experianThe three months financial results ending 31 December 2015, showed total growth of 6% at constant exchange rates, organic revenue was also up 6%, but at actual exchange rates, total revenue from continuing activities was down 3%.  By entering Brazil with the acquisition of Serasa, Experian added approximately one billion dollars to its revenues. That was when Brazil showed strength and there was room to grow Serasa’s business by injecting new services.  The ill winds of foreign exchange and the sagging economy of Brazil has put a dent into Experian’s dollar reported growth picture.  What does the future hold?

Seeking Alpha has recently published a report on the current state of Experian’s business stating that Experian has finally turned a corner but that has yet to be reflected in the share price.

Summary

Shares of Experian have done nothing for several years given the free credit report legislation dragging their online results – this is abating.

The new management team is restructuring their growth strategy towards a matrix approach growing in existing geographies with existing products lowering operational risks.  The company is likely to deleverage fairly rapidly while divesting non-core assets enhancing margins and aiding their capital position likely used for share buybacks.

Experian (OTCQX:EXPGY) (OTCQX:EXPGF) is a well-known business but not a well-known stock. Their primary operations are in their credit bureaus spread across 19 countries and the credit risk analysis scoring services to both businesses and individuals. The industry itself is highly oligopolistic with very high barriers to entry due to the massive amount of data required as well as the strong relationships with data providers. The company operates the second largest position in the US (behind Dun & Bradstreet) and holds the number one shares in both the UK and Brazil.

We think the interim low share price around $16-$17 is a solid entry opportunity. Management’s increased focus on sustainable ROIC and free cash flow should help them continue to buy back a large amount of shares and increase the dividend payout, currently yielding 2.50%. We think organic growth is set to inflect in 2016 after several bolt-ons over the last two years become integrated and they move into their matrix approach.Business Units Inv presentation Jan 2016 Alpa

(Source: Investor Presentation)

Progress Has Been Obscured

Over the last two years, the share price has largely traded between $16 and $19. The issues that have plagued the firm over the last few years are subsiding and we think the true growth rate is starting to materialize under the new management team. We believe that 2016 should be a watershed year on their return to mid-to-high single-digit organic revenue growth along with expanding margins with free cash flow conversion exceeding 100%.

The company has seen growth in Brazil come to a standstill as macro issues and increased competition, mainly from Boa Vista (partly owned by Equifax) and TransUnion making large plays in the country. Margins have compressed in the last two years due to the slowing growth and the dilutive effect of acquisitions (in addition to FX effects) of Passport and 41st Parameter. In addition, given the increased debt load and leverage, the company had suspended their share buyback program.

We believe these issues put the shares on the sidelines, but that the US consumer services business has turned a corner after years of disappointment. We are confident in the segments return to strong growth as they counter the entrants and push by competitors. In addition, Latin America showed better-than-expected strength with 5% revenue growth despite the weakness of the economy in Brazil. Sentiment has thus shifted with the sell-side pushing up estimates for growth in Latin America.

The recovery in the Consumer Services is underway. One of the main drags to operating performance was the introduction of legislation that guaranteed free credit reports to consumers. The effect of free credit report sites to their online website has abated and performance has stabilized, which we think is a key point for investors to see. The company’s fiscal first quarter 2016 revenue performance in Consumer Services was -10%. But that halved in the second quarter as they reached an important threshold with their online business surpassing their legacy operation in size.

In their North American and UK businesses, we think the company could see upside strength from the structural growth in small, faster-growing industries like automotive, business information, and healthcare. The latter is the most compelling given the ACA implementation and the need by providers to reduce their bad debt expense, fraud, and administration overhead.

The company is one of the highest quality businesses in Business Services, with very high returns on invested capital and significant barriers to entry. The key asset is their database within their marketing services (a piece of Credit Services division) which is sold to help businesses target their marketing spend. Organic revenue momentum is strengthening from zero in F3Q 2015 to the 4% generated in the F2Q 2016. We think that rate of organic growth will top 5% for all of fiscal 2016 and achieve at least 6% in the next two years with upside potential to 8%-9% should the stars align.

Tons of Surplus Capital

The company’s main strength lies in its strong cash flow and high profitability, namely within their largest segment, Credit Services (47% of sales). Pricing in the segment is mostly volume-driven, with high volume customers receiving discount billing. They also offer discounts to both consumers and lending institutions that supply them with credit information. The strong cash flow generation has allowed for a massive share buyback program of $600 million in addition to more M&A activity with the remaining $600 million in surplus capital.

