Exela Technologies is the rebirth of a Corp that was initially a special purpose acquisition company. The company now operates in the transaction intensive segment of the business process outsourcing industry. Investors have been skeptical of the company because of its short operating history as a public company, and the lack of clarity around its financial position as the company undertook a number of mid-year M&A deals. Further, the company's high debt levels pose some risk. Consequently, the company is materially undervalued relative to its peers, and its potential. Nevertheless, with its strong predictable free cashflows, and increasing clarity around its financial position, the company will likely service its debt, and see its valuation approach fair value over time.

Special Purpose Acquisition Companies (SPACS) are known for their complexity and often maligned incentive structure. They are often brought to life by principals (hedge funds, entrepreneurs, and private equity companies) who set up the legal structure and fund the company with cash. These entities often share the typical corporate governance structures of regular operating companies, such as an audit committee, and a compensation committee. The company is then permitted to raise additional capital from the public through an IPO, under certain restrictions. Usually, the founders of the SPAC are required to maintain upwards of 20% of the post-IPO equity, and make a qualifying transaction within a specified time. The concept of qualifying transactions limits the range of deals that can be done post-IPO. If the requirements are not met by the appointed time, the structure must be liquidated.

The prudent investor would have already realised why this structure can incentivise the wrong behaviour. SPACs are capitalised before any business model is identified, and there is a time limit on when a deal can be consummated. The principal is incentivised to consummate a deal quickly, sacrificing prudence for speed. The principal would then wait a few months before selling, to minimise the risk to his/her 20%, leaving us to hold the 'hot potato'.

How Did It All Start

Exela Technologies started out as special purpose entity created for the sole purpose of acquiring a legitimate business in the specialty chemicals industry. The company was conceived in July 15, 2014 as Quinpario Acquisition Corp. 2. Quinpario Acquisition Corp 2 was fathered by Jeffry N. Quinn, and his partners after they successfully raised US$175 Mn through their first child -- Quinpario Acquisition Corp. 1. Quin and most of his partners came from Solutia Inc. (formerly NYSE: SOA), a global specialty chemical and performance materials company, following its sale to Eastman Chemical Company (NYSE: EMN).

Through Quinpario Acquisition Corp 2, Mr. Quin and friends raised US$350 Mn from the public and shortly thereafter planned to consummate a transaction. The potential target had to have: 1) an enterprise value between US$700 Mn and US$2 Bn, 2) net tangible assets of at least US$5 Mn, 3) a definitive purchase agreement signed within 24 months from the closing of the IPO. If unable to consummate the business combination within 24 months, as promptly as possible but not more than ten business days thereafter, the principals would redeem 100% of the outstanding public shares and then seek to dissolve and liquidate. 4) Pursuant to Nasdaq listing rules, the initial business combination must be with a target business or businesses whose collective fair market value is at least equal to 80% of the balance in the trust account at the time of the signing of a definitive purchase agreement.

Tic toc tic toc, as the clock winded down Mr. Quin apparently found it difficult to get a deal at the right price, and so he decided to give the SPAC up for adoption. On September 1, 2016, Jeffry N. Quinn resigned from board of directors of the Company. On January 13, 2017 and January 17, 2017, Quinpario Acquisition Corp. 2 announced a non-binding letter of intent to acquire and combine Novitex and SourceHOV both of which operated in the transactions processing segment of the business process outsourcing industry (BPO). The deal was structured such that Quinpario became minority owners in a new corporation called Exela Technologies Corp, and the new parents would own 75% when they rolled their equity into the new corp.

At the time, Novitex was owned by certain funds managed by affiliates of Apollo Global Management (AGM) LLC, while SourceHOV was majority owned by HandsOn Global Management (HGM - a family office). SourceHOV is a business process outsourcing company with a long history of M&A and private equity ownership. At one point it was solely owned by AGM then ownership passed to The Rohatyn Group and AGM, then to HGM. Apollo Global Management acquired Pitney Bowes Management Services (PBMS) from Pitney Bowes for $400 million in late 2013 and renamed it to Novitex.

The Opportunity

With such a complicated family history, a number of material business transactions, and high debt, it is not surprising that the stock declined precipitously after these transactions were announced. The lack of clarity was further complicated by management's purportedly "sketchy" communications that engendered a lack of trust. In addition, one insider of the company recently disposed of 7% of his interest in company in a secondary offering in April-18. The stock declined from roughly US$10 per share to US$4.47 as at May 28, 2018 (reflecting fear). The most important question however, is what are these businesses worth when put together. We think they are worth a lot more than US$4.5 per share for a number of reasons.

