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DC Payments – 9.5% Yield With A 44% Cash Flow Payout Ratio
Aug. 4, 2014 4:13 PM ET | 8 comments | About: DirectCash Payments, Inc. (DCTFF)
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Disclosure: The author is long DCTFF. (More…)
Summary
9.5% dividend yield at a healthy, stable, growing company without any distress.
9.5% dividend yield represents only 57% of the company’s Cash Flow after maintenance capex, and only 44% of Cash Flow from Operations.
Lack of accounting profit is actually a tax mitigation strategy masking true cash generation.
DC Payments – 9.5% Yield with a Payout Ratio of 57% of FFO
Sometimes you need to look beneath the surface to see value where it is not readily apparent. We believe DirectCash Payments is one such example.
DirectCash Payments (TSX:DCI, OTC:OTC:DCTFF) is truly a hidden gem, with a dividend yield in excess of 9.5% and a payout ratio of just 57.0% of its post-capex Funds From Operations. We assign a price target of $25.85 implying 78.6% upside.
Overview
About the Company
DirectCash Payments is a Calgary, Alberta-based company which operates via two main business units, ATMs, and Banking Services (which includes prepaid cards and other related products):
ATM: DirectCash Payments is a full-service provider of ATM terminals with over 20,000 ATMs primarily located in Canada, Australia, and the UK. The business includes the sale of ATMs and ATM parts, ATM transaction processing, ATM ownership, ATM service and maintenance, and ATM management for retail clients. DirectCash Payments processes millions of transactions each week. ATMs represent over 83% of the total Gross Profit.
Gross Profit By Segment
Operating Metrics
Banking Services (Prepaid & Other): The banking services divisions includes the sale of prepaid debit and credit cards and related services. It also provides prepaid telecommunications products, the sale of debit terminals and related services, and a credit union and other financial institutions business (CUFI). In the LTM period, this division represents just under 17% of the total gross profit.
Gross Profit
Ownership
Encouragingly, CEO Jeff Smith owns 11.5% of the company.
Franklin Resources (Franklin Templeton) and Montrusco Bolton are the two largest institutional shareholders.
Shareholders
Bigger and Better – Growing and Strong:
When seeing a stock boasting a 9.5% dividend yield, one could be forgiven for exhibiting suspicion regarding the sustainability of the dividend. After all, a dividend unsupported by profits amounts to nothing more than a false promise.
Imagine our surprise when we examined the financial statements and discovered that DirectCash produces a sustainable, growing torrent of cash far in excess even of the amount required to sustain its uncommonly high dividend.
(click to enlarge)
Revenue By Segment and Gross Margin
Funds From Operations:
The company uses an adjusted cash flow metric called Funds From Operations. In this case, the company defines this as cash flow from operations less maintenance capital expenditures. We believe this to be a relevant and appropriate metric for this type of a business.
Gross Profit by Segment
Uninspiring Facade
At a glance, DirectCash does not appear to be very profitable: It has turned an accounting profit in only one of the last four quarters, and in only one quarter in 2013.
The business does not appear on our traditional value screens (our basic value screens look for low P/E and low P/Tangible Book).
DirectCash does not appear cheap on any of these metrics, as it lacks a meaningful P/E ratio, and trades at 2.0x book. The business does not even possess a tangible book value, as so much of its asset base is intangible assets comprising goodwill and customer relationships.
However, we believe that the financial statements are misleading and they mask the true profitability of the business.
(click to enlarge)
Financial Performance
Adjustments:
In addition to acquisition costs relating to M&A, we back out the amortization of certain transaction costs, which are one-time in nature, as well as an FX gain the company experienced in 2013.
Adjustments
However, the elephant in the room is the massive amortization of intangibles number. This number is massive in relation to the company’s P&L, and the financial statements were relatively vague as to the explanation. What did this represent and why was this number so high?