While the weakness in Brazilian real decimated their surplus capital in fiscal 2015, this was offset by some non-core asset disposals. We think an additional $800 million buyback could be undertaken in fiscal 2017 (starting mid-2016). We think a hint or formal announcement of which could come when they report in the next few days (or at the latest May), possibly supporting the share price. The company has undertaken less acquisitions over the last year as they’ve worked on integrating their two larger acquisitions in late 2013.

We think M&A activity is in the process of being de-emphasized as part of their growth strategy with the company favoring a return of free cash flow to shareholders. In fact, the company has made more asset disposals than acquisitions in the last year and management is forecasting another $150 million in additional disposals over the first half of 2016. The proceeds of which will be used directly into their organic capital investments to help accelerate organic growth.

Capital Structure a Key Component for Growth

Experian’s balance sheet is a key aspect, more so than most, into analyzing their growth prospects. This is due to the central role that dividend and share repurchases play into the valuation of the share price. The company is currently levered to 2.1x net debt to EBITDA after they funded their two large acquisitions, Passport Health and 41st Parameter in late-2013. The company issued several Euronotes with total net debt jumping from $900 million to $3.95 billion. The debt issuance comprised mainly of $2.75 billion of notes, with varying maturities from 2017 to 2021 and interest rates below 4.75% in addition to bank loans totaling $820 million and $576 million of commercial paper.

We think this additional debt load is causing fear in investors that the increases in the dividend payout and share repurchase program will slow. But given the massive free cash flow, cessation of acquisitions, and asset disposals, we think the company has significant capacity for additional share repurchases and mid-single digit dividend increases. We expect free cash flow to equate to nearly one-third of their market cap over the next three years, causing leverage ratios to fall back. In addition, the company is likely to continue to divest away from non-core assets and geographies that are not clearing the return hurdle objectives while focusing on their value creation within the core business of Credit Services. This should give a small boost to margins over time.

Long-Term Growth Drivers

The company, under new management that came on board in 2014, has refocused their growth strategy. Previously, the company simply expanded based on geography which created lumpy and inconsistent growth. But the new management team has noted that geographic expansion alone isn’t enough to achieve an acceptable level of organic revenue growth. The new management team wants to concentrate on the core business, which we think is the right move, and bring the business together.

We think this is evident given the ongoing debate as to the profitability and rationale for the Passport Health acquisition. This has also been raised by investors and analysts on several other acquisitions over the past several years, due to the high prices paid. We think a shift towards a matrix approach, and away from a strategy of leveraging their high return core US and UK credit services units to finance geographic expansion is likely the reason for the organic growth acceleration. This was typically achieved with platform acquisitions to enter new verticals and disciplines. The new management team is using this matrix approach in which existing disciplines will be rolled out into existing geographies, driving organic revenue growth. We believe this is the correct method which carries much less operational risks.

Valuation

We think the shares are worth approximately $21 based on a $1.45/pound exchange rate and EBITDA generation next year of $1.15 billion. We think the valuation is likely to be driven by solid top line organic revenue growth rising 5% to 6% this year and 6% to 7% in 2017 and 2018. The bolt-on acquisitions over the last couple of years should be fully integrated, driving EBITDA margins, and increasing top line organic revenue. We think this will help re-rate the shares higher towards a 14x multiple.

We do not think the company will undertake any further acquisitions as Passport and 41st Parameter are integrated along with their smaller tuck-ins. But the base case assumes a decent 3% boost from share buybacks which is likely to be low by at least 100 bps and more likely 200-300 bps. In addition, we think EBITDA margins achieve modest expansion of 20-40 bps per year driven by the disposal of non-core, underperforming asset sales.Experian Alpha Report Jan 2016

Conclusion

Experian is a bit of a mispricing phenomenon given their London Stock Exchange listing (with an ADR here in the US) and the few comparables globally. The market is clearly taking a wait-and-see approach to see if organic revenue growth momentum is sustained and doesn’t move back lower to the low-single digits. We believe their over-indexing to the US and UK is likely to help it outperform their peers while Brazil and the rest of emerging markets continue to drag on results. We think organic revenue growth will accelerate over the next few years driving the multiple higher towards 14x and breaking them out of the two-year trading range.

Source:  Seeking Alpha

Editorial comment:  BIIA has recieved the above as a complimentary copy. The contents of this post therefore do not reflect the oppinion of BIIA nor its members.