Bear Stearns puts buy recommendation on CheckFree 6.5% convertible

By Ronda Fears

Nashville, Tenn., Nov. 19 - Bear Stearns & Co. placed a buy recommendation on the CheckFree 6.5% convertible due 2006, saying that the 9.3% current yield and the 15.2% yield to maturity on the convertible pays an investor to wait for an economic turnaround and an acceleration in the profitability of the company because the company is a leader in online payments, has a strong cash position and alliances with major billing institutions.

"CheckFree is clearly the leader in this industry with first mover advantage, a proven track record and excellent customer service. Nonetheless, cutbacks in marketing spending by major billing partners, in the face of a slowing economy, has reduced the rate of consumer adoption of CheckFree's product and brought down its stock price," said Yaw Debrah, head of convertible research at Bear Stearns, in a recent report.

CheckFree's stock is down because of slower subscriber growth due to cut in bank spending, the report stated, adding that the Checkfree 6.5% convertible is down 19.5% for the year compared to a 22.5% drop in the Bear Stearns software and services convertible sub index. Software & Services stocks in general have been impacted by the slowdown in the economy, as companies have cut back on non-essential capital expenditure, putting projects to enhance productivity growth on the back burner, the report also noted.

"With the convertible trading as a fixed income instrument with a premium of over 250%, investment in this convertible will be based on an investors degree of comfort that the company has enough cash and resources to get through this economic slowdown and resume faster subscriber growth," Debrah said in the report.

Liquidity is not a problem, however. With liquid funds of $247 million, no debt principal payments due until the maturity of the convertible in 2006 and access to an untapped $30 million line of credit, the Bear Stearns analysts believe that the company has adequate liquidity. At Sept. 30, CheckFree had $183 million in cash, cash equivalents and short term investments and a further $64 million in long term investments. In total, the company had about $247 million in liquid funds, which makes the company net debt positive to the tune of about $75 million, with cash and investments covering the only debt of the company - the $172.5 million convertible - by 1.4 times.

Earning before interest, taxes, depreciation and amortization was $7 million, representing the third consecutive quarter that CheckFree has been EBITDA positive, the report stated. EBITDA covered interest expense in the quarter a comfortable 2.6 times, while long term debt to annualized EBITDA was 6.0 times. Taking into account interest expense for the quarter of $2.7 million and capital expenditure of $6.8 million, the company generated negative free cash flow of $2.5 million. The report also noted that Standard & Poor's rates the company single B, with a positive outlook.

"The rating reflects the narrow product and revenue base, very competitive industry conditions, an aggressive growth strategy and continued pro-forma operating losses. These factors are tempered by its good niche market position and adequate financial flexibility to support its growth initiatives," Debrah said in the report. "The positive outlook could lead to a higher rating over the ratings horizon if the expansion of CKFR's business base and improvement in debt protection measures takes place as projected by management."

There is enormous market potential for CheckFree's growth, the Bear Stearns analysts believe. "Considering the billions of transactions each year by consumers paying bills, the potential market size for electronic billing and paying is immense," the report stated. "However, in order for CKFR to increase and maintain its profitability, consumers and businesses must continue to adopt its services." Competition could be a positive factor for the company's growth, the report stated, because Checkfree is clearly the leader in this industry with first mover advantage, a proven track record and excellent customer service.

"Electronic commerce is a new and evolving rapidly, resulting in a dynamic, competitive environment. The strategic investments that the company is making today should result in even greater defendable competitive advantage when the economy recovers," Debrah said in the report. "Although barriers to entry are moderate, key strategic alliances have helped the company expand its market penetration. The company provided electronic billing and payment services for over 5.6 million consumers as of Sept. 30."

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