Quan’s Avid Hog Watchlist: EPIQ Systems (EPIQ)

by Quan Hoang

I found EPIQ Systems (EPIQ) in a list of companies whose share price compounded more than 10% a year since 1999. The market cap was $46 million at some time in 1999. The market cap today is $480 million.


Sales and Cash Flow Compounded More Than 15% Over the Last 10 years

EPIQ’s 10-year financial result is attractive. Gross margin was always higher than 50% although it’s been very volatile between 54% and 70%. From 2003 to 2012, sales compounded 17% and EBITDA compounded 8% a year.

EBITDA growth lags behind sales growth because of the decline in margin. This can be either a good or a bad sign. It’s possible that EPIQ can improve EBITDA margin so near-term earnings growth will surpass sales growth. It’s also possible that the company got into less profitable businesses or competition hurts margin.

In either case, EPIQ’s growth profile attracted me.

Also, I saw a nice trend in cash flow from operation (CFFO). CFFO grew from $20.6 million to $73.4 million in 2012. That’s over 15% annual growth. CapEx has quite a similar trend so I think current CapEx is normal.

Free cash flow in 2012 was $51.2 million. The current market cap is $480 million. That’s a very attractive price for a growth company.

Some other points I noticed from my quick glance at EPIQ’s 10-year financial result include:

  1. Share count increased from 26.4 million in 2003 to 35.9 million in the last quarter. This is a bad sign. They issued about $88 million equity in 2007 and repurchased $43 million. I think they also issue a lot of stock options. That would explain the gap between EBITDA growth and CFFO growth.
  2. They occasionally make acquisitions. They spent $267 million in acquisition from 2003 to 2005. They focused on the core from 2006 to 2009. They spent $52 million in 2010 and $167 million in 2011.
  3. Net increase in debt coincided with the acquisitions.


EPIQ Systems May Have Loyal Customers

Overall, I think it’s worth looking further at EPIQ. I went to the website and checked the investor relations page. I downloaded “EPIQ In A Nutshell” and read it.

That’s a nice introduction about EPIQ. It got me immediately interested in the eDiscovery business.

In a legal matter or dispute, there’s a need to collect evidence in computerized formats like emails, scanned hard copy pages, audio/video recordings, etc. EPIQ collects the evidence, sifts out the irrelevant data, and converts data in different formats into a common format. That allows clients to inspect data in a single document review software application.

EPIQ also provides tools to make it easier for customers to review data. Some examples are eliminating duplicate documents, grouping together near-duplicate document, or assembling together email messages within the same overall chain or discussion.

In one case, EPIQ collected 50 gigabytes of email. EPIQ then removed more than 1 million items, which would significantly save clients’ cost and effort.

I think customers won’t know how good an eDiscovery provider is until they actually use it. eDiscovery is an important tool for clients. Clients switching to a new provider may face uncertainty about productivity. If they never try a new provider, they’ll never compare. So, customers may be sticky. And EPIQ does business with 48 of the top 50 global law firms.

Besides, EPIQ provides bankruptcy management software. I think this is a good business. The software development cost is quite fixed. It requires subject matter expertise to enter this business. Reputation can be important in customer acquisition.

I don’t have a very good impression of EPIQ’s class action business.


Unstable Gross Margin Is Not a Concern

Feeling the business is good, I continued reading earnings call transcripts.

I found that EPIQ’s margin is unstable because it has a portfolio of different cyclical businesses with different margin profiles. For example, the bankruptcy business has a negative relationship with the economy while the eDiscovery business has a positive relationship. Within eDiscovery, document review (which is project-based) has lower margin than data processing and hosting.

I'm comfortable with EPIQ's unstable gross margin. I think they're in good businesses. As long as they maintain long-lasting relationships with law firms and corporate legal department, and gain market share, they'll improve EBITDA.


EPIQ’s CEO Is an Investor

I also think that the CEO is a good capital allocator. The CEO and his family own about 18% of the company. He is an investor. He acquired the company in 1988. They were in chapter 7 business. Then through acquisitions, chapter 11 became a big part of EPIQ. Before 2004, they made 100% revenue from the bankruptcy business. They acquired an eDiscovery company in 2005. Through organic growth and acquisitions, the eDiscovery business now contributes about 2/3 of revenue and half of EBITDA. eDiscovery segment 2012 EBITDA was $74 million. Total money paid for acquisitions in eDiscovery was less than $300 million.

