Massive Secular Tailwinds Drive Big Value in NCR

NCR is a leading provider of hardware, software, and services that allow businesses in the financial services, retail, hospitality, travel, and telecommunications industries to connect, interact, and transact with their customers. The stock has been trending downward for the past three months, off ~20% from its peak in October as a result of missing consensus sales estimates, but beating on earnings in both Q3 and Q4. This latest price decline puts the stock at $32.07, or 10.2x 2014E P/E, which I believe is a good entry point for a position. The current situation presents a great opportunity to buy shares in a strong business at a discounted valuation.

I believe that NCR is a great business to invest in over the medium term for four fundamental reasons which I will address below:

1) Shift of Product Mix to Software Driving Above Average EPS Growth
NCR has a huge breadth of products aimed at addressing all of the technology needs of its customers. It is the world's largest manufacturer of ATMs, with around a third of the world market share. It has large market share in the US, where it competes primarily with Diebold; large market share in Europe, where it competes primarily with Wincor; and large market share in India, China, and Brazil. To complement its financial services hardware offering, the firm offers a number of software solutions for banks including image recognition for check depositing, online banking and mobile banking, and mobile fraud security. The company also provides a range of self-service kiosks, POS devices, and consumables for its retail, hospitality, and travel customers, as well as complementary software which allow users to interact with businesses from their computer or at home. In addition, NCR offers a range of services, including maintenance and support, implementation, systems management, and transactional services, to meet the needs of their customers. More recently, the business has begun reselling networking equipment and providing services to telecom providers, which constitute a large portion of its emerging segment. NCR can now offer support and products for all areas of the omni-channel, and is a critical component of the customers' online and offline experiences. NCR's software business is well positioned for growth above the industry average as customers look to an integrated solution provider covering both hardware and software.

Management has showed a sustained commitment over the past 10 years to invest in organic and inorganic software opportunities and as the product mix continues to shift from lower margin hardware to higher margin software, this should allow margins to expand and earnings growth to outpace revenue growth.

2) NCR Benefits from a Number of Secular Tailwinds Driving Product Demand
As Microsoft announced that it will no longer support Windows XP, banks are at a crossroads in considering whether to upgrade their existing systems. Given the high cost of failure in the banking industry and the fact that ~80% of existing systems are run off Windows XP, the migration to Windows 7 presents a huge revenue opportunity for NCR as the financial services industry accelerates purchases for new ATM hardware in 2014 and into 2015.

In addition, the adoption of new EMV chip technology in the US and worldwide should spur a new investment cycle in POS technology for retail customers. Because this technology offers an increased level of payment security, Visa, MasterCard, and American Express are giving merchants in a number of countries, including the US, until October 2015 to transition to EMV technology before holding the merchants liable for domestic and cross-border counterfeit transactions. This forced liability shift for non-compliant retailers should motivate retailers to refresh the POS technology prior to the deadline.

Furthermore, the firm will continue to benefit across the board from the trend in omni-channel and self-service kiosks, as its customers in financial services, retail, hospitality, and travel segments look for ways to streamline the customer experience by creating a seamless online/offline customer experience, reducing wait times, and eliminating unnecessary operating costs.

3) Management Team's Focus on Effectively Deploying Free Cash Flow and Increasing FCF Yield
The current management team has recently implemented a number of changes which should continue to drive shareholder value going forward. First and foremost, Bill announced the change in compensation structure of the firm's bonus plans on the most recent earnings call, tying all employee bonuses to both NOPI and cash flow. Given that increasing cash flow conversion is a stated priority of the business, and that incentives drive performance, this helps to align management and shareholder incentives and is a step in the right direction. In addition, the team has set a very strict standard on its fixed capital investments, stating a 15% hurdle rate. Given that the business has historically had a very high ROIC of >20%, I believe management has done a good job reinvesting capital into NPV positive projects and will continue to attack future growth opportunities in a way that is beneficial to shareholders.

NCR's management team has publicly stated its commitment to reducing leverage levels from the current 4.0x+ debt/EBITDA to a more sustainable 2.0x over the next several years. The positive impact of the debt reduction is two-fold: first, the decrease in excess cash flow after debt payments reduces the incentive to redeploy excess cash flow in questionable organic investments or acquisitions; and second, as the company pays down its debt, the reduction in interest expense should positively impact EPS, adding several percentage points to NCR's EPS growth over the next several years.

Additionally, management is focused on increasing FCF yield and has stated its goal of increasing cash flow conversion from its current level of ~30% to 60-70% over the next several years. I believe this is achievable through a combination of actively managing working capital efficiency, a reduction in PP&E as the business rolls-off a number of one time investment projects including the expansion of NCR's manufacturing facilities, and the elimination of its Fox River liabilities. This increase in free cash flow conversion should add a roughly commensurate level to the valuation of the business.

4) Low Valuation Multiple Offers Room for Multiple Expansion
On a 2014E P/E, EBITDA, and revenue basis, the business's current valuation of 10.2x, 8.3x, and 1.3x places it at a material discount to the peer median multiples of 17.7x, 10.0x, 1.5x. The business also trades at a deep discount to the intrinsic value of the business as calculated through a discounted cash flow analysis. Using the base case 2014 and 2015 guidance provided by management as a starting point, the business should be trading at a value of ~$75 versus its current price of $32.07.

In addition, there is reason to believe that management's guidance for future revenue and earnings for 2014 are below their actual expectations for the year. On the latest earnings call, the management team pointed out with pride that the company had beaten consensus EPS estimates and guidance for the past 16 consecutive quarters and revised forward year guidance upwards the past four consecutive years. They will likely be hesitant to give up this win streak. As a result of consensus sales estimates misses the past two quarters, NCR's management will make a concerted effort to beat their guidance this quarter and in 2014.

Digging into their current financials, it appears that their guidance understates their future earnings potential, which I believe is further reinforced by the CEO purchasing over 100,000 shares in late January. For example, stripping out their SaaS revenue guidance for 2014E, management is projecting a $40m increase in SaaS revenue relative to PF2013 figures. Management then stated that they expect Digital Insight revenue to increase $25m, which implies organic SaaS revenue growth of $15m off an organic base of $145m. Given that NCR has consistently grown SaaS revenue in 10-20% across segments, and the business will benefit from 2014 being the first full-year of Retalix revenue (Retalix closed in Feb. 2013), I believe they are purposefully managing their guidance below their expectations.

Conclusion
I believe there are several catalysts which will allow long-term shareholders to realize value in the stock over the medium term. An improvement in product mix towards high margin software sales should lead to the bottom line outgrowing revenue. Additionally, the company will benefit in the future from revenue growth driven by strong secular tailwinds as their customers migrate to self-checkout and omni-channel solutions, refresh their product offerings as a result of changing EMV regulations, and complete the transition to Windows 7 products. Furthermore, the management team remains committed to effectively deploying cash flow and increasing free cash flow yield, and because the stock trades at a discount to both its peers and historical multiples, I believe that the P/E multiple will trend towards the peer median over time.

Over the next 5 years, these four factors should contribute to a 20-30% annualized return on the investment.