Description

Growth investors have piled out of Actuate, leaving this cash-rich enterprise software company trading at an EBIT/EV yield of over 16%, and EV/EBITDA of 5.7X. My conservative target is $6.50/share.

Why is it down so much!—Nearly a 2-year low!

The stock has gotten hammered because about 40% of their revenue comes from financial service customers and there is general softness in enterprise software sales. Furthermore management gave disappointing 2008 guidance. Instead of guiding for EPS growth in 2008, the company guided for flat earnings. They did this because they have exposure to the US financial services sector where IT spending is being delayed.

Why is it not as bad as it looks:

While there is definitely softness in their market, this is a temporary situation because Actuate’s products are essential for their customers. Furthermore, Actuate has increased its addressable market tenfold through its open source strategy, and has introduced several new products to augment growth. A prolonged delay in new customer orders is mitigated by recurring and growing maintenance/service revenues which account for about 58% of Gross Profit. Furthermore, management has demonstrated in the past that they are able to improve profitability in a soft environment.

What’s it worth:

I believe that Actuate is worth conservatively $6.50/share representing a 67% return, and could be worth as much as $9/share in a takeout by a strategic buyer who can leverage cost and sales synergies.

Brief Description of Actuate’s Business

Actuate provides software and services that enable its customers to bring interactive content to its customers, employees and partners. The software space that they are referred to is Business Intelligence. Applications built on Actuate’s open source-based platform provide all users inside and outside the firewall, including employees, customers and partners with information that they can easily access and understand to maximize revenue, cut costs, improve customer satisfaction, streamline operations, create competitive advantage and make better decisions. In other words, Actuate’s products enable an employee, partner or customer of a company to view and create reports that draw information from various sources into a web-based application.

For companies with significant customer, transactional and operational information, Actuate’s products help deliver this data to the most appropriate users, such as employees, management, business partners and customers, in the most efficient manner. Actuate’s reporting platform enable customers like American Express to provide a portal for customers to access account information online.

Customer Examples

There are many customer examples on Actuate’s website but here are a few that give you a sense of what their customers use them for:

1. 5^th Largest Telcom provider--Using Actuate, the Company built a Customer Self-Service Account Reporting application that delivers detailed account statements via email, PDF and print mail. Commercial customers now have the ability to drill down to an itemized status of activity and service utilization by division, department and even employee. This account status reporting application empowers the telco’s commercial customers with better service activity insight in order to make decisions about how to use telecom services more effectively. Actuate is able to produce the required 2-4 million pages per month account reports in a highly accelerated timeframe of under 72 hours.
2. Mellon Bank enhanced its clients ability to process, monitor and measure investment data from around the world for 20,000 users. By providing accurate and real-time customer information through the online channel, Mellon reduced the customers’ dependence on more expensive service channels.
3. Yahoo--Prior to Actuate, Yahoo! used dispersed reporting methods such as static web reporting, Oracle Reports, etc. Each report that was created had to be developed separately for each user. As a result, IT would have to create 500 separate reports for 500 people. There was no consolidated, corporate wide reporting platform. With Actuate, Yahoo was able to consolidate their reporting requirements and provide an efficient, scalable, highly searchable and easily updated alternative to the static web pages or traditional, paper-based reporting. By leveraging Actuate, Yahoo! has been able to increase the speed and quality of decision-making, increase operational efficiency and increase customer retention.

