|Shares Out. (in M):||48||P/E||0||0|
|Market Cap (in M):||308||P/FCF||0||0|
|Net Debt (in M):||-80||EBIT||0||0|
Absolute Software: Alpha About to Crescendo
Absolute Software is a relatively under-the-radar software play that we believe will rise 80-100% over the next 12-18 months, either through its own fundamentals or a (higher than average probability) sale event. If fundamentals stagnate and a sale does not occur, we are very confident a firm bottom exists given the highly visible, recurring revenue, pristine balance sheet, and rising dividend. At the current price you pay only 2x EV/Subscription Revenues and you get a 10% FCF yield and 3.9% dividend yield while you wait.
Click here or copy and paste the link below to see a properly formatted PDF version of this writeup:
Valuation: at a market price of $7.37 the fully diluted current market cap is $311 million and the EV $231 million. The stock is valued at a 10% FCF yield on what we believe are conservative and depressed FCF estimates, while also sporting a >4% Dividend yield (just raised 17%) and only 2x EV/Recurring Revenues on a company growing billings 14%-18% y-o-y.
Owners/Board: Crescendo Partners is entering year three of a 15% position in the name (and two board seats). As we outline below, Crescendo has a remarkable track record selling their Canadian Tech activist names, and three years has historically been the longest they’ve held a company. The company is a logical takeout candidate, either strategically or financially, and Crescendo has facilitated transactions to both types of buyers multiple times.
Fundamentals: ABT is sitting in an unusually sound position in the tech landscape, with its core product Computrace having little competition and sitting inside most laptops, tablets, and smartphones in the form of firmware before they ship to customers. This advantage should enable excellent cross-selling opportunities as they push further into Device Management, which is already a material piece of the business and growing 15-20%.
Visibility: the company’s revenue base is entirely subscription based with 90% customer retention and >100% dollar renewals.
Product: ABT has a compelling list of clientele with an unusually detailed customer testimonial page from a variety of industries describing how essential the product is. Additionally, its device management product (Absolute Manage) is on Gartner’s Visionary list and their Enterprise Mobility Management and Data Loss Prevention (DLP) recently arrived on Gartner’s list as Niche players. The core Computrace product does not fit into a Gartner box, but it is extremely respected in the Education vertical and is rapidly gaining credibility in Health Care and other data sensitive environments (utilities, aerospace & defense, etc.).
Balance Sheet: $80 million (USD) in cash (~25% of market cap) with no debt. We are sometimes fearful that tech companies with lots of cash tend to make reckless acquisitions; however in this case the new CEO (undoubtedly with coaxing from Crescendo) has stated all growth this year will be organic.
Management: we think the new CEO, Geoff, Hayden, is a winner. Coming from EMC Asia, where he managed a business multiples the size of ABT, he has said the right things in our view, and already comes across as having a superior grasp of the business (both its strengths and weaknesses). In particular, we agree there are simple ways to makes S&M more efficient while potentially lowering S&M on an absolute basis (currently 45% of sales in a business where 80% of billings come from existing customers).
Timing: we believe the stock has stagnated for three short term reasons:
Canada underperforming in general, with help from Dollar strength (and energy sector collapse)
Illiquid small/microcaps getting relatively crushed
Short term investors hoping the new CEO would be internally selected (and hence indicating a more imminent sale of the company) have departed since Geoff came aboard
Crescendo follows typical path and arranges sale of company in next 12-15 months
Improved focus and sales execution result in expanded margins and cash flow/earnings beats
Special dividends or large buybacks with huge and growing excess cash reserve
New competitive threats emerge (Chromebooks, others, particularly in MDM), resulting in unforeseen rise in churn from Education vertical
Shorter term salesforce disruptions
Absolute Software (ABT-TSE) is a small Canadian software company whose historical niche has been data protection and recovery for PCs. The company is a dinosaur by tech standards, founded in 1993, and has spent the last 20 years building out a major partner ecosystem with practically every major PC, Tablet, and Mobile OEM. They claim to have their core persistence technology embedded on over 500 million devices currently.
Bentley883 has done a good job chronicling their transformation from a purely anti-theft recovery in the laptop market company to a full scale device management and security firm at the PC, Tablet, and Smartphone level.
