Epiq
EPIQ Systems
Hidden Gem by Bill Mann
Risk-Level Rating: Medium
• A classic "boring business," the company specializes in bankruptcy and class action case management.
• Inside ownership is high, with the Olofson family controlling 25% of shares.
• Recent acquisitions have muddied results, presenting a spectacular buying opportunity.
Nasdaq: EPIQ
501 Kansas Ave.
Kansas City, KS 66105
Ph: 913-621-9500
www.epiqsystems.com
(Except price, amounts in millions)
Recent share price:$16.66
Market Cap:$298.1
Cash/Debt:$8.5/$71.0
Owner Earnings Run Rate:$24.4
Buy-Around Price: $17.20So far in Hidden Gems, we've recommended several companies that deal in misery: fire insurance (United Fire), terrorism insurance (Montpelier Re), death (Alderwoods), and collections (Portfolio Recovery). With this pick, we sidle a little closer to the grave dancers, seeking this time to profit from bankruptcy and class action lawsuits.
It may make some uneasy to even think about benefiting from tragedies like bankruptcy. However, I consider it an integral and beneficial part of the capital cycle. Japan, for example, remains in a 15-year recession because the government props up unprofitable companies rather than let them reorganize or die. It is not a pleasant process, least of all for the debtors. But we're not talking about becoming vulture investors by scavenging scraps from the downtrodden. We are investing in a company whose products help manage the process.
The Business
EPIQ Systems (Nasdaq: EPIQ), based in Kansas City, Kan., is a technology and software company that helps clients manage the complex processes of personal and corporate bankruptcy cases, class action suits, and other mass litigation. Its customers include bankruptcy trustees, law firms, corporations, and government agencies.
EPIQ's services automate many administrative tasks required during the bankruptcy and lawsuit management processes, including document and financial record management, filing, and asset and creditor tracking. Its proprietary software-driven system ensures timely and accurate administration of documents associated with complex bankruptcies and lawsuits. CEO Tom Olofson acquired the company soon after its founding in 1988 and holds more than 17% of shares. His family owns nearly 25%.
EPIQ's products are aimed at three types of bankruptcy: Chapters 7, 11, and 13. Chapter 7 (total liquidation) is most common, making up 71% of about 1.6 million bankruptcies in 2004. Chapters 9 and 11 are municipality and business reorganizations and account for 1% of all filings, while Chapter 13 is a reorganization format for individuals and represents 28% of total filings.
For Chapter 11 reorganizations, the "debtor in possession" (or the company itself) uses EPIQ. For liquidations, EPIQ is not paid by the companies or people in bankruptcy. Its clients are the managers of the bankruptcy process: trustees, law firms, and administrators. In these cases, EPIQ is paid a percentage of the asset proceeds. The trustee that elects to use EPIQ incurs no direct charge for using its services. EPIQ maintains marketing agreements with banks, which provide the trustee with the company's products in conjunction with deposit-related banking services. Until April 2004, EPIQ had an exclusive agreement with Bank of America (NYSE: BAC), but has since signed with other banks. Consulting firm Towers Perrin estimates that administration costs for class action suits exceeded $50 billion in 2004.
Also in 2004, EPIQ acquired Poorman-Douglass for $116 million in cash. Poorman-Douglass' services include notice printing, call centers management, and claims processing for large, complex class action suits that can take years to resolve. While other businesses offer bankruptcy administration services, they offer EPIQ's core case management suite little competition.
The Financials
Unfortunately, two factors make EPIQ's financial situation a bit convoluted: multiple acquisition and divestiture of assets and complex financial transactions. It's not as complicated as it seems, but beware making easy comparisons. For example, though top-line revenues grew 87% in 2004, net profits were stagnant. Remember, however, that EPIQ acquired Poorman-Douglass in January 2004 and disposed of its infrastructure software business that April. Attendant in that purchase are substantial revenues from reimbursed expenses, which are earnings neutral to EPIQ. In 2004, revenues totaled $125 million. Backing out reimbursements, EPIQ made $105 million in sales, $43 million (69%) higher than in 2003. Earnings were $0.52, versus $0.48 for 2003.
Also that year, EPIQ took on a $50 million convertible debt issue for the acquisition, which caused a spike in diluted shares outstanding, from 18 million up to 21 million. This is an accounting rule, and does not mean that share count has suddenly spiked. EPIQ is experiencing rapid growth, and has taken on a little debt in its acquisition of complementary companies.
