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41% Upside Potential With This Undervalued Stock

Investors can define value in many ways.

Some seek it by combing through a company's balance sheet to uncover assets that are not "marked to market" to current values. Others guesstimate what a company will likely do in the future (whether it's earnings growth, M&A or other type of event) and try to see if the current stock price reflects these predictions.

I, on the other hand, am a big fan of cash. Not necessarily cash on the balance sheet (which is great but holding too much of it might not be productive) but the cash flow that a company generates. Undervalued assets, future earnings and other catalysts are all valid sources of value but cash flow is easy to see and monetize. Hence, in my opinion, it is the best gauge of shareholder value.

One company that generates a whole lot of cash is CSG Systems International, Inc. (CSGS), a provider of various business support services (such as account activation and billing) primarily to the communications industry. Reflecting the stable nature of its telecom customer base, the company's top line has been growing steadily over the past seven years.

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Based on my analysis, CSGS produces approximately $110 million of free cash flow annually on a normalized basis, which translates to a 14% margin (on a revenue base of roughly $760 million) and an 11% yield (on an enterprise value of $1.0 billion).

CSGS not only generates a lot of cash but returns a big chunk of it to shareholders. The company's dividend, which it started paying in 2013, is currently $0.63 per share on an annualized basis, for a yield of 2.3%. It also has an ongoing share repurchase program, which averaged $15 million over the past three years. All of this is excess cash it has left over after reinvesting in its business and servicing its debt, which is manageable given an interest coverage ratio (EBITDA / interest expense) in excess of 7X.

I calculate the value of CSGS's current free cash flows to be $38 per share, which is almost 40% higher than the current stock price. Remember, this is just the value of the cash the company is generating today that is assumed to remain constant forever, without taking into account any future growth.

This assumption is clearly conservative since management continues to invest for the future, via capital expenditures (equal to about 4% of its revenue), research & development (which equals another 14%) and select bolt-on acquisitions.

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Recently, CSGS reported 2Q14 earnings that were in-line with consensus expectations and reiterated its previous guidance for the full year 2014. More importantly, the company announced an expanded and extended contract with one of its largest clients, Comcast Corporation (CMCSA). Comcast is in the midst of acquiring Time Warner Cable (TWC) to bolster its position as the largest cable operator in the U.S.

Given that CSGS generates more than 40% of its revenue from its top three customers, this was a positive development that was favorably received by the market (including an upgrade of the stock to Buy from Hold by one sell-side analyst).

In sum, CSGS is a solid company with a stable business model, strong cash flows / balance sheet, and shareholder-friendly capital allocation policies. Despite a strong run recently (up 5.3% over the past three months versus 3.9% for the S&P 500), the stock is trading below the value of its current earnings power and represents an attractive investment opportunity at current levels.

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Risks to Consider: Risks related to CSGS include ongoing consolidation in the telecommunications industry, increasing competition and liquidity risks related to its smaller market capitalization of roughly $1 billion.

Action to Take--> At current prices of $27-28 per share, I recommend purchase of CSGS for a potential total return of 41%.

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