| 2006 | 2007 | ||||||
| Price: | 27.20 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 900 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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Mkt Cap: $900mm
EV: $1094mm
Avg Dly Vol: $6.6mm
Cash EPS 1.25 1.68 1.99 2.29
FCF – NI Conversion 82% 101% 103% 104%
FY PE 25.0 17.9 14.9 12.8
FY Cash PE 21.8 16.2 13.7 11.9
FY FCF Mult 30.6 17.8 14.4 12.3
C07 C08 C09
CY EPS 1.43 1.75 2.05
CY Cash EPS 1.59 1.91 2.21
CY FCF 1.43 1.79 2.12
CY PE 19.0 15.6 13.3
CY Cash PE 17.1 14.3 12.3
CY FCF Mult 19.0 15.2 12.8
Note: TALX has 16c/share of after-tax goodwill amortization.
Please note that my EPS estimates post FY08 assume that the FCF is distributed as a dividend. In reality, TALX is likely to pay down debt or buy back stock and to generate EPS in FY09 and FY10 above my stated figures above due to the boost from FCF redeployment.
NPV @ 9.5%: $36.2
1-Year Target: 19x CY2008 Cash EPS = 20x $1.91 = $38.20
TALX is a great niche business that has an excellent competitive dynamics, robust growth, excellent free-cash-flow generating dynamics, and under-appreciated margin leverage and earnings growth prospects. The stock should significantly outperform the market over the next year as several key catalysts unfold. First and foremost, for FY2008 (ending March 2008), I expect TALX to earn $1.52/share of EPS versus current consensus of $1.35. This earnings outperformance should command a higher multiple on higher earnings, resulting in a very powerful stock. Second, an FTC investigation that was launched 6 months ago is likely to be resolved with no meaningful implications to the business. This investigation has created an overhang on the stock, and its removal should be an additional catalyst. Third, TALX has great cash flow characteristics and should be a free cash flow machine over time. My NPV analysis suggests that the company is worth $36 today based on a DCF of projected FCF’s at 9.5%. The company has 16c/share of after-tax acquisition-related goodwill amortization, but the company does not report Cash EPS and the sell-side community does not highlight either Cash EPS or the FCF profile of this company. Furthermore, the company is currently in investment cycle where they are going to spend for the next 3 quarters or so an unusually high amount of CapEx that will somewhat obfuscate the company’s excellent long-term cash generating capabilities (the spending is for a one-time consolidation of centers and facilities). One year from now, TALX should be able to grow the top-line 10%+ and have over 100% net income to free cash flow conversion.
First, what is TALX? TALX is a niche company that gets 35% of revenue and 50% of EBIT from a product called “The Work Number” which I will abbreviate as TWN. The rest of the business is a series of HR-service business lines that are complimentary to TWN and provide synergies with the key product. The other business lines include Unemployment Tax Management Services, Tax Credit & Incentive Services, and Talent Management Services. TALX reports segment gross margin instead of segment operating income. In F07, the split of gross margins is as follows: 52% The Work Number, 35% Unemployment Tax Management, 5.5% Tax Credit, and 8.1% Talent Management.
The Work Number is a business based around a database that provides employment and income verification to mortgage companies, consumer finance companies, and potential employers. TALX currently has 30% of the
This business has several dynamics that I like. There is definitely a first-mover advantage and network effect from being the first mover. Because of the need to go to the work number to verify with some employers, there probably is not a single major mortgage company or consumer finance company that doesn’t know about The Work Number today. Now that TALX is well established, they have the credibility that is needed to win over potential new employment record providers who would otherwise be leery of giving this sensitive data to an unknown entity. TALX is in a better position to monetize the data records as the defacto industry standard for database driven employment verification. As we stand today, TALX has no meaningful competition. There are a couple of small players who are trying to build a business, but it is going to be very difficult for them to make major inroads and if TALX plays its cards correctly they should never get too far.
The growth dynamics are also very strong. TWN grows through several multipliers. Revenue grows proportionally to the # of records in the database. Revenue growth is further attenuated by 4% annual price increases and by increasing usage in existing markets and new applications. Usage in the mortgage has increased as more and more companies became aware of TWN and as the data is being used in more and more stages of the mortgage (origination, verification before closing, sample verifications associated with MBS repackaging, refinancings, and pre-foreclosure activities). Usage in consumer finance is also growing as various areas such as sub-prime lending, auto lending, and other emerging areas are realizing the value that they can get by incorporating TWN data into their lending process.
The work number currently generates 33% of its revenue from mortgage finance customers, 26% from consumer finance customers, and 18% from pre-employment screening. Entering 2006, many investors were concerned about TWN’s exposure to the mortgage finance end market. What is amazing is that even though mortgage activity is down substantially this year, the mortgage segment is still growing in the teens. In fat, in the last quarter, mortgage finance grew +13.4% y/y even as originations and refinancing were tumbling (I’m still working on the relative value of an origination vs. a refi, but my sense is that an origination is worth at least 2x a refi). The reason for this delta is the growth multipliers discussed above. More records, pricing, and more using are offsetting the industry fall off. I am optimistic that we are bottomoning out from a macro point of view on mortgage orginations and refis, and that this segment will generate positive growth for TWN due to the growth multipliers discussed above.
