Description

Captaris presents a highly attractive investment with 50% upside and minimal downside. There is a large margin of safety, imminent catalyst, a mis-understood acquisition with earnings/cashflow upside, and a short-term mis-pricing in the marketplace.

Company Overview:

Captaris is a software company that provides products that automate business processes, manage documents electronically and provide information delivery services. Its software products address the enterprise fax server (Right Fax), e-document delivery (Alchemy), and business process automation (Workflow) markets. It sells its products primarily thru a global distribution network of resellers and systems integrators in 40 countries. The company is headquartered in Bellevue, WA and has approximately 440 employees. Captaris acquired a direct competitor, Castelle Inc. (ticker: CSTL) for $10.8M on July 11, 2007.

Valuation Summary:

Current Price/Share $4.00 (52-week High:$9.09, Low: $3.96) Fully diluted shares 27.5 Market Cap $110.0 Cash & Equivalents (1) 47.5 Debt 0.0 Value of Hidden Assets - NOLs(2) 2.6 Enterprise Value $59.9 (1) Includes short-term and long-term investments available for sale and restricted cash (2) Present Value of $8.7M of Federal NOLs. Excludes State and International NOLs of $16.4M

Valuation Multiples:

			Pro Forma (3)
	2006	LTM	2007E	2008E
EV/Revenue	0.6x	0.7x	0.6x	0.6x
EV/Maintenance Rev	1.7x	1.5x	1.5x	1.3x
EV/EBITDA	5.8x	15.4x	7.8x	6.1x
EV/FCF	4.2x	15.3x	7.0x	4.8x
Price/Tanglible Book	1.9x	2.5x	2.5x	2.2x
(3) Assumes Castelle deal closed on 1/1/07 and cost synergies recognized as per management's recent guidance.

Investment Thesis Overview

• Highly attractive risk/reward with minimal downside and a near-term takeout on the upside.

• Large margin of safety provided by the company’s large cash pile, recurring maintenance revenues and NOLs

• Potential upside of 50% with an intrinsic value of $6.00 that is trading at less than 5x Free Cash Flow.

• Low risk of obsolescence as a fax technology has a long tail and vital in many industries and internationally.

• Mis-understood acquisition: revenues and synergies from recent Castelle acquisition are not factored into the Company’s valuation and increased cash flow generation capability as it leverages its fixed cost structure. Company has the ability to take out significant more costs than they have initially stated.

• Near-term catalyst:

• On August 20 2007, Vector Capital (a private equity firm specializing in buyouts of technology companies) filed a 13D announcing that it owns 10% (at a cost basis of $4.75/share) of the company and is interested in purchasing the Captaris.
• On September 12, Vector entered into a NDA with Captaris to commence due diligence.
• On November 11, 2007, Ramius Capital, a hedge fund with 9.8%, filed a 13D stating that they do not believe that Captaris should remain a public company.
• Given the pressure that management and the board face from shareholders, we believe Vector Capital or a strategic buyer will ultimately purchase Captaris for a significant control premium to the current price.

• Short-term mis-pricing: Since mid-September, the stock is down 30% as the company missed its earnings guidance for Q3 but stated that it expects a strong Q4. We speculate that much of the sell-off in the company’s stock since Vector began its due diligence of the company was led by Quant Funds who comprise 5 out of the 10 largest shareholders and own more than 25% of the outstanding stock. Many of these quant funds including Goldman Sachs Alpha and Barclays Global have been known to liquidate shares to reduce exposure due to losses in other parts of their portfolios. I believe the Quant fund liquidations combined with the inevitable year-end tax loss selling provides a very attractive entry point with minimal risk of capital loss.

Margin of Safety Overview:

• Net Cash represents 43% of the market cap.

• There is no debt or contingent liabilities.

• Captaris has recurring maintenance revenues of $39M that are derived from over 19,000 customers. These maintenance contracts have historically had very high attach rates to new license sales and very high on-going renewal rates. I expect that these maintenance revenues will continue to grow as a result of new license sales and the addition of 3,000 customers that are added from the Castelle acquisition. Though the company does not break out maintenance gross margins, these tend to average over 80% in the software industry.

• Captaris has over $25M of federal, state and international net operating losses on its books. Given that Captaris is profitable, my analysis shows that the Federal NOLs alone have a present value of $2.6M.

• The company has spent $20M in last 2 years repurchasing nearly 10% of its shares outstanding. It currently has a buyback plan in place to purchase up to another $11M of shares. Given its recurring maintenance revenue stream and history of positive cash flow, Captaris also has the ability to take on leverage to fund additional share buybacks and maintain a more efficient capital structure. Since a leverage buyout fund is looking at taking the company private, it is clear that the Company can support some leverage.

Industry Overview:

• Captaris’ products compete in the electronic document delivery and electronic content management market. Businesses use these products to automate paper intensive processes, improve customer service, increase productivity, accelerate revenues, and efficiently capture, disseminate and store information. The total market size is over $7B while the worldwide addressable market for Captaris’ is probably $400M-500M.

• Though counter-intuitive, fax technology continues to be a long-tail product when compared with email and other document deliver methods. The use and distribution of paper-based contracts and claims by healthcare, government, insurance, real estate, and financial services firms will inevitably continue for a long-time. Even if we enter a recessionary environment where there's a significant economic slowdown, I believe that faxing will be necessary until electronic documents and digital signatures become 100% ubiquitous and accepted globally.