They are most well known for their penetration in the Education vertical (typically school districts K-12), but have recently made strong inroads in other “data sensitive” industries like Health Care, Government, Finance, and Aerospace/Defense.
Products and Business Model:
The company has two products generating a vast majority of billings: Computrace (~60%, growing 8-10%) and Absolute Manage (~35%, growing 15-20%).
Computrace is their lead, core product. Computrace is a subscription service whereby Absolute will track, secure, and recover computers for an organization over a set period of time, with the average contract length lasting 29 months. All contracts are fully paid upfront in cash, and the company claims they have a 90% customer retention rate.
The company’s competitive advantage is they work with the original equipment manufacturers (OEMs) and embed code at the firmware level. Without getting technical, firmware is permanent software that is read-only and ships with the device. This is a competitive advantage in that they have (generally) exclusive relationships with their OEM partners to get that software onto the devices, plus they advertise that their software has special “patented persistence,” meaning it hangs around (and even “rebuilds itself”) if a thief tries to completely wipe the unit, or the unit is factory reset. Per their annual report, they struggle to identify their competition:
“We have historically had few direct competitors for our Computrace product line… Based on our proprietary technology, patent protection, managed theft recovery approach and OEM relationships, we believe that our products maintain a competitive advantage in the marketplace, particularly within the commercial market.”- 2014 Annual Report
There are two primary purposes of Computrace: protect the data from theft, and recover the physical device from theft. If an organization is actually interested in recovering a stolen device they can pay extra to have “recovery agents” literally track down and retrieve the stolen device. This is more common in Education. If the company is more interested in locking down data, they can simply subscribe to that service, which allows IT to track, remotely lock, remotely edit/delete sensitive information, and provide alerts for suspicious activity. This is more common in information sensitive industries like Health Care, Government, and Financials.
Absolute Manage is their device management product, and is undoubtedly both more competitive and faster growing. Absolute believes their competitive advantage here is IT staff can manage and automate software processes (e.g. pushing updates, applications remotely) through any platform, any operating system, and almost any computer model. Thus an organization could have Macs, iOS, Surface Pros, and Android phones, and Absolute can efficiently handle all of them under one console. Within Absolute Manage is their Mobile Device Management product, which is a white hot area in the tech industry. For instance, one of the independent leaders, Airwatch, was acquired by VMware for $1.54 billion dollars, or over 15x trailing revenues. Absolute Manage produced $34 million in billings in 2014 (although only about 1/3 of this we believe was MDM). As mentioned above, there are a number of testimonials from customers on their website. We’ve pasted a couple links below that may be helpful (straight from the horse’s mouth) in how their offerings are differentiated, but would encourage investors to go through more on the site:
Good insight into how respected and irreplaceable Absolute Computrace is, and helps Health Care organization stay in compliance for data protection.
Cobb School District: http://www.absolute.com/en/customers/cobb-county-school-district
Good insight into how Absolute has a cross-platform advantage, when Computrace is combined with Absolute Manage.
Unique Sales Process
Although they do have a direct sales force, they claim that 80% of their revenue is generated through their OEM and VAR partners. Per management, 10-15% of their total sales and marketing budget goes towards “educating” PC OEMs sales people (we’re guessing this a mix of real education and wining/dining). As an example of the sales process, when a school district is buying computers from an OEM, the OEM will guide the school towards including Absolute’s solution. It’s our understanding that their direct sales force will then go after cross-selling opportunities and logical opportunities where the organization originally decided not to use Absolute’s product, as well as renewals.
The new CEO claims that there are low hanging fruit opportunities to make the sales force more efficient through “geographic rationalization” and by focusing on higher value accounts. For example, he noted that their sales coverage in New York had consisted of one sales rep living in Vancouver; with the Financials vertical being such an obvious use case for Absolute, we found this crazy (not to mention the lack of geographic proximity). Previous management was, in fact, criticized for stretching the sales force too thin and trying to be “everywhere at once.” New management has also taken their smallest 15-20% of customers and taken them off the plate of their direct sales force, instead building out a centralized “renewal center” for these lower value accounts.
