Jay Kilroy is a Managing Director and Portfolio Manager for Willis Investment Counsel, a $1 billion asset management firm located in the greater Atlanta area. The firm manages equities, fixed income, and alternative strategies using separately managed accounts and private investment funds. The below investment thesis was originally posted on SumZero , the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. This is not a recommendation to purchase and/or sell the specified security outlined in this report.
Thesis
Amdocs (NYSE: DOX) was cast into the bargain bin recently as the incoming CEO lowered near-term margin expectations despite a robust backlog. We know that Wall Street typically doesn't like it when company enters "investment mode," even if it is the right thing to do long-term. Even if I assume that margins remain at 15%-17% (versus historical 18%), Amdocs appears significantly undervalued. However, based on management's comments, I think margins will eventually turn back up, creating even more stock price upside. The company is withholding all longer-term and capital structure guidance until its Analyst Day on Feb. 23, 2011, which may serve as a catalyst to close the gap between current price and intrinsic value.
The new CEO, Eli Gelman, appears more focused on growth than his predecessor, which is why he is investing in sales and R&D now -- in hopes of accelerating the company's growth rates (primarily in the emerging markets). I view this as a free call option, as he is not investing capex. Rather, he is running the incremental investment through the P&L; thus, it's already in my intrinsic value estimate.
At the current price, Amdocs is selling for 12x-13x next-12-month (NTM) EPS and 10x NTM free cash flow (FCF), which reflect negative growth after incorporating DOX's $1.3 billion cash balance. Management knows the market is ignoring its cash, and in response, launched a $700 million share repurchase plan in mid-2010 -- which it intends to complete within 12 months. The new CEO also alluded to revisiting its capital structure policies, which may mean a larger share repurchase is in the offing.
Ignoring share repurchase, if I just assume that DOX plods along at the low end of its historical growth rate (3%), the company is worth mid-$40s. Seen another way, I see Amdocs generating $3.00-$3.25 in EPS in two years. A 13x-14x multiple on this earnings stream equals $39-$46 per share, or 40%-65% appreciation potential -- which is not bad considering the high-quality nature of Amdocs.
Background on Amdocs
Founded in 1982, Amdocs is a leading provider of software and services to communications companies in the U.S., Europe, and globally. The company's primary focus is to implement and manage software and services associated with business support systems (BSS) and operational support systems (OSS) to support operator needs. Amdocs' services and solutions support a broad range of customer care needs including billing systems, customer relationship management (CRM) software, directory systems, personalized portal and value-added services, portfolio management, as well as other management systems for wireless, wireline, IP, broadband, and other communications service providers.
Amdocs is one of the largest and most dominant players in the industry, and its success is attributable to its dual role as product vendor and systems integrator. The company's BSS products sit at the core of any communication provider's system because they enable the service provider to track and bill for usage, manage revenue, handle customer relations, and devise marketing packages and rate plans. It also provides solutions (OSS) that enable service providers to manage their communication networks, service fulfillment, and service assurance. This comprehensive set of offerings allows the company to build a long-term sustainable competitive advantage versus its competition. Further, Amdocs complements its packaged products with professional service offerings that include extensive consulting for system implementation followed by ongoing support, enhancement, and maintenance services. The service capabilities are a key component of the added value that Amdocs brings to its customers.
Amdocs' solutions enable carriers to manage their operations and maintain relationships with customers. These solutions take months or even years to implement because of their complexity, and since they are so intertwined with the critical operations of a carrier, companies rarely switch product vendors once these functions have been outsourced. Most of Amdocs' customers have been with the company for more than five years, which provides Amdocs with a strong recurring revenue base and good revenue visibility. Amdocs also benefits from the intense competition among service providers. As competition heats up, carriers look for service-heavy customized solutions that help them attract and retain subscribers, which in turn create demand for Amdocs' products. Having already established relationships with most of the large telecom providers, Amdocs stands a better chance of winning when clients look for an outsourcing partner.
Amdocs' competitors are split between a number of vendors that service the global telecom markets. The company faces competition from both internal solutions providers (i.e., departments within the communications service providers) as well as independent vendors that provide either an end to end suite of solutions, or point solution providers for specific customer needs (e.g., personalized portal solutions). Broadly, the company's competitive landscape can be segmented into three categories:
- Providers of BSS / OSS solutions (Comverse, Convergys, CSG Systems, Oracle, Telecordia)
- Network equipment providers (Alcatel Lucent, Ericsson, Huawei, Nokia Siemens, etc.)
