based land title registry system to an automated electronic registry, ISV over the next decade helped: 1) implement an electronic land title system (both surface land titles and mineral parcels), 2) automate the Province’s personal property registry (PPR, transferred from the Ministry of Justice) and 3) manage the Province’s Corporate Registry. As ISV reached profitability, the Province took a dividend from ISV starting in 2008 calculated at 90% of ISV’s net income.
By 2013, the Province decided to IPO ISV and sell to the public most of its ownership in ISV. Specifically, the Province sold 10.5 mln of its 17.5 mln shares for $147 mln initially via IPO, then another 1.575 mln shares at $14 per share. The Province currently owns 5.424 mln shares or a 31% interest.
To assure IPO investors ISV’s business sustainability, the Province entered into a 20 year Master Service Agreement (expiring 2033), given ISV the exclusive right (i.e. monopoly) to manage and operate the land, personal property and corporate registries for the Province. Some of the salient details of the MSA are:
ISV pays the Province $500,000 per year
With the exception of transaction value based fees, price increases of registry fees are limited to Saskatchewan CPI
ISV can use its existing systems and data to provide ancillary services (unless the Province has a reason to veto it, such as the use of data is illegal). The pricing for these services are not regulated by the Province.
As well, ISV set its initial dividend at $0.80 per share payable quarterly.
By creating a high margin (31% EBIT margins in 2014, 33% in 2013), low capital intensity (capex at 4.1% of sales in 2014, 3.7% in 2013) and dividend paying 20 year monopoly with a potential runway for growth (ancillary services, other provinces outside Saskatchewan), the Province took significant steps in protecting its control and interest in ISV by:
Holding a “golden share” with special right to veto transfer, sale, lease or exchange of ISV’s property or transfer the head office operations and functions outside Saskatchewan
Granting the Province the number of board members matching its ownership interest (i.e. 50% ownership = half of board appointed by Province), with a minimum of 2 Province appointed board members
Shareholders cannot generally own > 15% of ISV shares (for instance may not be entitled to dividend if in violation)
Why Does This Opportunity Exist?
Given ISV is an attractive monopoly business, there are a number of factors that is creating this opportunity for investors:
Cyclically weaker near-term results: Given Saskatchewan’s economy is commodity driven (oil and gas, potash and uranium) and Canada’s housing market is overheated, ISV has posted weaker results and a cautious outlook since 3Q14. To complicate matters, the sell-side seems to have missed that 2013 margins were exceptionally high as ISV deferred some spending in preparation for its IPO. As well, 2014 had an above normal level of high value transactions that significantly helped land registry revenues (transaction value based fees) and are unlikely to repeat. Finally, the reported 1Q15 EPS looked exceptionally weak given a seasonally slower quarter and the headwinds described above.
Government Ownership Overhang: While the Province’s intentions are not telegraphed to the market, its 31% ownership likely serves as a significant share overhang for ISV, especially considering the Province may act pro-cyclically (i.e. as the Province’s economy and tax revenues retreat, the Province may have a greater incentive to monetize its ISV stake)
Small Market Capitalization, Limited Liquidity and Investment Restrictions: ISV suggests its shareholder base consists of roughly 1/3 the Province, 1/3 Institutional Investors and 1/3 Retail Investors. With an already small market capitalization of $264 mln, ISV’s float is further reduced to $182 mln given the Province’s 31% stake. With Institutional investors likely already having established their positions at IPO, the current liquidity (or lack thereof) likely only supports the marginal trading of less sophisticated retail investors. As an entity that cannot be taken out in the near to medium term (as per ISV’s proxy circular the management team does not even have a change of control provision) , the number of funds willing to spend the time analyzing ISV is further constrained by ISV’s 15% ownership limit, or a maximum position of < $40 mln.
Balance Sheet Nuances: As of the latest quarter, there are a couple of key balance sheet items that make ISV’s valuation more compelling: a) a cash balance of $27 mln or ~ $1.54 per share and b) a deferred tax asset of $48.7 mln that can be used to directly offset taxes payable (i.e. not just a NOL carryforward).
ISV Investor Relations: There appears to be room for improvement with respect to ISV’s IR function. First, it is interesting to note ISV maintains its 2013 margins were unsustainable as some operating expenses were forgone ahead of its IPO – yet the sell-side did not seem to be aware of this and had to recently take down the margin assumptions significantly. Second, in my opinion, with my interaction with IR, they did not articulate their business, growth strategy and plans around the MSA as well as I expected.
Valuation, Understanding the Downside and Normalized FCF Generation
For ISV, the elephant in the room is how bad things could get as the Saskatchewan economy slows and what a reasonable normalized FCF run rate could be for the business.