There is some risk here. Anytime we hear “sales reorg” for a tech company (or “geographic rationalization” in this case), we cringe a little bit as it is fraught with short term risk at the very least. However, the CEO made it sound like there were literally sales resources sitting around doing nothing, and the changes were so obvious there would be minimal disruption. We are pretty confident these are the right longer term moves and that ultimately S&M as a % of sales can decline significantly. Consider that:
75-80% of sales come from existing customers
80% of sales come through their OEM channels
The VAR channel is underutilized but growing rapidly
Company still spends 45% on Sales and Marketing.
There is efficiency and leverage to be had here.
Crescendo Partners is an activist shop headquartered in New York, headed up by Eric Rosenfeld. A great primer on their process and thinking is right on Youtube, here:
Crescendo collectively owns 14.8% of Absolute, with a major position being built exactly two years ago in 2012 (about 10%), and then the remaining position was taken in 2013. Both Rosenfeld and fellow Crescendo activist Gregory Monahan are on the board (2 of 7 total board members) and have executed their typical “Canada Tech Activist” playbook, which involves:
Take a position in the company between 10-20% (check)
Get board representation (check)
Initiate a dividend (check)
Replace management (check)
Raise dividend (check)
Sell the company after 2-3 years (not yet…)
With some help from Absolute’s IR guy, and then additional digging, we’ve attempted to reconstruct Crescendo’s track record with Canada Technology activist investments. Below is a table summarizing their involvement in Canada Tech activism. We believe this is reasonably comprehensive, although it’s possible we missed one or two.
A few points on this table:
You can see that all but one of the companies was ultimately acquired, and all were acquired by year 3 or early year 4. We are now in Year 3 for Absolute.
In all but two cases they had board representation…with GEAC, they sent a threatening letter asking for board representation, then withdrew the request, then the company was sold two months later.
The acquirers range from other public companies (Amdocs) to Private Equity (Golden Gate Capital, twice), indicating an ability to facilitate different types of transactions.
The one misfire we could find, Hip Interactive, is a video game company, an area we believe is probably a bit outside of Crescendo’s expertise and more prone to catastrophe. We would place Absolute and its characteristics more in line with Bridgewater or Dalsa.
Does this mean Absolute is definitely going to get sold? Of course not. We merely point it out to show the quality of current shareholders/Board, and to state our belief that there is a significantly higher than normal likelihood given Crescendo’s track record, combined with what we believe are desirable, cash generating (but under generating) assets and a nice balance sheet.
The CEO Search
The old CEO, John Livingston, was a co-founder with 20 years of leadership experience with the company. He resigned at the end of 2013 and a new search was put out. At the time, there was speculation that this might pave the way for a quick sale of the company. In fact, when we spoke with the IR guy this summer, before Geoff Hayden was selected, our impression was that if an “insider” was selected as the new CEO it would greatly enhance the chance of a quick sale, while if an outsider was selected it would lessen the chances.
We believe the stock has stagnated partly because of the selection of an outsider CEO, for those hoping for a more immediate sale. We agree a sale is unlikely in the next couple quarters, however, we do not think Hayden’s hiring precludes a sale in the next 12-15 months. On the contrary, we expect Hayden was brought in to hit the low hanging fruit and make a sale that much more attractive.
The New CEO’s Early Message
It is early, but Geoff Hayden (presumably with coaching from Crescendo) is saying all the right things, in our view. His public appearances have been limited to two earnings call, and a presentation at a Cantor-Fitzgerald Canada Tech conference, but have provided solid insight into the direction they are heading.
No acquisitions: we worry about this for tech companies with way more cash than they need. Hayden was asked about his “focus on acquisitions and adding more IP to the portfolio”:
“Certainly over time, the breadth of our technology portfolio will emerge as an obstacle to growth, but I just don't see that at all moving into 2015. I think we've got a tremendously robust, compelling, competitive set of offerings that are substantially under-realized in terms of their growth potential, and the primary focus this year was on executing against the opportunity that they represent.”
We suspect Crescendo is influencing this statement, and there was likely tacit understanding between Hayden and the board that this would not be an empire building position. The large cash balance can instead be used for other purposes, be it a special dividend or a larger buyback. In the latest quarter, the company bumped up their DPS from $.06 to $.07 and renewed their option to buy up to 10% of the public float in the next 12 months.
