BroadVision shares are once again dirt cheap, offering strong downside protection and compelling upside. Even if one adopts an unreasonably pessimistic outlook, it is hard to see how shareholders buying at this price suffer permanent impairment of capital.

BroadVision has a market value of $123 million ($1.10 per share times 112 million shares outstanding). If $44 million of $54 million in net cash is considered excess cash, enterprise value is $79 million. Assuming an enterprise fair value multiple of ten times interest-adjusted net income, the current trading level implies an income expectation of $8 million in 2008.

 

Several arguments can be made for why a multiple of ten times is low for BroadVision, including (i) high returns on capital employed in the business; (ii) large and growing market opportunity; (iii) global business, with nearly 40% of revenue coming from Europe and Asia; (iv) recent release of upgraded version of core software products; (v) recent launch of new web-based product in China; (vi) strong balance sheet; and (vii) alignment of interests through large stock ownership by the founder and CEO.

 

Rather than discussing the multiple of earnings that might be appropriate, however, I want to focus on the likely level of earnings going forward. Specifically, I want to show why an implied expectation of $8 million in after-tax income (excluding interest income) is simply too low.

 

Note that in order to earn $8 million of interest-adjusted after-tax income, BroadVision needs to earn $8 million of EBIT. The company does not pay taxes and is unlikely to do so for a long time. BroadVision has a usable NOL of more than $700 million, expiring through 2022. The NOL easily exceeds the earnings BroadVision will generate from current operations over the next fifteen years. One could perhaps even argue that the large NOL makes BroadVision’s substantial cash balance worth more than “par,” as the company could acquire profitable businesses and use the NOL to shield income. (The company has so far not stated a desire to make acquisitions.)

 

BroadVision earned GAAP EBIT of $15 million in 2006 and $16 million in 2007. Pro forma EBIT, as calculated by the company, was $13 million in 2006 and $18 million in 2007. While BroadVision has stated an intention to expand the sales team and increase marketing spending to boost sales of its new software product suite (BroadVision 8.1), neither the announced S&M expansion nor a potential slowdown in IT spending support an expectation of a 50% drop in operating income during 2008. Perhaps “the market” knows something about the very short term, and given the recent price action of BroadVision stock, I would be surprised if the March quarter does not come in weak. However, even if some funds have correctly “sniffed out” recent weakness, nobody can accurately predict how the rest of the year will evolve. In the following two sections, I make some (hopefully) rational assumptions in an attempt to analyze how EBIT might be impacted by factors such as potential revenue performance and the anticipated increase in S&M expenses. The conclusion is that, while the market may have thrown in the towel on BroadVision, the underlying revenue dynamics are quite favorable -- and therefore likely to yield positive surprises for shareholders as the year unfolds.

 

 

One of the reasons BroadVision shares have pulled back more than 75% from their 52-week high may be the fact that the company failed to achieve revenue growth in 2007, with revenue declining 4%. What seems to be missed is that growth was stunted by declining service revenue, primarily a reflection of past declines in license revenue. BroadVision had an unbalanced license/service revenue mix of 29%/71% in 2006. Service revenue declined 21% in 2007, while license revenue grew 39%, resulting in a healthier license/service revenue mix of 42%/58%.

 

 

 

Scenario One. If license and service revenue simply continued their 2007 trend (up 39% and down 21%, respectively), overall revenue would grow 4% in 2008 and 13% in 2009. Here is the hypothetical breakdown of revenue assuming a continuation of recent trends:

 

 

While license revenue growth of 39% appears aggressive, note that license revenue remains well below levels reached earlier in the decade. Meanwhile, the addressable market for BroadVision software has likely grown. In addition, BroadVision achieved 39% growth in 2007 while selling the previous version of its software (BroadVision 8.1 was not released until the beginning of Q4). Finally, the company operated with a small sales team in 2007 and expects to hire additional salespeople to market BroadVision 8.1. It therefore seems conceivable that the company could maintain or even exceed recent growth rates in license revenue.

 

As for service revenue, the company notes in a recent 10-K that the “most significant change was the year-over-year decline in consulting revenues, which was because our customers purchased existing versions of our products. However, on a more positive note, we released new version of our product in the second half of 2007.” The 10-K also states that “consulting projects tend to trail license revenues between six to twelve months.” Given these factors and the fact that license revenue has resumed strong growth over the past several quarters, it appears likely service revenue will at least stabilize in the near future.

