Context: I thought ALIT was an interesting long in late 2023, with the combination of a poorly-communicated business model, product transition and investment cycle, as well as technical dynamics creating an attractive entry opportunity to own a relatively high-quality businesses. Since then, ALIT has had some execution missteps in underdelivering on near-term revenue and guiding down on mid-term revenue growth, but they recently sold off their lower-quality Professional Services business to private equity, thereby creating a reason to revisit the stock.
Company: $4B MC/$7B TEV HCM solutions company, providing outsourced employee benefits software and services to large enterprises. On the front-end they provide a software system of record for employee benefits data, as well as an app for employees to access benefits. They combine that on the back-end with a high-touch specialized service model. Employees increase usage of benefits while employers decrease benefits costs. The software makes this sticky, but enterprises pay ALIT to offload the support and admin hassle of health and wealth benefits (i.e. this is a tech-enabled BPO business). It’s the most ubiquitous company you’ve never heard of, as Alight is the only company that provides a full suite of benefits solutions at scale, serving mostly large enterprises (70% of F100; 50% of F500 across industries). ALIT has misunderstood business quality, as a 30-year distant market leader in benefits administration with marquee customers, 85% recurring revenue with 3-5 year contracts (large customers around for decade plus) and 98% gross revenue retention.
Situation: Investors won’t touch ALIT given the messy story and technical dynamics, having de-rated hom*ogeneously with the SPAC universe and with the overhang of PE owners selling out and high leverage post-buyout. Combine that with investments in modernizing a decade-old tech stack and repackaging the product offering, and you have a business that should see meaningful FCF inflection. ALIT was optically cheap before the recent divestiture (more below) with at 10x LTM EBITDA, but not unreasonably priced on LTM FCF at 13x levered and 19x unlevered (5.3% unlevered and 7.8% levered LTM yields). Now, my pro forma numbers are 16x NTM EBITDA and 16x LFCF, which feel like fair headline valuations. The question is, what does the FCF profile of the business look like in the medium-term coming out of this transition.
Update: (1) Professional Services (~30% of total revenue) sale for ~$1.2B (at 10x ‘23A EBITDA / 24x ‘23A FCF) announced in March 2024 (closing 2H24) was positively received by the market (+11%) due to improved PF’23A revenue visibility (84% to 90%+ recurring revenue mix), margin profile (GM up to 40% from 37%, adj EBITDA up to 25% from 22%) and slightly improved FCF conversion. This transaction simplifies and improves the business while providing cash for deleveraging (<3x) and buybacks. ALIT’s RemainCo will have a commercial relationship with the SoldCo for implementations. (2) 1Q24 miss and soft guide for FY26 (stock -16%; giving back all gains from the PS sale) as revenue contracted 2% (-3% for PF RemainCo ex Hosting) due to lower volumes and project revenues. The bright spots are that BPaaS revenues grew 22% and the bookings backlog grew to $3.1B, while PF BPaaS revenues shrunk from $208M to $117M, which I’m interpreting as entirely recurring revenue (i.e. not project revenue). I wonder how much emphasis investors should place on the project revenues that are non-recurring. The FY26 guide of 4-6% revenue growth (15% BPaaS growth) at 28% EBITDA margins was reaffirmed, so I think investors are largely reacting to the 1Q24 miss and similar performance in 2Q24, thereby putting pressure on 2H24 new deals. I think the long-term thesis (see below) is still intact. I think the stock can work if the returns on BPaaS conversions of the installed base and the cost savings are enough to make the returns math work.
Sentiment: I believe investors have given up on the stock after the weak 1Q24 print (PF revenue contraction) and soft mid-single-digit FY26 guide reiteration. I don’t have a strong sense for how conservative this guidance is, as ALIT has generally beat on revenue and EBITDA before 3Q23, but perhaps management is trying to reset investor expectations. My back-of-the-envelope pro forma 5-year math, assuming a 15x LFCF multiple and 15% hurdle rate, implies that the market is expecting low-single-digit revenue growth (assuming a 20% LFCF margin), but double-digit FCF growth. My model gets close to these levels with minimal credit for new net customer wins and modest operating leverage without massive BPaaS cost takeouts.
Model: Given the turnaround nature of this trade, my base case reflects negligible new customer growth (3%, with customers starting in non-BPaaS), with 2% revenue growth driven only by gradual conversion of the current installed base to BPaaS at a 20% price uplift and 50% gross margins going to 60% (per management). I also model gradual operating leverage without lumpy cost takeouts from restructuring efforts taking place over the prior 3-year period ($100M run-rate) or the future opex savings from AI reducing call volumes (~20% volume reduction). Assuming $50M of annual buybacks, no M&A, and cash sweep for debt paydown, I pencil out a 12% 5-year IRR using a 15x NTM LFCF exit multiple (12x NTM EBITDA). Using more aggressive new customer growth and price uplifts to get to management’s 6% revenue growth, I get a 17% 5-year IRR. That’s at a 24% adj EBITDA margin (vs management at 28% driven by cost takeout, which gets me to a 20% IRR). In the event that management is sandbagging guidance, there could be upside to this case. This feels like a risk/reward skew that is asymmetric to the upside.
Upside levers: In refining my turnaround case, I’ll plan to do more work on the following items in. The current risk/reward feels appropriate for building a starter position.
Will BPaaS conversions drive upsell and cross-sell in the installed base?
Current BPaaS traction looks promising (Worklife app MAUs and digital enrollments both up per May 2024 investor deck); will need to review customer and end-user reviews and usage trends for quality of build
Will the current investment cycle result in material run-rate cost structure improvements?
$140M 2-year restructuring program is supposed to drive $100M run-rate cost savings. How is this tracking?
What kind of operating efficiencies will be extracted from the new back-end system and AI features (call volumes down 20% and AI assistant interactions up 250% per May 2024 investor deck)
Will BPaaS allow for mid-market penetration?
Promising opportunity at 6% mid-market TAM penetration (per sell-side research), and the new cloud-based solution should make implementations smoother
What is the mid-market enterprise GTM motion? Not sure how existing partnerships set ALIT up for the opportunity, but this is a major diligence area
Management: The shaky execution track record gives me pause, CEO (Stephan Scholl) and SPAC sponsor (Bill Foley) have both run the playbook of transitioning levered companies to the cloud and into the MM while delevering, I feel like the risk/reward is meaningfully skewed to the upside. I worry that the CFO (Katie Rooney) is leaving with 15 years of institutional knowledge.
Ownership: Blackstone (LBO sponsor) has largely sold out and has a 3%, while Cannae (SPAC sponsor) has not been participating in secondary offerings. Starboard took a stake in February and successfully got two independent directors on board, while a handful of other value-oriented funds have started to build positions.
Risks: (1) Execution of BPaaS transition (mixed track record consisting of guide-downs and excuses for misses); (2) Macro concerns around late-cycle labor market dynamics (PEPM pricing model susceptible to furloughs; counting on labor market ‘soft landing’)
Catalysts: (1) inflection in BPaaS bookings performance (conversions, pricing uplift, margin uplift); (2) further traction in the middle-market enterprise segment (new logos); (3) returning capital to shareholders (via large buyback); and (4) private equity interest setting a valuation floor (recent deals done at mid-teens EBITDA multiples). Management is updating 2024 and mid-term guidance after the divestiture close. Sell-side estimates are also yet to be updated for the pro forma company.
