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Acquisitions can boost accounting earnings while destroying shareholder value, a fact illustrated by the high-low fallacy. This week’s Danger Zone pick began a large acquisition spree in 2012, which continued through 2015. On the surface, everything seems on the up and up. However, when we peer below the surface, we find that the fundamentals of the business are headed in the wrong direction. For this reason and more, ACI Worldwide (ACIW: $21/share) not only landed on June’s Most Dangerous Stocks list, but is this week’s Danger Zone pick.

Acquisitions Have Destroyed Shareholder Value

Since 2012, ACI Worldwide has completed eight separate acquisitions at a cumulative cost of $1.4 billion. These acquisitions stoked revenue, which grew 22% compounded annually from 2011-2015. However, these acquisitions came at the expense of economic earnings, the true cash flows of the business, which declined from $10 million in 2011 to -$26 million in 2015. Economic earnings have fallen even further, to -$48 million, over the trailing twelve months (TTM). Figure 1 shows the divergence of revenue and economic earnings. See the reconciliation of ACI Worldwide’s GAAP net income to economic earnings here.

Figure 1: Disconnect Between Revenue and Economic Earnings

NewConstructs_ACIW_EconEarningsVsRevenue_2016-06-20

Sources: New Constructs, LLC and company filings

These acquisitions have been an inefficient use of capital. ACI Worldwide’s return on invested capital (ROIC) has fallen from 11% in 2011 to a bottom-quintile 4% over the last twelve months.

Worse yet, ACI Worldwide’s total debt, which includes off-balance sheet operating leases, has grown from $128 million in 2011 to $825 million (34% of market cap) TTM. Over the same time, ACIW’s shares outstanding have increased from 39 million to 116 million. ACIW funded its acquisition-based growth at the expense of shareholders and has no profits to show for these actions.

Non-GAAP Earnings Overstate Business Operations

Investors must be aware of the dangers of non-GAAP earnings as they routinely remove standard costs of doing business, thereby creating a more positive picture of business operations. Here are expenses ACIW has removed when calculating its non-GAAP metrics, including non-GAAP revenue, non-GAAP operating income, adjusted EBITDA, and non-GAAP net income:

  1. Employee related actions
  2. Facility closure expenses
  3. Professional fees
  4. Data center move expenses
  5. Transition and technology costs

By removing these costs, ACIW is able to report non-GAAP results that are better than the company’s true profits. While non-GAAP and GAAP net income grew in 2015 year-over-year, ACIW’s after-tax profit (NOPAT), the normal, after-tax cash flow, declined 17% to $96 million. TTM NOPAT has fallen even further, to $78 million.

Longer-term, ACIW’s non-GAAP net income has grown from $50 million in 2011 to $95 million in 2015. In contrast, economic earnings have declined from $10 million in 2011 to -$26 million in 2015, per Figure 2.

Figure 2: ACI Worldwide’s Non-GAAP Overstates Profits

NewConstructs_ACIW_NonGAAPvsEconEarnings_2016-06-20

Sources: New Constructs, LLC and company filings

Negative Profitability Creates Competitive Disadvantages

The payment and banking market is highly competitive and ACIW identifies several competitors across each of its business segments. As noted in the company’s 10-K, competition comes from First Data Corp (FDC), Fiserv (FISV), Jack Henry & Associates (JKHY), Nelnet (NNI), and Western Union (WU), among others. These competitors are in addition to private service providers and in-house technology departments of potential customers. Per Figure 3, it is clear that much of the competition ACIW faces have higher margins and ROICs. ACIW recognizes that competitive factors in the market include price and commitment to continued R&D. However, having a lower margin and ROIC than most of its competition means that ACIW has less price flexibility and could also mean the firm has less ability to invest in R&D to improve its offerings.

Figure 3: ACIW’s Profitability Lags Behind Competition

NewConstructs_ACIW_PeerComparison_2016-06-20

Sources: New Constructs, LLC and company filings 

Bull Hopes Rest On Optimistic Assumptions Regarding Backlog Value

As revenue growth has slowed since 2014, as can be seen in Figure 1, bulls are left with few options: rely on ACIW’s ability to grow without acquisition and/or believe that the acquisitions will start adding economic value in the near future. Unfortunately for investors, growth without acquisition has been hard to come by, as the company’s TTM revenue is only marginally higher than 2014 revenue and organic revenue growth has been in the low single digits or, worse yet negative, as it was in 2014. Consensus estimates for revenue do not point to much of an improvement.

Buying into the potential profits windfalls from the recent acquisitions requires large assumptions, ones that are no sure bet. Specifically, we’re talking about ACIW’s 60-month backlog, which is essentially ACIW’s expected revenue over the next 60-months from existing contracts. We previously saw a backlog valuation prop up SolarCity’s (SCTY) stock’s valuation when analyzing its “retained value” metric. Though the business models are different, both backlogs require optimistic assumptions to justify their value.

Specifically, the key assumptions for ACIW’s 60-month backlog include:

  1. Maintenance fees are assumed to exist for duration of license term, even if committed maintenance term is less than license term.
  2. Non-recurring license agreements are assumed to renew as recurring revenue streams.
  3. Foreign currency exchange rates are assumed to remain constant over the 60-month period
  4. Pricing policies and practices are assumed to remain constant
  5. License, facilities management and software hosting are assumed to renew at the end of their committed term at a rate consistent with historical experiences.

While on their own, each assumption may not be hard to trust. But, bulls are taking a lot of risk that all assumptions will hold true over such an extended time. If the backlog is overstated, the future profitability of ACIW could be viewed much lower, which likely hurt the stock. As we’ll show below, the current valuation implies revenue and profit growth much faster than what has occurred in the past and well above consensus expectations.

Acquisition Hopes Rest On Overpayment

The biggest risk to our thesis is that a larger competitor acquires ACIW at a value at or above today’s price. As we’ll show below, unless a competitor is willing to destroy shareholder value, an acquisition at current prices would be unwise.

We don’t think ACIW is an attractive acquisition target at its current price. To begin, ACIW has liabilities that investors may not be aware of that make it more expensive than the accounting numbers suggest.

  1. $72 million in off-balance-sheet operating leases (3% of market cap)
  2. $39 million in outstanding employee stock options (1% of market cap)

After adjusting for these liabilities we can model multiple purchase price scenarios. Unfortunately for investors, only in the most optimistic of scenarios is ACIW worth more than the current share price.

Figures 4 and 5 show what we think Fiserv (FISV) should pay for ACIW to ensure the deal is truly accretive to ACIW’s shareholder value. Fiserv could be a potential acquirer of ACI Worldwide to jump-start its software as a service offerings and boost its cross-selling opportunities within the financial services and payments market. However, there are limits on how much

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