The mechanics of modeling ISV’s business is relatively straight forward, there are 3 business segments: 1) Land Title Registry, Land Surveys and Geomatics, 2) PPR and 3) Corporate Registry (with the first segment being the most important and accounting for > 3/4 of revenues). Without overcomplicating things, each segment is driven by a transaction volume assumption and a revenue per transaction assumptions. In terms of costs, as an information service business, most operating costs are relatively fixed (i.e. wages and salaries, IT services, occupancy costs, etc.)
By far, the most important assumption is the Land Title Registry’s registration volumes, which would fluctuate with the business cycle but still be roughly tied to the number of electronic land titles. In ISV’s 2013 prospectus (page 32), it was disclosed ISV maintained 2.4 mln electronic land records.
With the benefit of Teranet’s IPO in 2006, we can see in its prospectus (page 38) Teranet provides details to a very important key performance indicator that I believe is applicable to ISV: the historical Registration Activity Rate – which is the amount of registration volume divided by the number of land parcels in the province of Ontario. With data from 1973 to 2005, I believe this data set sufficiently captures multiple business cycles and trough, average and peak activity levels that can be used to evaluated ISV’s downside, base case and upside. Specifically, Teranet’s data set shows a trough registrations to land parcels of 0.25, an average of 0.4 and a peak of 0.55.
Equally important, one should get an idea how the underlying land title base grows over time, which should be roughly correlated to population and GDP growth. Again, over the same period, we can borrow from Teranet’s data in Ontario to see over the same period, their land parcel base grew at 2.4% CAGR.
While the economies of Saskatchewan and Ontario are not very similar, I think the above metrics helps set the valuation goal posts for ISV much better than going the route of running the historical correlations between commodity prices, population growth and house prices & activity against land title registration activity – as that would give a false sense of precision requiring commodity price forecasts and factors driving Saskatchewan GDP (feel free to review these factors described in the ISV prospectus, however).
Expanding on ISV’s deferred tax asset ($48.7 mln or $2.78 per share), it came about due to ISV transforming from a government owned entity (not taxable) to a public corporation. With the IPO, ISV’s assets were marked to fair value with higher depreciation, creating a significant tax shield for ISV’s income going forward. It is important to note the $48.7 mln is not an NOL carryforward but rather an amount that can directly offset taxes that the accountants determined would have a good probability of being used (obviously, since ISV is a high margin, profitable monopoly business).
Base Case Valuation $21.50, $0.99 FCF 2016, $1.55 FCF 2018 (Normal run rate)
In my ISV base case valuation, I assume no incremental growth prospects for ISV (despite likely growth opportunities which will be touched on in the bull case). My key assumptions are:
Land title activity rates drop to 0.35 in 2015, 0.37 in 2016 and 0.40 2017 and onward. Note this assumes volumes drop off 13% vs 2014. For Teranet, as it entered the financial crisis, the worst quarter registered an -8% volume drop in a quarter yr/yr.
Underlying land titles to grow at 2% (vs. Ontario’s history of 2.4%)
8% drop in pricing in 2015, and +1.5% pricing 2016 and onward
Minimal cash taxes until 2023 as the deferred tax asset gets used up
PPR Transaction Volumes down 2.5% in 2015, 0% in 2016 and +1.5% 2017 onwards. Pricing -7% in 2015 then +1.5% thereafter
Corporate Registry Volumes +5% in 2015, slowing to 2% over time. Pricing -1% in 2015, improving to +1% over time
Maintenance capex of $5.5 mln growing 2% per year
With these assumptions, I get $21.50 for ISV. As well, ex-cash, ISV is trading at 13.5x 2016 FCF and 8.8x by normal 2018 FCF (using the 0.4 registration activity rate). While the 2018 FCF number has minimal cash taxes, one can go through the mental gymnastics of assuming a 27% tax rate then adjusting the ISV share price by the leftover DTA at that point – which gets you close to an 8.5x normal FCF.
One of the critiques of the base case maybe: how do you know ISV will continue operating post 2033? My response is:
ISV has almost 20 years to expand its moat, add on ancillary services and make its users more captive to ISV’s platform (for instance, Teranet offered courses to and certified professionals (paralegals, real estate agents etc.) to use its system). This would make it very difficult for the Province to hand over to a new competitor to start from scratch.
As is the case with Teranet, even if ISV does not get a renewal in 2033, it is quite plausible the Province will opt for non-exclusive licenses for more than 1 operator for its land title registry. Again, with a 20+ year head start, ISV would most likely continue to prosper (as is the case with Teranet)
If both points 1 and 2 fail, ISV also would have had an opportunity to grow its business in other jurisdictions which we attach zero value to in the base case
Bear Case Valuation $12, $0.23 FCF 2016, Run rate FCF $0.55
In my bear case, I use most of the assumptions in the base case, except a trough 0.25 registration activity rate 2015 and onward. I believe this is sufficiently pessimistic as it uses a trough activity level forever and I don’t assume meaningful cost cutting and capex savings either.