 

Scenario Two. If recent license revenue growth continued and service revenue stabilized, overall revenue would grow 16% in 2008 and 20% in 2009. The following table shows this scenario:

 

 

Scenario Three. As a final top-line scenario, assume that license revenue grows not 39% but 17%, the rate achieved in Q4, while service revenue stays flat. As the following table shows, the resulting growth in total revenue would equal 7% in 2008 and 8% in 2009:

 

 

While it’s impossible to accurately predict BroadVision’s revenue growth in 2008 and 2009, the above analysis suggests that after seven years of declining revenue, we may be on the cusp of a trend reversal.

 

 

The increasing proportion of license revenue within the overall mix implies that gross profit dollars may grow faster than revenue dollars. In fact, the company grew gross profit by $2 million in 2007, even as revenue fell by $2 million. The following table shows gross profit in 2008 and 2009 under each of the three revenue scenarios above. The table assumes that profit margins for license and service revenue will equal the margin levels reported in 2007.

 

 

As the table shows, BroadVision could generate incremental gross profit of $4-$8 million in 2008 and $8-$20 million in 2009 (increases for both years are measured against the level of gross profit earned in 2007). Alternatively, if we assume a decline in service gross margins from 69% in 2007 to 60% in 2008 and 2009 due to a higher ratio of consulting to maintenance, incremental gross margin would amount to $1-$6 million in 2008 and $5-$17 million in 2009.

 

Let’s assume that BroadVision maintains research and development expenses at $10 million and general and administrative expenses at $6 million in each of 2008 and 2009. This assumption may not be far-fetched, because even if G&A creeps up, R&D could decline somewhat due to recent new product releases. With sales and marketing expenses amounting to $8 million in 2007, BroadVision could use the incremental gross profit dollars shown in the above table to boost S&M expenses by 50%-100% in 2008 and 100%-250% in 2009 (versus the 2007 level) while keeping EBIT constant. Even if service gross margin dropped to 60% in 2008 and 2009, the company could generate incremental gross profit dollars sufficient to boost S&M by 12%-70% in 2008 and 60%-210% in 2009 while keeping EBIT unchanged from 2007.

 

 

Investors may have irrationally judged the downside scenario for 2008 (i.e., EBIT down 50% or more) to be the likely scenario, partly because the company lacked clarity in the outlook it provided on the Q4 2007 earnings call (available in the investor relations section of www.broadvision.com, or directly at http://www.broadvision.com/attachment/downloads/videos/Q4-2007-Earnings.wav). Due to the uncertainties involved in the ongoing turnaround and the general lumpiness of revenue, BroadVision has had a policy of not providing earnings guidance.

 

The company did share some thoughts on the margin outlook for 2008, and this is where it may have confused investors. Management talked about boosting spending on marketing programs (excluding personnel) from under 2% of revenue in 2007 to 4%-5% of revenue or more in 2008. The company also stated it would accept meaningfully lower profit margins (15%-20% operating margin) as it invests in S&M and generates higher consulting services revenue (which would lower gross margin). CEO Chen later seemed to backtrack a bit, indicating that the outlook for operating margins in a range of 15%-20% might depend on positive revenue growth. If revenue failed to grow as expected, operating expenses might grow less than planned. Specifically, Chen stated in response to a question regarding operating expenses in 2008, “If you look at our ’07 as a baseline, I think we are relatively in line with that right now. So take that as a baseline… and then we believe that if our revenue is doing very well, we then would use the 15%-20% margin as the target to slide up or down with that. That’s kind of how we think we’ll be able to manage this… with a pretty healthy bottom line, but be able to really give our business that jolt, that extra investment that will be required.”

 

While no one can reliably predict BroadVision’s operating income in 2008, the revenue and gross profit dynamics discussed earlier suggest that the company will have quite a bit of room to maneuver on operating expenses as revenue likely grows in 2008 and gross margin stays strong due to continued growth in licenses. Certainly, management could choose to spend so much on sales and marketing that operating profit declines to $8 million or even lower. However, with management having executed the turnaround fairly well so far, and with 38 cents of every operating expense dollar indirectly coming from the CEO’s pocket, it appears unlikely that management will suddenly abandon its commitment to profitability and free cash flow.

