CSG Systems' Acquisition of Intec is a Transformational Move
CSG Systems (CSGS) is a provider of outsourced billing and account management, focused largely on the cable and direct broadcast satellite (DBS) market in North America. CSG's Advanced Convergent Platform (ACP) allows its clients to handle pretty much the entire lifecycle of a customer, from account setup, order processing, invoice production, billing, cancellation, etc. Over 45 million subscribers are processed through the company's systems. CSG's four largest customers account for nearly 65% of sales: Comcast (CMCSA; 24%), DISH Network (DISH; 18%), Time Warner (TWC; 13%), and Charter (CHTR; 9%).
I really like CSG's business model, and am keeping an eye on this as a future potential Top Buy pick. Let me tick off the many attractive points here:
* Stable, recurring revenues. All of the company's main contracts run through at least 2012, and some farther out than that. High visibility and reliability allow the company to be more aggressive when making investments.
* Very high switching costs. A client spends months to years and millions of dollars migrating onto CSG's platforms, and the cost in both time and potential business interruption makes it difficult to move off the system, unless there are very significant economic reasons for doing so.
* Cash cow business. CSG has produced stable free cash flow margins right around 25% of sales over the past 5 years. Free cash flow has exceeded operating earnings in each of the past 5 years, a real rarity, and a sign of high quality earnings. Free cash yield at $20 is about 16% - compare that to a bond yield!
Revenue growth has been stable at right about 5-7% a year, as the firm added subscribers onto their platform and enjoyed escalation clauses in its long term contracts. The biggest risk in the stock has always been the heavy customer concentration, which in 2008 allowed Comcast to re-negotiate its contract at lower payment rates. The threat of losing one of its "big 4" customers has always kept the valuation relatively low. Additionally, a data center migration from First Data to Infocrossing has created some non-recurring costs that have held down earnings per share in 2010.
However, CSG is about to change dramatically...
In late September, CSG announced a transformational move with its $372 million bid to acquire U.K. billing provider Intec. Intec is a similar business to CSG, but focuses on the telecommunications market, servicing such multi-national telecoms as Vodafone (VOD), China Mobile (CHL), and AT&T (T). Intec brought in about $266 million in 2009 at operating margins around 16% - very similar to CSG.
There are positives and negatives to the deal. It's a big deal for a smaller company like CSG. They will be committing $130 million in cash (61% of reserves), and another $250 million or so in new debt facilities. The balance sheet will be ugly once the deal closes, with an estimated $400 million in total debt and a debt-to-equity ratio nearing 200%. This is by far the biggest deal CSG has attempted - integration risk is a huge concern. Competitors like Amdocs (DOX) will be watching closely for opportunities to win business.
On the positive side, the deal accomplishes a few things for CSG. Most importantly, it lessens customer concentration; the "big 4" clients will account for about 42% of sales after the deal. Furthermore, it gives CSG a solid foothold in a new vertical market (telecom), and expands the company to a global presence.
Ultimately, I believe the Intec deal is a good one. The business models are similar. The combined company should do about $800 million in revenue at similar 16-18% operating margins. Estimated free cash flow of about $160 million annually should easily allow CSG to pay down the debt. And all of this is without accounting for potential cost savings due to overlapping functions.
Assuming the company can continue its usual 5-7% revenue growth at stable margins, CSG looks to be worth about $25 in my model, a 31% premium to current prices. The stock should be appealing to more conservative MFI investors due to the predictability of cash flows. Steve owns no position in any stocks discussed in this article.