We think the business it worth between US$6.0-US$11.0 per share given the track record, and status of the lead shareholders, the nature of the business and its industry, its conservative valuation, and low risk of bankruptcy. All of these factors point to more upside than downside and we like that. We also expect that the true financial position of the company will become clearer with the anniversary of merger related transactions, and synergies. This will likely bolster investor confidence in the future of the company.

The Lead Shareholders and Insiders

The top 5 insiders own 75% of the company even after recent selling is taken into account, and they are very experienced in the business process outsourcing industry. Approximately 51% of the company is owned by EX-Sigma 2 LLC/Chadha Par, 18% by Apollo Global Management, and 5% by Jeffry N Quinn. Only a few legacy directors associated with the SPAC have been selling significant amounts. Jeffry N Quinn himself has sold only a small amount (roughly 5% of his position). Apollo Global Management and EX-Sigma both have sold approximately 7% of their holdings. We think that this spotty selling does not reflect negative sentiment around the business. Additionally, a number of institutional investors have been slowly building big positions in the company, one of which is David Einhorn's Green Light Capital which has amassed a 6% stake in the company (Source: US SEC Form 4 Filings, compiled and analysed using our big data analytics platform-- Aporak).

Top 5 Insider Ownership as at May 17, 2018

Who are the Lead Shareholders?

Apollo Global Management is reportedly the second largest private equity fund in the world, with asset under management (AUM) of approximately US$249 Bn -- a size rivalled only by Blackstone Private Equity. The company was founded by Leon Black -- a Michael Milken alumni -- and purported value investor. The company engages in various type of investments across the capital structure of businesses, including credit, equity, and mezzanine (Source: corporate website). Below we have a podcast of Leon Black explaining his investment philosophy to investors.

EX-Sigma 2 LLC is a fund operated by Par Chadha, Chief Executive Officer and Chief Investment Officer of HGM. According to Par Chadha's LinkedIn page, and the website of his family office, he has over:

40 years of experience building and operating businesses in the Americas, Europe and Asia, including execution of mergers and acquisitions, integration of businesses and public offerings. Par serves as chairman of a Exela technologies, Inc. (Nasdaq:Xela) since July, 2017. Par has served as Chairman of SourceHOV since 2011 and was Chairman of Lason Inc. from 2007 to 2011 until its merger with SourceCorp, a predecessor company of SourceHOV. Since 2005, Mr. Chadha has served as a Director of HOV Services Limited(NSE:HOVS), a company listed on the National Stock exchange of India, acting as its Chairman from 2009 to 2011.

He is also:

co-founder and owner of Rule 14, LLC, a leading big data mining and automation company formed in 2011, and during his career, Mr. Chadha has founded or co-founded other technology companies in the fields of metro optical networks, systems-on-silicon and communications. forming a market-leading business process outsourcing platform with expertise in financial technology, information services and data processing.

Some of the executives at Exela Technologies are also principals at the HGM family office. For example, Jim Reynolds who is listed as COO and Partner at HGM is also listed as Chief Financial Officer at Exela, Ronald Cogburn who is principal at HGM is the CEO of Exela Technologies. Some may argue that there are conflicts of interest here, however when one person owns 51% of a company he will surely will have a vested interest in making it work for all shareholders.

The Nature of the Business and its Industry

Exela Technologies sits at a sweet spot in the value of chain of businesses that are heavily reliant transactions processing and automation, such as financial institutions and health care providers. Generally, we are captivated with these kinds of businesses for several reasons. Most importantly, it takes a customer a number of years to move off the platform that these companies provide, because these platforms are intimately integrated into the service offerings of these customers. The drawback is that these businesses typically have long sales cycles, but once a good relationship is established with a customer it is very hard to replace it. In addition, many companies globally are moving to more automation to reduce cost and increase service standard reliability. These two forces put together lead to growing predictable recurring revenues and cash flows.

In the case of Exela Technologies, our internal estimates for annual revenues is about US$ 1.5Bn as at 2017 (more on why we use estimates later), with recurring EBITDA (adjusted for one-off expenses) is estimated at US$295Mn, leading to an estimated EBITDA margin of approximately 16.5%. The company is segmented into three business units: Information Transactions Processing Solutions (79% of revenues), Health Care Solutions 14.9%, and legal and Loss Prevention Services (5.8%). The company also have a 95% renewal rate on strategic accounts, which we would adjust downwards to 85% to reflect uncertainty around what the word "strategic" means. In any case the company has a very diverse clientele, with 6 clients generating greater than 25 million in revenues, and 197 clients generating between US$1Mn and US$5Mn in revenues. This give us a big degree of confidence around the visibility of revenues and the predictability of cashflows. Revenue per employee stood at US$68,181 which is somewhat above average for businesses in this space. Capital expenditure intensity is low at approximately 2%-5% of 2017E revenues. By all accounts, this business would be a "Blue Print" leverage buyout candidate.