 

 

BroadVision was a “dot com” highflier that made founder and CEO Pehong Chen #167 on the Forbes 400 list eight years ago, ahead of Ron Burkle, Donald Trump, and Henry Kravis. Based in Redwood City, Calif., BroadVision employs 195 people (+23% y-y) and sells software that helps companies run transaction-intensive websites featuring sophisticated personalization and customer service functionality. It has a blue chip global client list, including Baker Hughes, Citibank, Epson, Fiat, Hilti, Iberia, ING, Prime Polymer, Renault, Sony, Vodafone, and Xerox (close to 40% of revenue comes from Europe and Asia). Pehong Chen still runs the company and owns 38% of shares. Palo Alto Investors owns 14% and appears to have increased its position over the past year.

 

As a major provider of software to run large websites, BroadVision became one of the most prominent Internet infrastructure firms in the late 1990s, reaching a peak market value of more than $25 billion. Then the bottom fell out (demand from dot coms evaporated), and the painful six-year slide began (2001-2006). BroadVision shares fell from a high of $800 to under $1 as the company posted steep revenue declines, took asset write-offs, incurred restructuring charges, worked to eliminate large liabilities such as office leases, and saw shareholders’ equity turn negative.

 

BroadVision’s incredible fall from grace came with a worthwhile lesson: Striving to meet the sometimes capricious demands of Wall Street, such as the imperative of growth at any price in the late 1990s, may not always coincide with the long-term interest of shareholders. CEO Chen learned the hard way that survival and prosperity could be assured only through sustained profitability. In 2006, Chen saved the company by cost-cutting his way to profitability, stabilizing license revenue, and personally investing millions of dollars to buy out and retire debt (later converted into equity, followed by a rights offering). In 2007, BroadVision experienced a major positive inflection point in license revenue, aided by renewed client confidence in the company’s financial position and product roadmap.

 

 

As discussed above, I conservatively calculate a “market expectation” of $8 million in EBIT embedded in BroadVision’s current stock price. Also as presented, it appears likely that EBIT will come in substantially higher than $8 million. In fact, if revenue growth materializes, EBIT may not decline much from 2007. In an aggressive but not impossible scenario, EBIT may stay flat or even increase in 2008, assuming that existing and new clients quickly embrace the company’s new product lineup. Meanwhile, it is exceedingly difficult to conceive a scenario in which profitability completely evaporates. Therefore, if fundamentals evolve worse than expected, i.e., EBIT declines by 50%, BroadVision’s stock price may simply remain unchanged. On the other hand, the upside remains impressive, driven both by the potential for strong revenue and income growth over the next several years, as well as the potential for significant revaluation of the multiple investors are willing to pay for the company.

 

 

Potential drop in EBIT. Clearly, “the market” expects BroadVision’s operating income to plunge in 2008. In addition to the EBIT analysis presented above, I believe it is important to note that an operating income drop would not represent an adverse exogenous event, such as product obsolescence or the loss of a major client. Rather, an EBIT drop would reflect a strategic choice by management to invest in the business to maximize net present value for shareholders. With CEO Pehong Chen (i) owning 38% of the company and (ii) having taken BroadVision to the pinnacle of the Internet software world once before, I am quite comfortable with management’s choice to reignite top-line growth. An alternative but likely inferior choice would be to continue maximizing EBIT while keeping revenue fairly constant. If management wanted to run the business strictly for cash, the company could curtail R&D expenses, thereby saving up to another $10 million per year. Having released an upgraded product lineup, BroadVision could keep revenue constant, or even growing slightly, while earning EBIT of more than $20 million per year (assuming some curtailment of R&D). At that rate, the entire market cap would be in cash in just three years.

 

Competition from larger competitors. BroadVision competes against a number of companies that may have greater resources and deeper customer relationships, including Art Technology Group, BEA Systems (Oracle), IBM, and Vignette. However, BroadVision has been able to maintain its client roster even as it has gone through financial distress. Now that the company can go to existing and prospective clients with a new product lineup and a strong balance sheet, the selling proposition has improved.

 

Impact of recession. The company has clients across a wide range of industries, including financial services (filings do not break out revenue by industry). A prolonged recession would certainly impact BroadVision’s ability to achieve meaningful revenue growth. However, whether the company succeeds or not may depend less on the economic environment than on its ability to execute. As CEO Chen noted on the Q4 2007 earnings call, “Being small in our footprint right now, we are operating under a law of small numbers. We ought to be able to handle what we need to handle despite the macro conditions.”

 

 

This is not a solicitation to buy or sell stocks. Please do your own independent analysis before buying or selling BVSN (or any other stock). We have a long position in BVSN at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on our BVSN buying or selling activities.