Operating Targets: for the first time we are able to locate, the company laid out margin targets at the Cantor presentation (not on the call, so perhaps still unknown to most investors). These are longer term targets in the tradition of how a high flying IPO might present them (or old company like CAT, IBM, KR), but it is still a step up from a company that spends a puzzling amount on Sales & Marketing. Below is a recreation:
Sales & Marketing
We went through each of these line items with management, and were pleasantly surprised to hear how well thought out and less “hopeful” than one might imagine.
Gross Margin (+600 bps): this is primarily a function of product mix and the industry verticals where growth opportunities are more likely. Both Absolute Manage and the non-Education verticals of Computrace carry higher gross margins, as the Educational vertical is more known for opting in to the “theft protection” plan. This carries a lower gross margin % (although higher gross dollars), as they have to include recovery agents (real people knocking on doors investigating theft) in the COGS. Health Care and Government tend to care less about recovering the device and more about protecting/eliminating the data. The timing here will be gradual but should start right away. From a GAAP perspective, they have some amortization in COGS that is running off in the next couple years, and will result in GAAP gross margin expansion as well. We model slow but steady expansion here, as has been the case the last few years:
Sales and Marketing (+700 bps): spending too much on S&M has long been a bugaboo for the company and we touch on it in other parts of the report. To reiterate, they are spending 45% of sales on S&M despite a) generating 80% of revenues through OEM partners and b) generating 75-80% of revenues from existing customers. They have a three prong plan here. One is to reallocate extremely inefficient sales force to more productive geographies (New York, Texas, and Chicago were cited). The second prong is a particular strength of the new CEO, which is to develop the VAR channel further in order to effectively lower S&M expense. Finally, they are continuing an effort made by the previous CEO to make renewals less valuable for the sales team and make cross-selling and new sales more valuable. The timing here will be gradual but should begin over the next few quarters. Management has guided to a small y/y increase in S&M, but a lot of that spend will be one time brand marketing to increase commercial awareness of Computrace.
General & Admin (+300 bps): they have lowered corporate overhead fairly significantly, apparently, and believe this range can be seen almost immediately. We are modeling G&A moving to 10% of sales contracts this year.
2015 Expectations: Fiscal 2015 is already underway and we are now into Q2 of 2015. The company is always coy with guidance, stating simply that sales contracts and cash flow would be higher than the previous year (same guidance as last year). However, Geoff and the CFO Errol Olsen made a pair of bullish statement about the pipeline and renewal base during the call for the upcoming year.
“The comments I'll make about pipeline based on the analysis that we've done is it's certainly richer in terms of quantity and quality than it was a year ago or a quarter ago as you'd expect…there is a concentration of opportunity in education, but as well above-average growth in pipeline, in some of the key corporate and healthcare sectors.”
On the most recent call, there was not much more added, except the CFO did state:
We believe that we have the right strategy, product portfolio and team for success, and our outlook for fiscal 2015 remains robust and on track.
And on the upcoming renewal base:
“Directionally, it is higher. Right. And with our average contract term being about two-and-a-half years, I think that if you just look at the increase, going back two-and-a-half years compared to three-and-a-half years ago it's probably directionally the best indicator there."
This is a bit rough, but based on this commentary we do believe the company probably has a 2-3 quarter tailwind of companies
renewing (e.g. the growth of customers 2.5 years ago who will be up for renewal now is significantly higher than it was entering last year). The 2.5 years number is based on the average contract length (~29 months).
Additionally, they guided to a 5-10% growth in operating expenses, which should (hopefully) be lower than sales growth and should thus provide some of the margin expansion described above.
Consumer Business: they sell a consumer anti-theft product called Absolute Lojack that has declined to less than 5% of Sales contracts. We know this business is in severe decline (consumers simply do not care about their data as much, so the “persistence” technology advantage is lost for most consumers), that it loses money, and that competition is fiercer. We expect it to get nominal priority at best, and potentially get sold or liquidated, which should marginally improve underlying profitability at the cost of very little revenue. As it becomes less and less significant, it will also become less of hindrance on growth. In the latest quarter it managed to lower overall billings growth from 14% to 10% (commercial billings +14%, consumer billings -38%); however, we just lapped the last quarter of relatively “difficult” comps and future headwinds won’t be as pronounced.
