Track Group — Update 15 February 2016

Track Group’s tracking solutions blend real-time GPS tracking devices with around-the-clock monitoring and data analytics for the global offender management market. This encompasses the monitoring of parolees/probationers under community supervision orders (for both corrections and military organisations) and the monitoring of defendants pre-trial (for law enforcement). Over the past couple of years, the company has transitioned its business through a series of M&A transactions (see Exhibit 1).

The company’s strategy is to expand its offerings on a subscription basis to provide an end-to-end offender management solution to support re-socialisation, monitoring and predictive analytics for offenders. Management wants to grow its portfolio of proprietary and non-proprietary real-time monitoring and intervention products through a combination of internal development and acquisition. The company’s expertise and hence current focus is on the offender management market. However, its tracking/monitoring technology could ultimately be applied to other verticals such as the home care market (for seniors or sufferers of Alzheimer’s) or asset tracking.

Track Group began operations primarily as a manufacturer producing the actual tracking device. In a strategic repositioning, through the acquisitions outlined below and restructuring of the procurement process, Track Group has transitioned its business to a service and analytics model. Although the company continues to produce the devices, management’s focus has shifted to providing an end-to-end service to the corrections industry.

As electronic monitoring is a competitive area, Track Group aims to differentiate itself by providing a package of services from which its customers can select on a PaaS basis. This includes the basic tracking devices, add-ons including an alcohol monitoring device, monitoring services and/or analytics services.

The business model enables the company to generate recurring revenue from subscription contracts. This approach enables recurring and higher margin revenue compared to one-time sales of physical tracking devices. As a result, management expects the transition to this model to both accelerate revenue growth and lead to improved margins and cash flows.

Acquisitions broaden product offering and customer base

With the company’s stated aim of broadening its product offering through internal development and M&A, we expect the company will make additional acquisitions.

In November 2013 Track Group signed a substantial contract with the Chilean prison service to supply up to 9,400 devices over 41 months, with the contract worth up to $70m revenue (assuming 100% utilisation of the 9,400 tags). A $3.4m performance bond was posted by Track Group as a condition of the contract and will be returned on successful completion. In FY15, this contract generated revenues of $3.9m (19% of total FY15 revenues) as tags were rolled out. We expect continued growth in the number of tags in use through FY16 and FY17.

In October 2015, Track Group was awarded a contract by the Virginia Department of Corrections (DoC) to provide monitoring services. The contract calls for Track Group to deliver solutions based on GPS and biometric voice verification technology designed to monitor more than 16,000 offenders and defendants. At the end of 2014, Virginia had 37,544 inmates incarcerated, with an additional 1,732 on parole and 54,966 on probation (source: Bureau of Justice Statistics).

The contract has a minimum term of two years, with four one-year extensions at Virginia’s option, for a total term of six years. The contract is valued at an estimated $11.3m over the six years. In addition, the contract allows other state agencies to secure monitoring services without a formal bidding process, which management believes could also enhance the company’s opportunities in Virginia. Successful execution of this contract could facilitate further expansion within the state and in contiguous markets.

We understand from management that there are a number of substantial contracts coming up for tender over the next few years; if Track Group can win some of these contracts it could prove transformational for the business. The company has indicated that the process to win the Chilean contract was extremely competitive and that Track Group won because it was able to demonstrate more consistent and intense oversight of the offenders being monitored. Management believes this win could lead to additional contracts in other markets. Track’s share of the US and international electronic monitoring markets is low, providing plenty of scope to grow.

Track Group reported revenue growth of 70% in FY15. The Chilean contract generated revenues of $3.9m in the year (from zero in FY14) and we estimate that the remaining c $4m revenue increase was generated by the recently acquired businesses and a small improvement in the legacy Track Group business. The company noted that tag subscriptions grew from 6,400 at the end of FY14 to more than 10,000 at the end of FY15 – we estimate that the majority of this increase was from the roll-out of the Chilean contract.

Gross margin increased to 60.2%, showing an upwards progression through the year (Q1 55.7%, Q2 57.9%, Q3 62.0%, Q4 63.5%), helped by the contribution of higher-margin analytics sales from the G2 Research acquisition. During FY15, the business began using an external fulfilment service provider so now it no longer assembles, repairs, or processes inventory or monitoring equipment – this has also contributed to the improved margin.

In “Other Income”, the company reported $4.9m of disgorgement profits – we treat this as a one-off credit. The company paid a small amount of tax in several overseas territories; in the US the company has unrecognised tax losses worth $142m (these start to expire from 2020).