Actuate's Products are Mission Critical to their Customers--JP Morgan Example

Actuate has financial institution customers like JP Morgan who use Actuate’s software and services to allow JP Morgan’s customers to access account data on the web. Actuate’s software behind this technology saves costs that would be incurred from hiring additional tellers or having additional labor to process transactions manually. An example of the mission-critical nature aspect of Actuate’s software is last year when Actuate found that JP Morgan was not paying the full amount of its license and maintenance fees. Actuate threatened to terminate the license and support. JP Morgan then asked the District Court in New York for an emergency injunction to prevent Actuate’s license termination. In their filing, JP Morgan states that Actuate’s refusal to provide assistance (that only Actuate is capable of providing) would have devastating and irreparable harm to JPMC, its customers and its business partners. JP Morgan also stated that if they were unable to use Actuate’s software: thousands of JPM’s individual banking customers would not be able to receive their monthly bank statements, annual tax statements, or obtain vital information concerning the activity and status of their accounts. Furthermore JPM would not be able to carry out many of its government reporting obligations, as required by federal, state and foreign laws and regulations. Also, JPM would be unable to service certain of its institutional business partners, the markets in certain specialized securities would be adversely affected, and some units of JPM would effectively be entirely unable to conduct business. This complaint was voluntarily dismissed in May of last year and JP Morgan continues to buy from Actuate.

Huge Open Source Opportunity

Actuate is leveraging Open Source to increase revenues at a low cost. Actuate’s open source product, BIRT (Business Intelligence & Reporting Tool) is used to grow its customer base so that it can up-sell its proprietary, complementary solutions. BIRT is a software tool that enables developers to build business intelligence and business reporting applications. BIRT replaced Actuate’s eRDPro. Within the 4,000 enterprise customers of Actuate, there are 10,000 developers that built reporting applications with eRDPro. Since the Open Source BIRT was released in late 2005, there are an estimated 100,000 developers using BIRT to build reporting applications. Historically, eRDPro generated less than 5% of the Actuate’s revenues while the majority of revenues were driven by the company’s complementary deployment solutions (called iServer and iPortal). So essentially, BIRT is replacing nominal revenue-generating product but creating a much larger market for which to sell essential Actuate products. In short, Actuate has increased the amount of developers using its basic tool by 10X which incurring minimal cost. Actuate’s revenue from this initiative is growing rapidly: from doing $1million in 2006, to $8million last year, to an estimated $16 million this year. Actuate is therefore attracting new customers that it hasn't had in the past while not spending excessively on Sales and Marketing.


Actuate’s Financial Service Exposure is less than you think.

There is no doubt that if you are selling big ticket perpetual license software into Citicorp or any other bank right now, you will run into several roadblocks. However, Actuate’s exposure to this is less than it appears for the following reasons:

1. Financial Services is getting to be a smaller portion of their revenue. It used to be between 50-65% of revenues in the past, while it was just 35% in the 4^th quarter.
   
2. Most of the financial service revenue is derived from maintenance and services which is recurring in nature. A customer is much less likely to cancel a maintenance contract.
   
3. Actuate’s products are “mission critical” as JP Morgan dispute demonstrates. Customers may slow down purchases but not stop completely.

Actuate has grown earnings in slowdowns before

Management does a great job in maintaining or growing earnings in tough operating environments. They are able to do this because maintenance/services is a steady growing business and they are able to cut sales and marketing costs fairly easily. In 2004 software license sales dropped 18%, but was mitigated by an 11% growth in maintenance/services. Despite this, Actuate was able to grow adjusted EBIT by 33% in 2004. Again in 2005, license sales dropped 13.5% while maintenance/services grew 12%. Despite, this environment, the company grew adjusted EBIT by 157%. This was followed by 30% growth in 2006 and 48% in 2007. Fortunately, management has been able to get ahead of the curve on softness in their business and they should be able to do the same in the current environment.

The Maintenance/Service Business is Steady and Growing

The nature of Actuate's business model is that they sell a perpetual software license which is lumpy in nature and then sell essential maintenance and services relating to the license indefinitely into the future. Since the software is mission critical, renewals of maintenance is high, and it essentially becomes an annuity stream that keeps compounding. Margins are excellent in this revenue stream because it doesn't require too much sales, marketing or R&D. The recurring nature of this business provides really good stability and is an important valuation metric to a would-be acquirer. Here is the impressive years of growth and earnings in this side of the business:

	2002	2003	2004	2005	2006	2007
Revenues	50.9	56.9	61.9	69.5	81.6	87.4
Profit	27	33.3	37.2	45.8	53.7	62.5
Margin	53%	58%	60%	66%	66%	71%

CEO and CFO Buying/Company Buyback

Over the past 6 months and as early February the CEO bought 37,000 shares at an average cost of $5.78. The CFO bought 130,000 shares at an average price of $5.47. The company also has been buying back stock regularly and will continue to be aggressive at these levels.