They issued equity and repurchased shares. When the price was about $14, they said that they wouldn't consider buying back additional shares at that price. But they also said they wouldn't consider issuing shares because they want to issue at a higher price. The last time they issued shares was at over $17.


The eDiscovery Business is Worth More Than EPIQ’s Market Price

Value investors may be interested in the CEO’s comment:

All right. Now let's look at EPIQ stock for a minute. Remember I said that there have been 3 breakouts in the stock. If you go way to the left end of that chart back to 1997, we did our IPO. And these prices are adjusted for splits naturally and the way all of the financial professionals do it, they adjust the historical prices for the dividend. And so they're properly adjusted for the dividend and for the split adjustments. So when the company went public, $0.88 a share. That's the number way off to the one side, $0.88 a share. You see the first breakout is in that very first year. It goes from $0.88 to $3.30, which is almost quadrupling the price of the stock. So it was a good year. Some of you in the room remember that.
Okay. Why did that happen? That happened because bankruptcy for Epiq was actually discovered. In other words, when Chris and I were on the roadshow doing the IPO presentation, the biggest obstacle we had and the reason that a number of investment banks passed on doing the IPO with us is they said, "Who in the world is going to invest in a company that's in a crazy business like bankruptcy? It's unheard of. I mean, bankruptcy is not a really good word in financial circles. I don't think you guys are going to get this balloon up in the air. It's not going to work, so we'll take a rain check. We'll pass."
Found some people who did it. We actually went to Minneapolis and did it and actually had a pretty successful IPO in Minneapolis. But you see, later that year, later that year, bankruptcy got discovered. We're the only public company that was in the bankruptcy business, and it got discovered. Then the bankruptcy business was pretty good back then, so you had a breakout in the stock.
Now the next breakout is 2001. And you can see $4.82 up to $12.24. Well, my goodness, that's up 2.5x, not bad for a year's work. And it actually peaked at $16.50 that year. But what happened in 2001, exactly the same thing that happened in 2007. It was the anticipatory effect of the bankruptcy cycle. In 2001, immediately following that anticipation, you had Enron and WorldCom and all of those -- and you all remember that. And so the stock really escalated. And then you can see the next few years, the stock just kind of up and down, up and down, up and down, just kind of went to sleep for a few years.
2007, another break. This time, it goes up at about 1.6x, pretty good year. And it goes from $10.74 to $16.53, but it had a high of $20.39, so right under $20.5. The anticipation of the next bankruptcy cycle, which was a meltdown in the '08, '09 and Lehman Brothers and all the rest of it. So what do we know? We know when there's a robust bankruptcy cycle, Epiq stock will flourish. And we know when it will start to flourish is the anticipatory effect before the bankruptcy cycle actually takes off, typically a year or so before.
Now what we're not happy about is what happened to stock the last few years. Because here is what is not reflected in that '07 to '12 period. The double-digit-growth performance in all of the financial metrics in which we really measure. There are clearly some other companies that have done that. There are not a lot. There are not a lot that for 5 straight years have been double-digit in every category that they're measured. And that's our job, and that's what we strive to do, but it doesn't reflect an evaluation of the company. It does not reflect the initiation of the dividend. So you have the dividend on top of the double-digit growth performance. But here's what it really does not reflect. This is probably the single most important thing that it doesn't reflect. In that 5-year period, we developed the finest global eDiscovery business. There's nothing better in the world right now in the eDiscovery business than Epiq Systems, $0.25 billion this year, all over the world. Chris is going to talk to you about it in a few minutes. It's a fascinating story. And we actually entered that market the very, very end of 2005. So our first year in, it was 2006. And it was a $20 million, $25 million business at that time. It's tenfold today, and that includes a couple of acquisitions in there, but they worked. They worked and they have really contributed. So the business has grown tenfold. And we're now a global leader, and it's a terrific business to be in. One of the things people say to us about bankruptcy is, "We love you in bankruptcy, but it's a finite market." "Gosh, we wish bankruptcy was 10x as big as it is." Well, so do we. Not a perfect world. But there's a lot of growth for us there. But guess what, eDiscovery is huge. It's a multibillion-dollar market, and it's global, and it's growing double-digit. And if you would go out and value eDiscovery companies, and you start looking at the multiples you'd get, multiple on revenue, multiple on EBITDA, it is way, way, way north of the multiples that Epiq has today. And so we have to do something about that, and we have to take initiatives to do that.
So we think going forward, the eDiscovery business, another bankruptcy cycle, continuation of the dividend program, we are also going to examine some additional share buyback. We've done that historically. Our board will take another look at that. We'll decide what we may want to do about that because we are legitimately in the business of building the value of the stock. Look, I can look at it 2 ways. I can say if I go back to 1997, I mean, I owned stock from 1997, right? Hey, $0.88 to $12 or $13, it's not bad. It's actually hard to duplicate. It's hard to duplicate. I do a lot of investing and there's not a lot of companies that are up 13, 14, 15-fold in that timeframe. We are not remotely satisfied with where our stock is. Because it doesn't make any sense to go back to 1997, who cares at this point. We look at the last couple of years, and the stock isn't doing what the stock should be doing. So we need to really stay very focused on that, and I think that we are going to see the stock benefit from eDiscovery and from another bankruptcy cycle. And we are going to look for new ways to communicate the right message because Epiq is not being put in the right category right now. We don't have the right multiples, we are not being assessed financially correctly, and we need to figure out what to do about it.