On 9 February, the company reported Q116 results. The table below shows the key data:

Revenue growth of 36.7% was driven by the growth in monitoring devices in the Americas (we assume this was mainly due to the Chile contract) and to a lesser extent the impact of the G2 Research acquisition (November 2014). The company noted that it had expanded deployment of its data analytics service to Detroit, Indianapolis and Philadelphia, also contributing to growth.

The company provided a reconciliation of net income to adjusted EBITDA.

Operating expenses totalled $20.7m for FY15, up from $14.5m in FY14. Stripping out the one-off charges as per the reconciliation, we estimate “clean” operating expenses totalled $16.1m in FY15 ($11.2m FY14) and $13.2m excluding depreciation and amortisation ($9.6m FY14). The majority of the increase in costs will have been from the recent acquisitions. For Q116, clean operating expenses totalled $4.7m ($4.1m Q115) or $4.0m excluding depreciation ($3.5m Q115).

The company has provided the following guidance:

We have revised our forecasts to reflect the low end of the range for both years. To achieve the low end of FY16 guidance, we expect the number of subscribers on the Chile contract to continue to grow and the Virginia DoJ contract to start to contribute. The acquisition of G2 Research also adds a combination of one-off project revenues and recurring revenues. On the Q1 revenue run rate, with no additional growth, Track Group would achieve FY16 revenues of $25.3m.

For FY17, we expect the company to earn revenues closer to $2m from the Virginia contract, with additional growth from Chile and growth in sales of analytics solutions.

In FY15 Track Group restructured its $28m of short-term unsecured debt maturing in 2016 into $30.4m maturing in July 2018 with the same lender, Conrent Invest. The 8% interest rate remains unchanged. Most of the additional $2.4m in financing relates to fees and interest accrued through to January 2016. Track Group’s amended debt facility also provides the company with a voluntary prepayment option that allows Track Group to prepay all principal and interest before July 2018 without incurring a penalty or prepayment fee.

Subsequently, Track Group entered into an agreement with Sapinda Asia for a $5m unsecured revolver that incurs interest at 8% pa on borrowed funds and 3% on the untapped amount outstanding on the revolver. Sapinda Asia is a major shareholder of Track Group. In our view the refinancing improves the company’s financial flexibility and should make it easier to finance future transactions. The company ended FY15 with cash of $4.9m versus $11.1m at the end of FY14.

The company needs capital to pursue strategic M&A to complement its organic growth initiatives. Earlier this month, the board and major shareholder approved an amendment to enable Track Group to issue up to 30m common shares from the previous authorization of 15m. We note that the company is pursuing an up-listing to a regulated exchange – this should provide the company with improved access to funding.

If Track Group can follow up the Chilean and Virginia DoC contracts by securing further state or nationwide deals, we believe there is clear potential to drive upside. The opportunity for electronic monitoring of offenders is clearly substantial and there is further potential in other verticals such as healthcare and logistics, although the pace of growth and ultimate potential market size is difficult to quantify. Given Track’s comparatively early stage of development and the lack of direct peers, we believe that a reverse DCF provides the best gauge as to what the company needs to achieve to both justify its current valuation and drive further upside.

Our reverse DCF suggests that the current valuation prices in a revenue CAGR of 15.5% to c $88m in 2025 with EBITDA margins reaching 25% at this time. Revenue CAGR from 2017 to 2025 (ie after our explicit forecast period) is 9.7%. Our revenue forecasts assume annual growth of devices in use falling to 10% by 2025 before churn of 8%, with a declining daily lease price. In addition, we have factored in a CAGR of 8% for other revenues (which incorporates analytics and product sales) from 2017-2025. We estimate that this could be achieved through rolling-out and retaining only three or four significant contracts similar in volume size to Chile over the next 10 years. Our DCF assumes a WACC of 10% and terminal growth of 2%. There is a high degree of uncertainty in these assumptions and therefore it is useful to look at a range of revenue growth rates and terminal EBITDA margins (Exhibit 6). Varying the WACC by +1%/-1% impacts the valuation by -16%/+20%.

In the table below, we compare Track Group’s valuation to a selection of peers. They range from large companies where electronic monitoring is a small proportion of the business (3M, G4S) to smaller companies that are active in the wider tracking market. Assuming that Track Group is able to achieve the revenues and profitability in its recent outlook statement (our forecasts assume it reaches the low end of the range in FY16 and FY17), the valuation looks in line with the peer group on an EV/Sales and EV/EBITDA basis. If the company is able to reach the top end of its guidance range, this could drive share price upside.