I get to $12 from a business value of $9, $1.54 in cash and $1.74 in unused DTA.
In this bear case scenario, the chances of ISV operating post 2033 is ironically slightly higher than the base case as the less robust economics of the business probably deters competitors from wanting to enter.
Teranet Takeout Multiple During Financial Crisis Implies $16.50 for ISV
Another valid question when assessing the downside for ISV is: What if 2014 represented peak earnings and Saskatchewan’s housing and economy began to crash?
Fortunately, we had a comparable situation with Teranet when it was taken out by Borealis, an infrastructure arm of the Ontario pension plan OMERS (http://www.borealis.ca/case-studies/teranet).
Borealis initially made a take out bid for Teranet at $11 per share in September 2008, only to revise it lower in November 2008 in light of market conditions (the great financial crisis) to $10.25 per share. This take-out price represented a ~10.5x EV/EBITDA multiple on 2007 EBITDA (likely what was viewed at the time as close to peak earnings in 2007 as the economy sourced in 2008).
A 10.5x EV/EBITDA multiple on 2014 EBITDA for ISV results in a ~$16.50 share price – which is still nicely above where ISV is currently trading.
Implications of Teranet Paying for the Privilege of Managing Manitoba’s Land Title Registry – Implied value of $12.50 to $16.40 for ISV
Recently, Teranet decided to enter Manitoba by taking over their land title and personal property registry in a 30 year agreement where Teranet would pay for this privilege with $75 mln up front and an annual payment of $11 mln, escalating to $24 mln by the end of the 30 year period.
Doing some simple math, I estimate the annual payment is escalating at about 2.7% for 30 years. If I do an NPV at 8% (these are royalty payments after all) for only 20 years (so its comparable to ISV’s MSA term), I get a present value of these payments at $191 mln. This $191 mln value does not include the incremental economic profit Teranet would make on this agreement (and we will ignore this for the sake of conservatism).
Now with Manitoba’s 2013 GDP at $61 bln and Saskatchewan’s at $83 bln, the difference between the provinces is around 36%. If we don’t adjust for the GDP difference, I would get an ISV per share value of $12.50 (including $1.54 cash). If we do adjust the implied value of such a registry agreement by 36%, I get an ISV per share value of $16.4.
Bull Case Valuation $26
Conceptually, it makes sense ISV would have growth opportunities first and foremost by providing additional ancillary services within Saskatchewan given its leg up on the data and MSA with the government. As well, these services, unless vetoed by the Province, are not subject to price increase limitations to Saskatchewan CPI. Secondarily, there could be additional opportunities for registry related services at the municipal level. As well, ISV could replicate its business outside Saskatchewan, although competition from other players would limit the amount of upside available in these endeavours (i.e. Teranet paying up to operate in Manitoba).
Given the multiple level of assumptions required to guesstimate how ISV can create value through growth opportunities/acquisitions, I concede there is a fair amount of fluff involved in estimating the upside from this. Therefore, in my upside scenario, all I am assuming is that the net cash on ISV’s balance sheet is used to generate 15% incremental returns (i.e. $8-9 mln in additional revenues, $3-$4 mln in incremental EBITDA 2-3 years out). To support this growth, I dialed up the capex to $8.5 mln per year growing at 2% CAGR. With these assumptions and volumes and pricing for ISV’s existing segments the same, I get an upside case of $26 for ISV.
Note on ESC Corporate Services Acquisition
Last week, ISV announced the acquisition of ESC Corporate Services a corporate and registry services provider in Ontario and Quebec for $28 mln ($21 mln in cash and $7 mln earn out). ISV gave little details on the acquisition other than that it will help them establish a foothold in Ontario and Quebec and the potential to expand their services into Western Canada. ESC was categorized as having attractive gross margins, FCF and low capex, with $11 mln revenues in 2014. A sell-side note speculated ESC might generate $1-$3 mln in EBITDA, which is lower than the bull case of $3-$4 mln EBITDA I assume 2-3 years out.
I think the bottom line is the transaction probably generates incremental EBITDA that is more useful than having excess cash on the balance sheet. With limited information, I wouldn’t come to the conclusion the transaction destroys value. Assuming an incremental $1 mln in annual capex and that the $2 mln EBITDA drops to FCF and using my base case assumptions, I am getting $21 per share for ISV. Depending on how this pans out, this may make my bull case of +$3 to $4 mln EBITDA 2-3 years out look aggressive.
Saskatchewan macro risk
MSA gets terminated in 20 years
Using Teranet as a parallel proves to be wrong
Poor capital allocation by management (i.e. bad acquisitions)
Disclaimer: The write-up is only intended for VIC members and not for dissemination.
Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.
Land Title Transaction Activity Stabilizes
Continued FCF Generation
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