- Systems integrators (Accenture, Cognizant, Hewlett-Packard, IBM, Infosys, Wipro)
Historically, the company has looked to acquisitions to bolster its solutions portfolio, generally through tuck-in, technology-related deals. Amdocs generates revenues through several avenues including (1) the initial sales of licenses to use the company's products and related services, (2) providing managed services and other services for the company's solutions, and (3) recurring revenue from support and maintenance provided to operators and from incremental license fees resulting from increased customer volume. The company services its global carrier base with operations in more than 60 countries and more than 17,200 employees.
While Amdocs has a broad customer base with service providers from over 60 countries, 75% of sales come from North American carriers, with Europe 15% and Asia 10%. Globally, the company's 10 largest customers represented 75% of sales. AT&T and Bell Mobility comprise 40% of sales, but neither is up for renewal until 2017.
Traditionally, the company has traditionally served Tier 1 and Tier 2 service providers in the developed markets (i.e., AT&T, Sprint, Bell Mobility), but increasingly has been expanding to emerging markets such as Eastern Europe (including Russia, Ukraine, among others), India, Latin America, and Southeast Asia. The company's customer base is now located in more than 60 countries worldwide. While headquartered in Chesterfield, Missouri, Amdocs' management, along with about one quarter of its development staff, are based in Israel. The company has other production and operating centers in Canada, China, Cyprus, India, Ireland, Israel, and in the U.S., and employs more than 17,000 personnel worldwide.
Amdocs' services-based strategy provides the company with strong customer relationships, healthy visibility and a relatively stabilized revenue stream. At the core of its platform is its CES 8 solution, which provides its fifth-generation integrated prepaid and postpaid billing platform, customer relationship management (CRM) and ordering applications, service delivery, service and resource management (OSS), revenue management and portfolio management. The platform is based on an open architecture that allows for increased functionality, scalability, modularity, and adaptability for service providers.
Amdocs' approach to the market is, however, differentiated versus many of its peers. Rather than providing just the core software elements of its solution, the company provides a full end-to-end services platform, signing multi-year service contracts with its carrier partners. This compares with some of its peers, which may provide the core software platform but partner with a systems integrator to deliver additional services, including managed services. For example, Comverse may work with an IBM or Accenture in delivering a similar offering. Amdocs' revenue model of contracting with a carrier over a multi-year period creates a deeper relationship, high replacement costs as well as a more stabilized
revenue stream for the company. The company's business model provides a comparatively higher degree of visibility on its revenue streams, and supports healthy cash generation.
Amdocs' services include business consulting, systems integration and delivery services, managed services and product services to support the deployment and operations of the company's products. Within business consulting, the company offers advisory and optimization services. Under systems integration and delivery services, Amdocs provides
program management, solution implementation, business readiness and deployment, workforce performance and learning services. Under product services, the company offers product support and professional services. Within managed services, the company provides business process operations, application management and IT and infrastructure management.
Managed Services now comprise almost half of Amdoc's revenues. "Managed Services" are where the carriers effectively hand over the management of their back-fend systems for billing and customer care operations to Amdocs over a long term contract (3-7 years). Over the past several years, Amdocs has successfully migrated its service platform toward developing managed service relationship with its carriers -- Managed Services is now 45% of annual revenue. In these arrangements, Amdocs typically recognizes revenue from the operation of a customer's system as services are performed based on time elapsed, output produced or volume of data processed, depending on the specific contract terms of the managed services arrangement. Typically, managed services contracts are long-term in duration and are not subject to seasonality. Revenue from ongoing support services is recognized as work is performed. Revenue from third-party hardware sales is recognized upon delivery, and installation and revenue from third-party software sales is recognized upon delivery.
Overall, as carriers continue to look for means to lower their total costs of reducing their network related expenditures, managed service contracts allow service producer the opportunity to benefit from improved efficiencies and long-term savings over the day to day costs of operating and managing these systems. It also worth noting that while initial margins on managed services projects can be lower, margins tend to improve over time as the company drives operational efficiencies through the service provider's network.
