Liquidity Services Inc.(LQDT) has a high ROIC business model and an underexploited balance sheet. Several areas of the business are growing rapidly and have massive potential markets, but these positive factors have been obscured by headline risk surrounding contract renegotiations and a goodwill write down related to a since disposed of acquisition. LQDT is selling at a steep discount to a reasonable private market value.

LQDT has an approximately $200 million market cap and an $95 million enterprise value, once the large cash holding is subtracted out. On a per share basis LQDT has ranged from $4.42-$10.61 over the past year, and its recent price around $6.70 is nearly 90% below the all time high in 2012.

Salvage Business

LQDT is in the “reverse supply chain” business, operating multiple on line auction marketplaces for surplus and salvage assets. LQDT generates a revenue by retaining a portion of proceeds from sales of surplus managed for sellers. About 60% of merchandise volume is sold using a consignment model slightly over 30% on a purchase model(entailing inventory risk), and profit sharing is the remaining. The salvage business is highly fragmented both by geography and product type, with few competitors offering integrated solutions. LQDT runs multiple website offering over 500 product categories across major industry verticals including consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts, hardware, energy equipment, capital assets, transit equipment, etc. etc.

Disposal of surplus is not a core function or a core cost of most businesses. Consequently customers care primarily about ease and convenience, and are less likely to be overly price sensitive, although a well established platform that is able to generate higher returns on surplus is at an advantage. Liquidity Services on line platform and large buyer base provide competitive advantage in serving corporate and government customers . LQDT’s base of registered buyers and a transactions completions have grown steadily,between 2006 and 2015. Global Merchandise Volume(GMV) has risen at a rate of approximately 19% per year since 2006. Network effects are significant competitive advantage.

The competitive advantage is also demonstrated by the high ROIC the business has typically earned. ROIC excluding goodwill has been above 20% in 8 of the last 10 years. In many years Return on capital is off the charts high when you consider the company has historically maintained a cash balance well in excess of what is necessary to operate the capital light business(to be fair they do have operating leases though).

There are several growth areas into which LQDT could reinvest capital. LQDT still has negligible international exposure, although its Asia/Pacific revenue doubled in 2015. Its expansion overseas is driven by demand from existing US customers with overseas operations. Additionally, the state/local government business (GovDeals) has grown steadily since it was acquired in Revenue for GovDeals is up 13.1% y/y and GMV was up 12.3% in the first half of fiscal 2016, due to both new customers and increased volume from existing customers. GovDeals has signed up barely 10% US municipalities, but is over 10x the size of its next largest competitor. Additionally, GovDeals is generally commission only revenue, rather than consignment revenue.

LQDT reported an increase in registered buyers/sellers in the energy industry, although volume has not yet increased drastically since prices of equipment have not yet settled. This area will eventually provide an amusing and temporary boost in volume, although is relatively small compared to the state/local government and international opportunities.

Headline Risks

LQDT is a meta-dumpster dive. Headline risk is present due to customer concentration and a previous botched acquisition.

LQDT management has continuously worked to diversify away from dependence on the DOD , and DOD contracts as a percent of revenue have declined from over 90% in 2004 20 40% in 2015 as other industry verticals have grown. LQDT declined to bid on the DOD rolling stock contract due to unprofitability. LQDT still has non-rolling stock asset and scrap liquidation contracts with the DOD but they were renegotiated at less profitable rates.. The compliance issues of dealing with the DOD provide some imperfect entry barriers.

LQDT recognized a goodwill impairment of $147 million in 2015 due to the sale of Jacob’s Trading, which it drastically overpayed for several years earlier.(this was basically a major contract with Wal-Mart). Nonetheless given the multiple other bolt-on acquisitions it is hard to argue that management is bad at allocating capital.

Is it losing network effects？ While GMV is down significantly due to the Jacob’s sale, completed transactions and total auction participants for the first 6 months of 2016 were flat compared to the prior year. There is not evidence that buyers have abandoned the platform. Meanwhile, the GovDeal business continues to grow at a double digit annualized pace, regardless the Jacob’s Trading or DOD issues.

LQDT is in the midst of executing what it calls the “Liquidity One” transformation which will attempt to more fully integrate the multiple auction websites, and increase international presence. The silly corporate jargon name can be forgiven given the compelling logic of the changes.

Overall the headline risks appear well mitigated by the low valuation and significant growth in other areas of the business.

Valuation

Given the unpredictably of the future, I have embedded several layers of conservative assumptions in valution. EBITDA as a % of GMV has historically ranged from 5.7%-11.2%. The average from 2006-2014 was 7.9%. My valuation assumes it will be 5.0%. Additionally, I take the highest level of CAPEX of 2014 to be the long run maintenance CAPEX. The base case assumes no growth. The upside case is still well below management’s growth expectations. EV/EBITDA multiples of 8-12 for a growing high ROIC business seem reasonably conservative. For what its worth, EV/EBITDA for LQDT ranged between 13 and 28 from 2006-2014, although it was growing at a faster rate during that time period.

Back of the envelope:

600,000 GMV and an 8x EV/EBITDA multiple = 43% upside

800,000 GMV and 12X EV/EBITDA multiple = 140% upside.

I expect GMV and EBITDA as a % of GMV to normalize starting 2018, once the “Liquidity One” plan is implemented(some parts of the plan are being implemented this summer). Under a wide range of conservative assumptions investors have significant upside.

Also notable: Genco, which generated $1.6 billion in annual revenue operating a similar business to LQDT was acquired by FedEx for $1.4 billion. Unfortunately I didn’t locate profitability data on Genco, but its unlikely its long term profitability record would be much better than LQDT. Applying the equivalent EV/sales multiple to LQDT’s trough annual revenue of $300 million results in a price of $262.5 million, nearly 3 times the current $95 million enterprise value of LQDT.