The Valuation
Cash flow is where EPIQ shines. For 2004, it made more than $34 million in free cash flow (adjusted for some one-time events related to various corporate transactions). Its cash-generating capabilities clearly eclipse its less exciting earnings power. Not to overstate its one-year performance — as its results on a year-to-year basis vary greatly — but I believe this company is undervalued on current operations by 10% to 40%. As long as the market for its products remains as fertile as it appears it might, EPIQ's growth potential becomes, well, epic.
And just as we focus on cash generation, so does its management. In the most recent conference call, Olofson noted that cash from operations is its main performance metric. Even with additional debt, EPIQ currently trades at an enterprise value-to-free cash flow multiple of about 12. If every conversion warrant were exercised, EPIQ would still only trade at a multiple to free cash flow of 15. I'd expect these valuations from low-margin, low-growth behemoths in debt, not one with considerable growth prospects in a high-margin business. I can only assume that the market regards the reduction in margins and earnings as signs of a weakening business, not those of a changed one.
The Risks
People mistakenly confuse government laws with natural law. The rules could change, as they did when President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act this year, and every time EPIQ may be adversely (or positively) affected. At a minimum, each time laws change, the company must adjust its offerings accordingly. And the laws will continue to change. I've picked EPIQ to serve as a countercyclical. It may well suffer if the economy picks up steam and corporate and personal bankruptcies drop. However, today's debt levels are an almost foolproof indicator of future bankruptcy filings. According to the Federal Reserve, individual and corporate debt has risen from already-high levels in 2004.
Another risk is EPIQ's number of acquisitions. While these businesses seem perfectly suited for one another, a company that grows through acquisition may still blow it. EPIQ took on debt to finance its operations after it bought Poorman-Douglass, a transaction that fundamentally changed EPIQ's business mix.
Conclusion
Bankruptcy and class action cases won't be going away, and they've only become more complicated. Investors like us can make money on the process of getting people and companies back on their feet or liquidating their assets. Why not? I'm certain EPIQ is going to.
EPIQ Systems
Hidden Gem by Bill Mann
Risk-Level Rating: Medium
• A classic "boring business," the company specializes in bankruptcy and class action case management.
• Inside ownership is high, with the Olofson family controlling 25% of shares.
• Recent acquisitions have muddied results, presenting a spectacular buying opportunity.
Nasdaq: EPIQ
501 Kansas Ave.
Kansas City, KS 66105
Ph: 913-621-9500
www.epiqsystems.com
(Except price, amounts in millions)
Recent share price:$16.66
Market Cap:$298.1
Cash/Debt:$8.5/$71.0
Owner Earnings Run Rate:$24.4
Buy-Around Price: $17.20So far in Hidden Gems, we've recommended several companies that deal in misery: fire insurance (United Fire), terrorism insurance (Montpelier Re), death (Alderwoods), and collections (Portfolio Recovery). With this pick, we sidle a little closer to the grave dancers, seeking this time to profit from bankruptcy and class action lawsuits.
It may make some uneasy to even think about benefiting from tragedies like bankruptcy. However, I consider it an integral and beneficial part of the capital cycle. Japan, for example, remains in a 15-year recession because the government props up unprofitable companies rather than let them reorganize or die. It is not a pleasant process, least of all for the debtors. But we're not talking about becoming vulture investors by scavenging scraps from the downtrodden. We are investing in a company whose products help manage the process.
The Business
EPIQ Systems (Nasdaq: EPIQ), based in Kansas City, Kan., is a technology and software company that helps clients manage the complex processes of personal and corporate bankruptcy cases, class action suits, and other mass litigation. Its customers include bankruptcy trustees, law firms, corporations, and government agencies.
EPIQ's services automate many administrative tasks required during the bankruptcy and lawsuit management processes, including document and financial record management, filing, and asset and creditor tracking. Its proprietary software-driven system ensures timely and accurate administration of documents associated with complex bankruptcies and lawsuits. CEO Tom Olofson acquired the company soon after its founding in 1988 and holds more than 17% of shares. His family owns nearly 25%.
