News has leaked of a group of private equity (PE) companies bidding on NCR, with Warburg Pincus leading the way. By going private, NCR has a great shot at turning itself around and delivering value to its customers. (By the way, what does it say about NCR if Blackstone, the PE that put $800M of debt into the company and took two board seats, doesn’t buy it?)
But there’s a better-than-coin-flip chance NCR screws it up. Again.
If you recall, activist investors rightly pushed (in our opinion, at least) NCR to go private in 2015. Despite offers from several PE firms, none closed a deal because NCR had too much hair. For memory’s sake, Blackstone and Carlyle teamed up for a $10B offer and Apollo and Thoma Bravo formed a consortium to bid on NCR as well.
We think it’s important to understand the mechanics of taking a company private, and what role PE firms play, before going much further.
For starters, PE firms acquire assets with a mix of equity (cash) and debt (borrowed capital). PE was a very attractive asset class in the 1980’s because they could borrow money for cheap (let’s say 3% interest), invest that capital in a company, sell out of the company, and make a handsome profit on the capital they borrowed at 3%. In this way PE firms lever debt to increase the amount they can pay for companies. This is not without risk, of course, but using leverage gives PE funds much more purchasing power.
If you look at the bids NCR garnered in 2015 you’ll notice that it’s not one PE fund bidding on NCR but a consortium. Why is that?
PE funds raise, well, funds. They’ll traunch capital together from a number if investors (an investor in a PE fund is called a Limited Partner, or LP) and put a name on the fund: usually something like Fund 1, Fund 2, etc. We never said they were creative.
Fund sizes have been growing over the past few years as governments around the world dropped interest rates. When investors could no longer earn decent returns on debt instruments, capital flocked to private markets. So while bonds might return 2-6%, private equity aims to return 15%+. When governments pushed down interest rates to 0%, money had to move to find a return. See below graphic.
Even so, in July of 2015 when NCR was fielding bids they had an enterprise value (EV) of roughly $8.3B. This would be far too large for any one PE fund to stomach. (You can look at the largest funds ever raised in history – they’re only getting larger as returns accrete to the private markets and bypass public investors thanks to the government!). Thus funds pool resources when looking at larger deals.
How much of a PE transaction will be financed by debt? In the case of NCR, one of the funds bidding in 2015 was going to finance the deal with 6.5x EBITDA worth of debt. The higher the debt ratio the cheaper the transaction, but also the more risky the deal becomes. Lower risk companies generally find higher amounts of debt heaped on. In PE parlance this is called “turns of debt”, with a “turn” being 1x company EBITDA. So if a company was doing $10M in EBITDA, 5 turns would be $50M of debt.
When PE funds take a company private they offer a market premium, meaning that they buy the shares at a price higher than they’re trading in the public equities market. There are caveats for distressed assets, but usually boards won’t approve a takeover unless shareholders get a good return.
Today, NCR has an EV of $7.4B.
This is up from where it was last year, but not because NCR has seen any material growth: it’s mostly because the market is up over the same period of time. NCR’s Q1 2018 revenues were $1.52B and NCR’s Q1 2019 revenues were $1.54B, a trivial rise of 1.3%. Meanwhile the S&P has gone from 2,700 to 2,880, or up by 6.25%, over the same period of time.
For the record, the S&P has gone from 2,100 in July of 2015, when NCR was receiving bids, to 2,880 today. In objective terms, it makes NCR’s board and management look really dumb for passing on a potential acquisition.
NCR’s real problems, however, get remedied if it can go private.
NCR’s management are incentivized to increase share prices. While creating value for customers is usually rewarded by higher share prices, they’re not always related. In NCR’s case, they’re entirely disjointed.
Currently, NCR is on the path of multiple arbitrage: they’re taking a company that sells software on a one-time basis and trying to convince their customers to pay a recurring fee for the same goods. The reason for doing so is a one-time software business gets a 1x revenue multiple while a recurring software business commands a ~8x revenue multiple.
Unfortunately for NCR’s customers the software is not getting any better, and the customer experience is not improving. Instead, NCR is rushing to add other solutions that can squeeze more dollars of their customers (think JetPay for payments processing) without fixing their existing problems. This is classic short-termism and why some are creating a new stock market that rewards long-term thinking.