The long-term nature of Amdocs' contracts with its carrier customers provides the company with a relatively stable revenue stream and good visibility, however, there can be variability in the company's revenue stream. As noted above, part of the company's service contract is dependent on the timing and development of certain elements of its projects which can be dependent on individual carrier's discretion.
Key Managed Services Contracts
| Company | Expiration Year |
|---|---|
| Sprint Nextel | 2011 |
| Vodafone (Netherlands) | 2011 |
| T-Mobile UK | 2013 |
| MetroPCS | 2014 |
| Vonage | 2015 |
| Bell Canada | 2017 |
| AT&T | 2017 |
Where will growth come from?
Developed markets becoming more data-centric. U.S. carriers are deriving an increasing mix of revenues from data services. Two years ago, data was only 24% of sales; now it's 33% and climbing by 2-3 percentage points a quarter. The proliferation of smartphones will only accelerate this trend. Data is more complex than voice, and thus as more complex services get a bigger slice of the revenue pie, developed-market carriers are going to have to increasingly rely on more complex back end systems to fully capture the revenue opportunities generated from the shift to data services.
Emerging market growth. Emerging market carriers are focused on supporting a rapidly growing base of subscribers; this growth can potentially constrain inadequate back end systems. Amdocs entered the Indian market in 2004, and now counts some of the region's largest carriers such as BSNL, Reliance, and Tata as customers and is looking to expand its regional presence over the next few years. India has doubled subscribers to 600 million-plus over the past year, which will increasingly constrain carrier systems. The adoption of data will impact emerging markets as well, and is likely to increasingly require more sophisticated systems to monetize and retain higher-value customers while providing support to a growing base of lower ARPU customers -- driving the need for more complex solutions. To stay with the India example, India only recently announced 3G licenses, which means data uptake will begin to ramp in 2011.
Financial strength
The company is rated BBB and carries essentially no debt and $1.3 billion of unrestricted cash. DOX has made eight acquisitions approximating $900 million in aggregate over the past five years. Recent deals have been very small, which has allowed cash to build. In response to these growing cash balances, management recently authorized a new $700 million share repurchase plan, representing 12% of its share count -- which it expects to complete within 12 months. Management has not sworn off acquisitions, but did have the following to say on the topic recently:
"We are not under huge pressure to augment our products. I think we already have the best products and solutions in the marketplace. But we built this company for growth. I would say this is the DNA of the company and while other companies are either buying growth through M&A or cost cutting every day, we will carefully watch our profitability and balance this with our growth." -- Eli Gelman, CEO, November 3, 2010
Risks
Amdocs' biggest risk is its highly concentrated customer portfolio. Its core customers include Tier 1 service providers such as AT&T, Sprint, Bell Canada, and Vodafone. As the company focuses on strengthening its relationships with stronger Tier 1 providers, client concentration is inevitable. However, this strategy is driven by the belief that larger players will have sufficient resources to continue to dominate in the future. Amdocs' top 10 clients contributed 76% of total revenue in fiscal 2009, while its top three clients accounted for 50%. Even though client relationships tend to be sticky, any customer loss could interrupt the company's growth. AT&T and Bell Canada equal 40% of sales but both of these contracts are not negotiable until 2017, significantly dampening the risk factor relating to concentration.
Another risk is "Israel risk." Amdocs' management, along with about one quarter of its development staff, are based in Israel. If Israel comes under attack, investors may get nervous about owning companies with a large portion of their staff in this small yet volatile country.
Given the company's growing cash balances, capital allocation is obviously a risk factor, but management's propensity for small acquisitions coupled with the CEO's recent commentary about not wanting to do deals right now, leads me to believe this risk factor is contained.
Higher taxes are obviously a risk, as DOX benefits from Israel's low tax structure.
In sum: Variant view
Amdocs is mispriced due to disappointment about management's recent margin reduction. Many investors are short-term-oriented and don't like being disappointed or waiting around for improvement. All of these factors are currently weighing on Amdocs currently. We like the public statements of Amdoc's new CEO thus far and believe his actions could be the difference between revealing Amdoc's true business value or keeping it hidden. (Here is a full listing of valuation metrics.)
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