Amortization of Intangibles:
From our discussions with the company, it is our understanding that when DirectCash acquires a competitor which also owns ATMs, it ‘re-values’ (i.e. writes up) the value of the customer contracts. This allows DirectCash to depreciate that customer asset for accounting purposes.
Adjustments 2 – Tax
This is not an unfair practice, as once the contract expires DirectCash may lose the contract and the customer may choose another company to manage its ATMs. However, we believe that DirectCash generally has excellent customer retention, and that most of these customers will indeed remain with the company even when the contract expires. We speculate that retention rates will be in excess of 80%, and that the 20% lose will be offset by new sales.
We have come to believe that the amortization of intangibles is conducted primarily for the purpose of reducing the business’ tax burden. DirectCash did not owe any tax in 2013; in fact it owed -$2.4 million of taxes in 2013. Technically the company paid $6.3 million in cash taxes and received a corresponding $8.7 million deferred tax benefit – so the taxes which the company paid still did reduce the cash flow.
Nonetheless, we believe that the revaluation of customer contracts and subsequent writedown likely represents a deliberate attempt to reduce tax by allowing the company not to show an accounting profit even while the business performance is robust.
The implications of this are that DirectCash relies on further acquisitions to keep its tax burden low. In the absence of acquisitions, we believe the company may be subject to a 25% to 30% tax rate. Given that the company did in fact pay $6 million in cash tax in 2013, we believe that the effect of an acquisition-free steady state business would cost the company an incremental $4 million of cash, as shown below.
For two reasons we do not believe rising taxes to be a material concern. The first reason is that the quantum of the difference is not profound, and the second is that we believe that DirectCash will continue to acquire strategically.
The Risks:
There are two main components of the bear case for this stock. While both of these concerns are legitimate, we find neither of them to be compelling although we believe they should be addressed.
Cash Store Financial
DirectCash has a large prepaid card customer in the payday loans space which has filed for and been granted creditor protection. This customer, Cash Store Financial, is part of DirectCash’s Banking Services / Prepaid & Other segment, which is increasingly a minor portion of the whole business (the whole business unit comprises under 18% of DirectCash’s Gross Profit in Q1 2014).
This customer has already been declining in terms of its contribution to DirectCash for some time now, and in Q1 2014, it contributed only $2.3 million or gross profit (or $9.2 million on an annualized basis).
This customer has closed stores representing about 30% of DirectCash’s business with them. It is possible that the business will continue as a going concern, and that no incremental stores will be closed at all. It is worthwhile to note that creditor protection will not necessarily result in a liquidation, and moreover, DirectCash has no receivables from this customer, so the only potential further effect is in terms of gross margin contribution.
Although it is only an estimate, we believe the incremental effect of a further reduction in business with this customer is approximately $1 million of gross margin per quarter. Thus the total likely incremental exposure is approximately $4 million in contribution per annum, and assuming 75% of this converts to EBITDA and cash flow, it implies a reduction of cash flow of $3 million per year, which is not material in the face of the many offsets from mechanisms by which DirectCash is growing its business. We see this essentially as typical customer churn.
Secular Decline in ATMs
Some have alleged that in the evolving world of payments, ATMs are in secular decline and will soon be obsolete. We think that is a naïve proposition.
It is fair to say that ATMs will not used forever, but we do not believe the decline will be immediate or precipitous, and this is evidenced by the fact that transactions per terminal for DirectCash ATMs are actually increasing.
It is likely that population segments using ATMs most frequently likely suggests that ATM use will be sticky, and will continue for many years and even decades to come.
Moreover, it is also fair to say that DirectCash will attempt to remain current and will likely evolve with the technology of payments.
There are also many areas of the world which are not as saturated with ATMs as western markets, and these could present as growth markets for DirectCash and ATM use.
Conclusion and Valuation
With markets at levels that are expensive by historical standards, we believe that a growing business with a strong cash flow yield such as DirectCash could trade at 11.0x Funds From Operations. This implies a share price of $25.85, which is a 78.6% return to target. Even at this level the company would exhibit a competitive dividend yield of 5.3%.