You can read NCR’s CEO’s compensation plan if you want to see how short-termism is structured:
In connection with his appointment, the Company and Mr. Hayford entered into a letter agreement, dated April 27, 2018, under which he will receive an annual base salary of at least $1,000,000, and participate in the Company’s Management Incentive Plan with a total annual cash target bonus opportunity of 150% of his base salary. For the 2018 year, Mr. Hayford’s cash bonus will be no less than the pro-rated portion of his target bonus amount. He will also receive new hire equity awards of stock options with a total award value equal to $2,500,000 (the “Sign-On Options”), stock options with a total award value equal to $5,000,000 (the “2018 Options”), and time-based restricted stock units with an award value equal to $5,000,000 (the “2018 RSUs”), with each such award being the subject of a separate grant agreement. He will also be eligible for future annual equity grants under the Company’s Long-Term Incentive Program which, for each of 2019 and 2020, will include awards with an aggregate value of no less than $10,000,000, and which, for 2019, will be increased to a minimum of $12,500,000 if NCR’s common stock trades at $40 per share or more for at least fifteen consecutive trading days during the period from May 1, 2018 through February 15, 2019. Mr. Hayford will participate in the NCR Executive Severance Plan with a separation benefit of one and one half times (1.5x) his annual base salary and target bonus (as defined in the plan) in the event of a qualifying termination, and will participate in the Amended and Restated NCR Change in Control Severance Plan with a “Tier I” benefit level. In addition, if Mr. Hayford is terminated without “cause” or resigns from NCR voluntarily for “good reason”, the unvested portion of the Sign-On Options, 2018 Options and 2018 RSUs will immediately vest, and the Sign-On Options and 2018 Options will remain exercisable until the earlier of the first anniversary of the termination of his employment and the option expiration date. Mr. Hayford also will be entitled to certain other perquisites, including limited personal use of corporate aircraft. The agreement also contains customary employment terms and conditions, and in-term and post-term restrictive covenants applicable to Mr. Hayford
Given the short term view, NCR is not investing enough R&D to stay relevant, especially if it wants to be a real data or software innovator (see below from Connected Payments awesomeness).
If NCR were to invest heavily in R&D and fix its problems, earnings would fall, management would get axed, and a PE consortium would surely win the battle to go private.
Even though this is the best outcome for NCR’s customers and the company longer term, NCR’s management (and board of directors, sadly) are not incentivized to innovate. By going private the PE funds can bring in a suitable management team and make the requisite investments to save the company.
It’s really that simple.
If you were to ask us what to do, it’s straightforward.
- Carve up the company. Retail, Restaurant, and Finance are very distinct business units. Retail and Restaurant could be bundled as a combined entity, but including Finance makes no sense. Split up the assets
- Replace management with software/data entrepreneurs and start an apology tour. When you talk with NCR’s own Aloha Advisory Board, 80% of them have plans to leave the software in the next two years. What does that say about faith in the brand and ability to make good on (apparently hollow) promises over the past decade? Admit your problems and hire leadership that will actually get things done. Put a vision in front of the customers and give them permission to fire you if you don’t solve their problems by an agreed-upon deadline
- Simplify the hell out of the org chart. If you saw how matrixed NCR was you’d quickly understand why nothing gets executed. Breaking the company into business units is a start, but there are tons of issues around product, innovation, and engineering ownership. How can startups build replacement POS systems with a few million dollars while NCR burns hundreds of millions in R&D with nothing to show for it? Irresponsible capital allocation, hubris, and apathy for results – that’s the simple answer. Here’s the fix: engineers report up to product managers. The end. No buy-in required from 1,000 different groups to make a decision. The TMT division of any respectable PE fund should know how to organize a software company that can execute, and none of them would come away with the org chart NCR currently employs
- Slash the company workforce and invest the savings into R&D. The R&D must first be directed towards fixing the core products. Everyone wants to rush into new revenue growth at higher multiples but what good does that do if your core offering is useless? PE funds need to own this asset for five years: if you don’t fix the core issues there will be nothing left to arbitrage when you need liquidity. It will take two years to fix the POS assets so if you can’t commit to that, don’t buy the business
- Partner with third parties for everything else. If you want to buy or cannibalize them later fine, we can have that conversation, but it’s nonsensical to waste time with meetings whose agenda is choosing new wall colors while your house is burning to the ground
- Change the culture. This comes from the top down. Hiring new leadership that is open, transparent, and innovative will do wonders for company morale, productivity, and trickle through to customer success. Seriously, NCR’s NPS (net promoter score) from the restaurant brands we interviewed that collectively represented over 10,000 Aloha locations was -71. -71! If you sold a literal pile of shit at least someone would use it as fertilizer and give you a positive review. This is simply amazing
NCR’s bloat and product irrelevance is a byproduct of inertial complacency. With a chance at a fresh start, why not do it right from day one?
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