Airwatch Acquisition: VMWare recently acquired Airwatch, a pure play Mobile Device Management company, for $1.54 billion dollars, which was roughly 15-16x sales. This is not to suggest Absolute could sell their MDM product for that much, but does indicate just how valuable firms perceive Mobile Device Management, and how hot a sector it is. Absolute management also noted that after this deal “pricing” got better, as apparently Airwatch was pricing extremely aggressively.
International Market: this market has been somewhat weak the last few quarters, but management claims the pipeline is stronger than ever and that some particularly large deals are waiting in the wings. Management is taking their “geographic focus” and applying it internationally, where they see plenty of opportunity in Brazil, Australia, and Asia. Certainly upside to target sales contracts could come from the International space if some of the larger contracts (e.g. $1 million plus) are consummated.
Screening: company may not screen as cheap on an EV basis as it actually is, given that they have $15 million of cash in “Long Term investments.” However, this is liquid and is included when they refer to their own cash balance. They state in their MD&A that their cash balance is $80.3 million.
Q1, 2015: was something of a non-event, as Geoff reiterated his core message and billings came in roughly as expected (cash flow was higher). Geoff mentioned two interesting tidbits, perhaps leveraging his strengths with EMC Asia:
VAR Channel. In Q1, the revenues from the VAR channel were greater than the whole second half of 2014. He seemed bullish in the opportunity to leverage the VAR channel for greater S&M efficiency.
New OEM Partnerships. Geoff stated he expected to announce “major” new Asian partnerships in the coming quarter.
Geoff’s incentives: we are awaiting a “circular” that will describe Geoff’s incentives more explicitly, and will be looking for any language on change in control payouts.
Taxes: They paid almost zero in cash taxes in 2014 due to R&D credits, and expect to pay close to zero in 2015. However, the CFO has said a longer term tax forecast should ramp up to 25%, which could be a longer term FCF headwind.
Given our expectation that Crescendo Partners will want to exit the position in the next 1-2 years, we believe a relative comp and transactions comps analysis is appropriate. However, we have also done some detailed DCF work to reflect some of the longer term margin upside we believe exists in the company.
Relative Valuation. The company is cheap given its profile, at ~10% FCF yield, ~4% Dividend yield, and 2x EV/Subscription Revenues. We have put together a group of software peers ranging from SaaS subscription companies that are not of the RGAAC (revenue growth at all cost) variety, along with some other security firms and a couple of other small/midcap software firms that manage to some kind of margin. A table is below.
Give our opinion that the company is about to start showing more operating leverage, 10-15% sales growth, along with the Crescendo ownership dynamic, we believe the company should trade at least close to inline to the median of this comp group. More directly, 18x FCF seems like a good starting point and yields 50% upside with what we believe is low FCF.
On the downside, we believe dividend investors would support the stock at around a 5% yield ex some kind of Black Swan event for the company. This would put the stock at $5.60 (CAD), or down 22% from current levels.
Transaction Comps. As we’ve mentioned Ad Nauseam, the ownership dynamic combined with the pristine balance sheet and depressed margins should make Absolute a takeout target. What has private equity been willing to pay the last few months? Here are three of the most recent pure play software comps:
We believe Absolute would sell well above the troubled CPWR but below RealPage, and probably roughly around what Tibco sold for to Vista Equity. Tibco had a similar narrative to Absolute (founder likely overspending and mismanaging, activists circling the stock, but attractive assets). A sale tomorrow at 4x sales contracts would be an ~80% premium, or about 50% using the EBITDA multiple.
We have included a 5 year DCF Base Case (and Bear/Bull in the Appendix). The key points on the DCF are as follows:
Billings Growth this year stays at the company’s longer term CAGR (~10%) despite consumer becoming less of a tailwind and a larger base of customers up for renewal this year than last year. This imbeds reasonable conservatism, although we’ll leave the real conservatism to our Bear Case. Growth then steps down each year until 2019.
Given our opinion that S&M is inflated, we model lower S&M as % of billings over the next 5 years, as growth in S&M is muted while billings rise.
We model a steadily increasing cash tax rate to management’s 25% target.
We believe we are being a bit high on capex in 2015 and beyond.
Gross margins rise slowly as mix slowly changes each year