The Financials

The best way to analyze Actuate's financial statements is on a proforma basis particularly since they expense stock options and the expense number can fluctuate. Stock compensation expense is NON-CASH but I do take options into consideration when I calculate Enterprise ValueI also exclude certain non-cash charges to focus on the cash earnings power of the business.

	2007		2008
License Rev	53.2		48
Maintenance/Serv	87.4		91
Total Revenue	140.6		139
License GP	51.2		45.6
Maint/Serv GP	62.5		64.6
Total GP	113.7		110.2
Sales and Marketing	55.3		50
R&D	21.8		22.2
G&A	17.7		18
Amort of Intang.	1
Restructuring	1.6
Total Costs	124.5		120
GAAP EBIT	16.1		18.9
Interest Income	3.1		2.2
EBT	19.3		21.1
Taxes	-.8		6.3
NI	20.1		14.8
Adjustments
GAAP EBIT	16.1		18.9
add:
Amort of Intangibles	1.5		1.5
Restructuring	1.6
Duplicate Rent Exp.	.7
Stock Comp Exp	9		9
Total Adjustments	12.8		10.5
Adjusted EBIT	29		29.4
Depreciation	2.4		2.4
Adjusted EBITDA	31.4		31.8

For 2009, I am assuming they get back on track of their earnings growth and do about $37mm in Adjusted EBIT.

Capitalization/Stock Options

The company has a boatload of stock options which quite frankly I am not all too excited about because it complicates analysis and dilutes everyone. On the flip side, these options are a healthy incentive to get the stock price up.

Shares Outstanding	61.4
Options Outstanding (including non-exercisable)	18.1
Stock Price	3.88
Market Cap	238
Market Cap after all options exercised	308
Cash on Balance Sheet	68.4
Cash from all Options Exercised	64.8
Adjusted Enterprise Value	175

Valuation

I like to value the company based on how an acquirer would look at it which is why I take into consideration all the options getting exercised and thus included in share count. In addition, there is about 15-20mm in sales marketing/overhead that could be taken out by a strategic buyer should that occur. My target on the stock assumes that it should trade at an EBIT/EV yield at about 9.5% which is somewhere comparable enterprise software companies are (INFA, COGN acquired by IBM, and SPSS). Software companies are also valued on an EV to sales, and EV to maintenance revenues but I'd rather focus on earnings (But if you put an EV/Sales multiple on Actuate it would be considerably higher than my target price).

Speaking of Cash, I am modeling that they bring in about 25mm in free cash flow in 2008, which is higher than 2007 due to a high receivable balance in December that was collected. With an adjust EV of $175mm, this is how the valuation looks based on 2007, 2008, 2009.

	2007	2008	2009
Adj. EBIT	29	29.4	37
EBIT/EV Yield	16.6%	16.8%	21.1%

Analysis of Target Price:

2009 EBIT	37
Target EBIT/EV Yield	9.5%
Targeted EV	390
Cash on Balance Sheet plus Option Cash	133
Total Market Cap	523
Target Price (Market Cap/FDS)	523/79.5= $6.58/share

Catalysts

I think that getting acquired is a likely outcome for Actuate. There has been a lot of consolidation in their space with very few independent business intelligence customers left. Actuate's management has worked with or for large companies like Oracle and IBM and should fit nicely into any organization.

Catalyst

Getting Acquired, Resumption of Sales Growth, Stock Buybacks