EPIQ Is Not Very Cheap

Is EPIQ really cheap? I can’t tell for sure.

My concern is the level of debt they have. At the end of 2012, they had $209 million net debt. That's 2.5 Debt/EBITDA. If I look at the company at that time, I would have expected net debt to go down to less than $180 million.

But net debt level ballooned to $249 million at the end of 2013 Q2. That's because of the increase in receivables and a reversal of customer deposit. Cash collections vary with different projects. But they always had positive cash flow in Q2. So, does this indicate aggressive sales?

I would like to wait to see if they'll collect receivables, and see if net debt goes down.

The company is not really cheap based on EV/EBITDA. The market cap is $480 million. Net debt is $249 million. So, EV is $729 million. EBITDA in 2012 was $83 million. So, EV/EBITDA is 8.8. If they end FY 2013 with $180 million net debt as I expected, and if EBITDA grows to $90 million, EV/EBITDA would be 7.3. That would be a better price. We’ll see if that happens.

P/FCF is not low. FCF in 2012 was $51 million. But they had $14 million customer deposit. It’s not a normal item. They also had $7 million share-based compensation. Share-based compensation is non-cash but it’s a real expense. My quick and dirty estimate of that expense is the reported number, $7 million. So, adjusted FCF is $30 million (= 51 – 14 – 7). So, current P/FCF is 16. That’s not a safe price.

Finally, I looked at a sum of the parts value. eDiscovery is growing double-digit. The bankruptcy and settlement administration businesses are more cyclical. So, eDiscovery deserves a higher multiple. And it's conservative if we allocate more corporate expense to eDiscovery.

So, from 2005 to 2012, corporate expense increased by $25 million to $36 million. Beside corporate expense, share-based compensation is about $7 million. EPIQ entered the eDiscovery business in 2005. So, I don't think we should allocate more than $25 million expense to eDiscovery.

eDiscovery made $74 million in segment EBITDA. So, let's say eDiscovery makes $50 million as a standalone business.

From 2005 to 2012, the bankruptcy and settlement administration business together made on average $52 million in segment EBITDA. After $24 million allocated to eDiscovery, there's $19 million corporate expense and share-based compensation for the two businesses. So, these businesses would make $33 million EBITDA.

All these business segments can turn a lot of EBITDA into cash flow. I think eDiscovery deserves 10-12 EV/EBITDA. Bankruptcy and settlement administration deserves 6-8 EV/EBITDA. So, the value would be between $698 million and $864 million. Current EV is $729 million. There’s not much margin of safety.


3 Keys to Watch

So, I would like to keep EPIQ in my watch list. 3 keys I would like to watch:

  1. Cash collections in the next several quarters.
  2. Debt level and EV/EBITDA.
  3. Pricing in the eDiscovery business.

From the conference call, I learned that there’s pricing deflation in the eDiscovery business. That’s a surprise to my initial impression that customers are sticky. So, I would like to do more scuttlebutt. Especially, I would like to talk to EPIQ’s salespeople. So, if any reader knows EPIQ’s customers, employees or competitors, please send me an email.

Talk to Quan about EPIQ Systems (EPIQ)

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