Valuation & Price Target
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Comments (8)
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airlarr
Comments (220)| + Follow | Send Message
Who are similar companies operating in the USA? Are U S competitors a potential threat to DCI?
5 Aug, 04:36 PMReply! Report AbuseLike0
Yorkville Investor , Contributor
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Author’s reply » DirectCash operates mainly in Canada, Australia and the UK; I am not aware of any plans to enter the USA.
Of course there is indeed competition in all of the markets in which they operate, however the sales contracts seems to be relatively long in duration and customer retention seems pretty good.
The market for non-bank ATM management is fragmented, as is the market for prepaid cards, so there is no monolithic competitor of note. Competition is always a threat but it is not a prominent worry of mine with this stock.
6 Aug, 08:44 AMReply! Report AbuseLike0
elvislevel
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This does look pretty amazing. Why is it down almost 50%?
6 Aug, 12:02 PMReply! Report AbuseLike0
Yorkville Investor , Contributor
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Author’s reply » The stock fell about 35% – from ~$21.5 to ~$14 when the troubles with Cash Store Financial, a large DirectCash customer, were aired in several news outlets.
What I believe the market didn’t know was that Cash Store Financial was already a diminishing component of DirectCash’s contribution
However, that is just my speculation; I have only been following the stock for a couple months.
7 Aug, 09:27 AMReply! Report AbuseLike0
Glen Bradford , Contributor
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very interesting indeed.
6 Aug, 10:46 PMReply! Report AbuseLike0
Jason Kaplan , Contributor
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The payout ratio is based on unlevered FCF. I never understood doing this since interest expense is essentially a cost of doing business. Looks like the payout was about 60% of LFCF in 2013.
Over what period does the company amortization customer acquisition costs? Is there a schedule forecasting intangible amortization costs for 2014/2015? It has been going up recently due to acquisitions I presume.
7 Aug, 11:53 AMReply! Report AbuseLike0
Yorkville Investor , Contributor
Comments (65)| Following | Send Message
Author’s reply » Jason, I believe your characterization is inaccurate:
– In fact the payout ratio it is *not* based on unlevered FCF.
– The company’s MD&A states:
“DCPayments calculates funds from operations as: Net income (loss) plus or minus depreciation, amortization, deferred income taxes expense (benefit), *NON-CASH* finance costs and unrealized foreign exchange loss (gain) and after provision for productive capital maintenance expenditures”
– The main finance cost is interest:
– Interest on the 3 tranches of debt was $16.0 million of the $19.7 million in total “finance costs” in 2013
– Interest *is* a cash expense, therefore this is the levered FCF.
– The finance costs which are *excluded* from the calculation are *non-cash* items such as: unrealized loss/gain on FX, and amortized transaction costs.
7 Aug, 01:23 PMReply! Report AbuseLike0
Jason Kaplan , Contributor
Comments (343)| Following | Send Message
I would point you to the audited cash flow statement. I’m really not interested in how DC Payments defines it. In 2013 the company generated $59.8M in cash from operations per the audited cash flow statement. $4.5M for capex and $17.2M in interest paid (which shows up under ‘financing’). Finance costs of $19.6M are a non-cash add back in the operating activities for some reason. So LFCF is $38.1M. Dividend paid is $23.1M. 23.1M/38.1M = 60.6% payout ratio.
I think the issue is with what the company defines as non-cash financing costs, at least at the operating level. In 2013 the company added back all $19.6M in financing costs in the operating activities on the cash flow statement only to subtract $17.2M in ‘interest paid’ under financing activities. It doesn’t make a lot of sense to me. Must be how Canada or IFRS works.
