NCR Transforming, But The Street Seems Up To Speed

By Stephen D. Simpson, CFA | August 20, 2013 AAA

NCR (NYSE:NCR) has already gone a long way toward transforming itself from a tired, slow-growing manufacturer of ATM and point of sale (POS) hardware to a more dynamic payments technology company. In addition to addressing client needs for more front-end productivity, NCR has really augmented its faster-growing software and service operations. The only downside to the story is valuation, as today's valuation already assumes that these moves will meaningfully upgrade the company's future cash flows. Faster And Cheaper Is The Service ParadigmBanks and retailers share a common goal – reducing the cost of providing services as low as possible without compromising service levels to such a degree that customers go elsewhere. This is already a controversial topic as it pertains to self-checkout kiosks. NCR has strong share here (despite competing with IBM (NYSE:IBM), Fujitsu, and Wincor Nexdorf), and counts major retailers like Wal-Mart (NYSE:WMT) among its customers, but many customers refuse to use them – whether it be for reasons of complexity, simply not wanting to, or objecting to replacing jobs with machines. For better or worse, that trend is only going to increase, and I expect customers will see even more of it at their local branch bank. Banks are desperate to reduce operating costs, and while the ATM market is generally seen as a staid, replacement market shared largely between NCR and Diebold (NYSE:DBD), there could be additional growth and technology opportunities here. It wouldn't surprise, for instance, if banks move away from live in-bank tellers and instead adopt machines that can incorporate live video for customers who need assistance or interaction.SEE: Cut Your Bank Fees Services And Software Driving Growth And MarginsIn addition to rethinking what payment/financial service hardware can be (or do), NCR is looking to increasingly augment its growth with additional service and software offerings. NCR already generates more than half of its revenue from services, and the software business was up 44% in the second quarter (contributing more than 12% of revenue).  As companies like VeriFone (NYSE:PAY) and Ingenico have seen elsewhere in the POS space, there's an increasing demand for a variety of processing services and software packages to improve efficiency. Likewise, NCR now has its software/service-focused Retalix operations offering both POS-oriented software products and services, as well as more broad-based ERP/ERM solutions for the retailing and hospitality business. While I would expect ongoing competition from SAP (NYSE:SAP) and Oracle (Nasdaq:ORCL), NCR does at least offer the advantages of a software suite designed particularly for the needs of the retail and hospitality industries. Improving Financials Offer HopeTalking about long-term strategic opportunities is all well and good, but companies also have to deliver on the potential. To that end, NCR is doing pretty well. Revenue rose 9% in the second quarter, with 13% growth in services (offsetting 5% growth in products) and the aforementioned 44% growth in software. While Retalix is certainly helping the reported growth from the retailing and hospitality businesses (up 26% and 22%, respectively), the 1% decline in the core financial services segment is testament to the fact that while banks want to reduce operating expenses, they're not particularly enthusiastic about spending more today to achieve savings down the road.  Gross margin improved 130bp on a GAAP basis, and 160bp on an adjusted non-GAAP calculation. Likewise, operating income rose about 7% by GAAP, but 18% on an adjusted basis, with a full point of operating margin expansion. It's also worth noting that the company continues to make good progress on its pension funding issues, and the overhang should largely go away in 2014.SEE: A Look At Corporate Profit Margins The Bottom LineWhile IBM's strong hardware and software capabilities shouldn't be underestimated, I like NCR's chances for competing against companies like Diebold and VeriFone in the future. At a minimum, I believe that the convergence and intermingling of hardware and software is only going to intensify in the near-to-intermediate future and those companies who don't have the capabilities on both ends will either be forced to buy them (M&A), develop them quickly, or lose business. The only problem is that it seems like the Street is basically on top of all of this. These shares are up almost 70% over the past year, and even a long-term revenue growth rate in the mid single-digits coupled with significant improvements in free cash flow generation (well above historical rates) isn't enough to produce a compelling fair value unless you just ignore the net debt on the balance sheet. Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

 

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