EPIQ's products are aimed at three types of bankruptcy: Chapters 7, 11, and 13. Chapter 7 (total liquidation) is most common, making up 71% of about 1.6 million bankruptcies in 2004. Chapters 9 and 11 are municipality and business reorganizations and account for 1% of all filings, while Chapter 13 is a reorganization format for individuals and represents 28% of total filings.
For Chapter 11 reorganizations, the "debtor in possession" (or the company itself) uses EPIQ. For liquidations, EPIQ is not paid by the companies or people in bankruptcy. Its clients are the managers of the bankruptcy process: trustees, law firms, and administrators. In these cases, EPIQ is paid a percentage of the asset proceeds. The trustee that elects to use EPIQ incurs no direct charge for using its services. EPIQ maintains marketing agreements with banks, which provide the trustee with the company's products in conjunction with deposit-related banking services. Until April 2004, EPIQ had an exclusive agreement with Bank of America (NYSE: BAC), but has since signed with other banks. Consulting firm Towers Perrin estimates that administration costs for class action suits exceeded $50 billion in 2004.
Also in 2004, EPIQ acquired Poorman-Douglass for $116 million in cash. Poorman-Douglass' services include notice printing, call centers management, and claims processing for large, complex class action suits that can take years to resolve. While other businesses offer bankruptcy administration services, they offer EPIQ's core case management suite little competition.
The Financials
Unfortunately, two factors make EPIQ's financial situation a bit convoluted: multiple acquisition and divestiture of assets and complex financial transactions. It's not as complicated as it seems, but beware making easy comparisons. For example, though top-line revenues grew 87% in 2004, net profits were stagnant. Remember, however, that EPIQ acquired Poorman-Douglass in January 2004 and disposed of its infrastructure software business that April. Attendant in that purchase are substantial revenues from reimbursed expenses, which are earnings neutral to EPIQ. In 2004, revenues totaled $125 million. Backing out reimbursements, EPIQ made $105 million in sales, $43 million (69%) higher than in 2003. Earnings were $0.52, versus $0.48 for 2003.
Also that year, EPIQ took on a $50 million convertible debt issue for the acquisition, which caused a spike in diluted shares outstanding, from 18 million up to 21 million. This is an accounting rule, and does not mean that share count has suddenly spiked. EPIQ is experiencing rapid growth, and has taken on a little debt in its acquisition of complementary companies.
The Valuation
Cash flow is where EPIQ shines. For 2004, it made more than $34 million in free cash flow (adjusted for some one-time events related to various corporate transactions). Its cash-generating capabilities clearly eclipse its less exciting earnings power. Not to overstate its one-year performance — as its results on a year-to-year basis vary greatly — but I believe this company is undervalued on current operations by 10% to 40%. As long as the market for its products remains as fertile as it appears it might, EPIQ's growth potential becomes, well, epic.
And just as we focus on cash generation, so does its management. In the most recent conference call, Olofson noted that cash from operations is its main performance metric. Even with additional debt, EPIQ currently trades at an enterprise value-to-free cash flow multiple of about 12. If every conversion warrant were exercised, EPIQ would still only trade at a multiple to free cash flow of 15. I'd expect these valuations from low-margin, low-growth behemoths in debt, not one with considerable growth prospects in a high-margin business. I can only assume that the market regards the reduction in margins and earnings as signs of a weakening business, not those of a changed one.
The Risks
People mistakenly confuse government laws with natural law. The rules could change, as they did when President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act this year, and every time EPIQ may be adversely (or positively) affected. At a minimum, each time laws change, the company must adjust its offerings accordingly. And the laws will continue to change. I've picked EPIQ to serve as a countercyclical. It may well suffer if the economy picks up steam and corporate and personal bankruptcies drop. However, today's debt levels are an almost foolproof indicator of future bankruptcy filings. According to the Federal Reserve, individual and corporate debt has risen from already-high levels in 2004.
Another risk is EPIQ's number of acquisitions. While these businesses seem perfectly suited for one another, a company that grows through acquisition may still blow it. EPIQ took on debt to finance its operations after it bought Poorman-Douglass, a transaction that fundamentally changed EPIQ's business mix.
Conclusion
Bankruptcy and class action cases won't be going away, and they've only become more complicated. Investors like us can make money on the process of getting people and companies back on their feet or liquidating their assets. Why not? I'm certain EPIQ is going to.
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