This small cap’s cash flow reveals its true earning power
MICHAEL MCCLOSKEY
Special to The Globe and Mail
Published Tuesday, Apr. 22 2014, 7:27 PM EDT
Last updated Tuesday, Apr. 22 2014, 7:57 PM EDT
5 comments
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AA
Prolonged bull markets such as the present one make finding bargains exceedingly difficult for value investors. The opportunities that do exist are generally not obvious. Our recent investment in DirectCash is a case in point.
DirectCash Payments Inc. currently operates more than 20,000 ATMs worldwide, in convenience stores, restaurants, airports, casinos, bars and other venues. It is the largest non-bank branded ATM provider in Canada and Australia, and the second-largest provider in Britain. DirectCash makes a small fee on each transaction that it processes. Multiply that small fee by over 100 million transactions a year and it starts to add up.
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DirectCash is exactly the type of opportunity that we look for. The business is easy to understand, earns high returns on capital employed and generates significant free cash flow.
Given the company’s small market capitalization and very limited following by the analyst community, DirectCash remains largely unknown by investors. The company earned virtually nothing in 2013, according to its audited financial statements. Yet, this doesn’t tell the whole story. A look at DirectCash’s cash flow reveals the company’s true earning power.
DirectCash’s path to becoming a major international ATM player included several major acquisitions over the past few years. While it bought ATM machines, the more valuable assets acquired were the thousands of existing customer contracts. As a result, the vast majority of the assets acquired were intangible assets that are amortized over the remaining life of the contracts, typically four years. The value assigned to the contracts is written off entirely. However, DirectCast has a historical renewal rate well in excess of 90 per cent, with minimal renewal costs. Therefore, there is still value in the contracts. We believe that most of the $52-million of depreciation and amortization expense incurred in 2013 did not truly represent a real expense.
Rather than the audited number, we prefer to look at the company’s owner earnings, which require the use of considerable judgment. We arrive at that figure by starting with the company’s projected EBITDA and deducting maintenance capital expenditures, interest expense and cash taxes. (EBITDA represents earnings before interest, taxes, depreciation and amortization.)
We estimate that DirectCash’s owner earnings will exceed $2.10 a share in 2014. With the stock currently trading at $13.26, this translates to a price to earnings ratio of about 6.3 times. Its current dividend yield is 10.4 per cent, with a payout ratio of less than 65 per cent of owner earnings.
Like any investment, DirectCash does have a few risks that we have considered and are monitoring. The company’s debt levels are slightly higher than we prefer, which is directly attributable to the financing of the recent acquisitions. Its debt trades at a premium, reflecting the bondholders’ confidence.
In a pinch, DirectCash could reduce its dividend and redirect cash flow to paying down debt more aggressively. We don’t expect a dividend cut to happen, but it is a nice escape hatch if the need arises.
DirectCash also has a prepaid card business, from which it earns transaction fees without taking any credit risk. However, the company’s largest prepaid customer, Cash Store Financial Services Inc., is experiencing severe difficulties and may soon disappear. Fortunately, prepaid cards are only about 10 per cent of gross profit, a smaller part of the company’s profitability than some have speculated.
As is often the case with smaller companies, key man risk is real at DirectCash. The company’s CEO, Jeff Smith, is an excellent operator and the business is heavily reliant on his talents. He is the company’s largest shareholder and uses equity-based awards sparingly. Mr. Smith appears to make decisions based on long-term cash flows, not on the short-term impact to the company’s accounting earnings. In other words, he thinks and acts like an owner.
If you believe that we are rapidly becoming a cashless society and ATM transaction volumes will drop off precipitously, you are better off avoiding an investment in DirectCash. For us, we are comfortable having Mr. Smith and his team as our business partners. We believe that they will continue to deliver impressive financial results. In time, the market will figure out that the stock is currently mispriced. It always does.
Michael McCloskey is the founder & president of GreensKeeper Asset Management. GreensKeeper, its affiliates, and certain accounts managed by them may hold long or short equity positions of a profiled company and may from time to time trade in these securities.