Now, The Problem

As is the case with most things associated with private equity, the company is highly levered, with Debt service coverage ratio of 5.5x (vs industry average of around 2.0x). In addition, the company has a fairly short operating history as a public company, and several M&A transactions occurring mid-year. The company itself was formed in a 3-part business combination that occurred in the middle of the previous fiscal year (FY-17). On top of that the company did one small disposition in FY-17 and made one tuck-in acquisition FY-18 . These transactions ultimately lead to one-off merger related costs, and generally messy financial statements that are very difficult to understand. Pro forma estimates are required to get a full picture of the status of the business.

Conservative Valuation

We like this business as an investment because the current valuation gives us a strategic advantage to make a profit. Though a profit is not guaranteed, the downside from this price level appears small. At US$4.5 per share the company trades at 7.0 X consensus 2018 EBITDA, which is very conservative multiple for this kind of business. Although most competitors are less indebted, good performing businesses in this industry trade at 10x-15x next fiscal year EBITDA, with a median of 12X. Adittionally, the EBITDA estimates used here is likely to under estimate actual EBITDA for FY-18. At the low end we expect adjusted EBITDA to come out at US$260, which still gives us a degree of downside protection. The company's 10-Q filings indicated that the company grew revenues by 8.7% Y-o-Y in Q1 of FY-18, relative to the same period a year earlier. Adjusted EBITDA (adjusted for non-recurring expenses) grew by 10.9%, representing a 17.7% EBITDA margin over the same period. Even more compelling is the fact that management has up their guidance for revenues, EBITDA and cash flows for full year FY-18. Revenues are expected fall between $1.55Bn to $1.58Bn, a pro forma growth of 6.5% to 8.5%. Adjusted EBITDA is now anticipated at around $310Mn, a pro forma Y-o-Y growth of 20% to 26%.

Comparable Companies: Exela Technologies

Usually in leverage buyouts, a substantial portion of the expected return on investment comes from the repayment of debt. Typically, private equity expected annual return at the portfolio company level is around 30%. So even if we assume that EBITDA remains fairly flat, the return on investment is likely to be substantial.

On top of this is the fact that management expects to obtain synergies which could push the EBITDA to management's "further adjusted" EBITDA estimate of $330 million to $355 million or a margin of 21% to 22%. This "further adjusted" assumes synergies of $40 million to $45 million in savings in 2018 alone. This would put the EBITDA margin way above its peers so were are a bit sketical of this number. In the long-term management expects to see revenue growth in the range of 3% to 4%, adjusted EBITDA margin guidance in the range of 22% to 23%, and adjusted free Cash Flow conversion in the range of 87% to 89%.

The table below allows our readers to recalculate the stock price with changes in the EBITDA estimate, and the enterprise value multiple. As can be seen, reasonable estimates for the EBITDA and the multiple would put the valuation of the company within the range US$7.0-US$11.0 per share. Enter your own estimates to get comfortable with the valuation.

Low Likelihood of Bankruptcy

In light of the company's high debt levels we would be irresponsible if we didn't consider the possibility that the company could go bust. Though the threat is real, we think it is an unlikely scenario, even within a context where the economy is benign. The nature of the business model, as explained earlier, is such that the volatility of revenues and cashflows are low. The company generates recurring revenues of between 85% to 95%. It takes a customer a very long time to move off their platform, which makes losing clients very hard. Furthermore, the maturity profile of the debt is stretched out. Over the first 5 years debt payments amounts to an annual average of US$18Mn. In July, 2023 (the 6th year) the company will have to pay US$ 1.3Bn in debt. So, what we have is a company with Debt service coverage ratio of 5.0x with the bulk of the debt maturing in 6 years, and with strong steady free cash flows. In addition, only 23% (US$300Mn) of the debt is variable rate, and management has recently taken on a fixed for variable rate SWAP to keep the interest cost fixed as rates rise.

Final Thoughts

Exela Technologies' limited public operating history, and high debt pose some degree of risk to investors. Nevertheless, we are encouraged by the company's strong and steady free cash flow, and extended debt profile, which put the company's management in a fairly comfortable position. The stock currently trades below fair market value, and we share ownership with lead investors who are heavily incentivised to ensure that value accrues to all shareholders. With continue growth revenues and EBITDA, and more clarity around the real financial position of the company, there is a highly likelihood that the stock will approach fair value.