TWN reports the number of records in the database, new adds, backlog, and % of records that are related to current employment (vs. historic employment). The numbers look as follows: TWN has 138.3mm records, a backlog of 10.7mm records, actual adds of 5.2mm in the last quarter and 4.1mm in the quarter before, new signings of 6mm records last quarter and 6.7mm records the quarter before (difference between actual adds and new signings goes into the backlog). About 28% of the 138.3mm records relate to current employment, and TWN has about 29% of the
The Tax Management business for TALX is less exciting with prospects for 3-5% long-term organic revenue growth and minimal long term margin expansion (though margins could expand nicely for the next 1-2 years due to some on-going consolidation and cost initiatives). While the business are less exciting in its own right, it does fit very strategically with the TWN and the whole purpose of buying companies in this area has been to feed the TWN growth engine. You see, to do the Tax Management business, TALX needs to get access to the very same records that they use for TWN. This creates a relationship with more and more employers and creates a natural cross sell. TALX can even do things such as offer discounts on tax services for companies that decide to also give their records to TWN. The fit is beautiful, and it has been a powerful driver of the record growth in TWN.
The main reason I am above the street on F2008 EPS is that the market is currently underestimating the incremental margins and margin leverage that TALX will enjoy over the next year. TWN has 82% gross margins, 90% incremental gross margins, and 65-70% incremental EBIT margins. Tax Management and Talent Management has 25-30% incremental EBIT margins. It appears that while I am mostly in agreement with the sell-side on F2008 revenue, they are missing the margin leverage opportunity. The table below summarizes the source of the difference:
Me JMP AG Edwards
TWN Rev 131.9 139 135
Total Rev 316.9 317 311
Total Gross Profit 207.1 206 202
S&M 48.9 50 51.4
G&A 60.6 64.8 83.8
EBIT 97.6 90.9 86.7
In my opinion, the best two models out there from a segment detail point of view are the JMP Securities and AG Edwards models. I highly recommend referring to their models if you have a relationship with either or both firms.
In addition to the powerful dynamics of the core business, there are two “upside kickers” that could come into play over the next year and really get this stock into high gear. The first is the I-9 revenue opportunity. TALX is trying to sell to its existing customer base (which covers ~40mm employees) a product/service that helps manage I-9 forms. The cost of the service is about $1/employee/year and the margins should exceed 45%. If they get 20mm records at a 40% margin, that would add 15c to EPS. Even more importantly is the one source offering that TWN is going to launch in 2007 (beta test Q107 and full launch Q2/Q3 07). As it stands now, TWN only gets revenue when a verifier asked about somebody in the TWN database. If the person is not there, TWN tells the customer and the customer has to use traditional means of verifying the employment. They usually either use their own staff to follow-up or outsource it to a call center. TALX is looking at offering a one-stop solution where if the record is not in the database (happens 2/3 of the time), the customer for the same price can get the answer with 3 day turnaround form TALX. TALX is planning to contract with an outsourced provider at a rate that will provide variable costs and 40%+ incremental margins. Management is keeping expectations for this offering low, but it could really take off and be a source of powerful upside. To size the offering, consider the following. TALX currently does about $93mm of verification-related TWN revenue. With only 10% penetration and a 2x multiplier (a customer who uses this for the other 2/3 of employees not in the database would have a 2x multiplier), TALX could get $18mm of additional revenue with a 40% incremental margin or an additional 13c/share of EPS. All this is incremental to my robust base business outlook and strong FCF profile! TALX could truly become a growth stock darling in 2007 and could go far beyond my target of $35.
One thing that has kept some investors away from the TALX opportunity is an ongoing FTC investigation. Apparently, one of the customers of the tax management business complained to the FTC, and they are investigating. I am not concerned about the risk for several reasons. First, TWN was built organically and TALX basically created the business, so it is hard to see acquisition-related antirust issues there. The tax management business is pretty fragmented and pretty competitive, so it is hard to see too much of an argument there. I believe this FTC issue will get resolved favorably in the next 3-4 months and will be an upside catalyst. This issue has served as a distraction and is making it possible to get this beautiful underlying business at a very fair price. The investigation started 6 months ago, and I hear they usually take 6 months or so to clear up. With the heavy amount of M&A these days, maybe it takes a little longer.
Risks
1) Key User Segments (Mortgage Companies, Consumer Finance, Employment Screening) decide to find alternative to TWN or to minimize their usage
2) Record growth of TWN slows or shrinks. Right now, the trends are very favorable, and there seems to be a great deal of room for growth, but a slowdown or change in sentiment of the value proposition of TWN is always possible
3) Margin leverage that I am counting on for my big 2008 does not come through
4) Privacy issues or legislation (I am not aware of anything out there now, but always a potential concern).
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