Products:

Captaris has four main product lines.

• RightFax – this is the Company’s main product line and represents 75-80% of revenues. RightFax enables large and medium enterprises to send and receive high volumes of faxes and automatically route and store them. The products are typically sold as a fax server. Revenues are derived from hardware, software, installation services and maintenance contracts.

• Alchemy – represents approximately 10% of revenue. This product enables storage, archiving and document management of various types of electronic content. The product is used by organizations that need to meet regulatory compliance or disaster recovery objectives. The product is built on Microsoft .Net architecture and integrates with Microsoft Sharepoint (collaboration software).

• Workflow – represents approximately 5% of revenue. Workflow is a set of tools built on Microsoft technology that enable organizations using Microsoft software to rapidly develop and integrate automated business processes.

• Castelle FaxPress – represents 10% of revenue. This is a lower-end Fax Server product that is sold thru direct thru the web and thru channels partners. Castelle also has a set of connectors that work with multi-function printer companies such as Canon, Xerox and Ricoh.

Go to Market Strategy:

• Captaris sells its products in the US and internationally primarily thru an indirect channel of 1,000 systems integrators, value-added resellers and partners. These selling partners are typically small-to-medium size organizations with a regional focus. Captaris provides leads, training, and sales support services to the channel.

• In my channel checks with half a dozen of these partners, it is evident that Captaris’ channel is one of its hidden assets. Many of the partners have been working with the company for up to 10 years and have a good relationship with them. The channel primarily sells the RightFax products based on its affordable price point ($15-25k/server), ease of installation (1-2 days), high return on investment to the customer (over 40%) and high maintenance attachment rates (near 100%).

• In my discussion with the channel, it’s evident that they are not overly concerned about disruptive technologies such as email replacing fax. They continue to sell RightFax and are beginning to sell the Alchemy product. However, they struggle to sell the Workflow product as it requires significant technical expertise.

Customers:

• Primarily Fortune 1000 companies with all of the Fortune 100 companies as customers.

• Over 22,000 maintenance contracts (19,000 from Captaris and 3,000 from Castelle)

Growth opportunities

Captaris’ cumulative average revenue growth rate over the last 4 years is 5%. Revenue growth slowed in 2007 as a result of weakness in the US and the financial services market and management’s distraction related to the Castelle acquisition. The international markets and the Alchemy product were the few growth areas. The Company claims that the following opportunities exist to enable future growth.

• International markets

• Fax Over IP products

• Microsoft Sharepoint connector tools for the Alchemy product

• OEM sales from integrations with multi-function printers companies and strategic partners

Management

I believe that the quality of the management team is average at best (its a good thing someone else is about to buy this company). Since early 2006, they have done a good job of taking out costs and maintaining a very healthy channel base, however, they have been poor at finding scaleable growth opportunities. The Alchemy and Workflow product acquisitions were not integrated well and as a result have been unsuccessful to date. Though the Castelle integration just started, management has not done a good job of communicating the benefits of this recent acquisition to shareholders and channel partners which caused the stock to drop after the Q2 earnings call. In the Q3 quarter, management missed their guidance which caused the stock to take another leg down. Management blamed weakness in the financial service sector but stated that they see signs of a recovery in the first mon th of the Q4 quarter and are expecting a strong quarter.

Competitive Landscape:

• Captaris is the largest player in the enterprise market with over $100M in revenues. Smaller competitors in the enterprise market include Omtool Ltd (public), Dicom Group plc (public), Esker SA (public), Fenestrae B.V. (private), Sagem-Interstar Inc. (private)

• J2 Global (public) and Premiere Global Services (public) are the primary competitors in the consumer and SMB market with hosted solutions.

Ticker	Company	EV/Rev	EV/EBITDA	EV/FCF
OMTL.OB	Omtool Ltd.	1.0x	NM	NM
DCM.L	Dicom Group plc	0.8x	7.0x	8.2x
ESK.PA	Esker SA	1.1x	19.6x	9.5x
JCOM	J2 Global Communications, Inc.	4.6x	10.6x	10.5x
PGI	Premiere Global Services, Inc.	2.0x	10.7x	8.8x
Average		1.9x	12.0x	9.3x
CAPA	Captaris (Pro Forma)	0.6x	7.8x	7.0x

• There has been significant consolidation in the industry over the last few years as the market has matured. The following are precedent M&A transactions

Target	Acquiror	Date	Price (M)	EV/Rev	EV/EBITDA
Castelle	Captaris	7/07	$10.8	1.0x	15.8x
BlueChip Tech	Omtool Ltd.	12/06	$4.3	1.0x	11.2x
TOPCALL International	Dicom Group, plc	12/04	$49.0	1.3x	17.0x
Information Mgmt Research	Captaris	10/04	$26.5	NA	NA
Teamplate	Captaris	9/03	$12.0	NA	NA
eFax.com	J2 Global	7/00	$29.7	1.4x	NM
Documentum	EMC	10/03	$1,451.0	5.3x	39.5x
Average (1)			$22.1	1.2x	14.7x
(1) Excludes EMC/Documentum transaction

• In the software industry, acquirers often value targets based on recurring maintenance revenues as they are often able to strip out significant labor-based G&A, R&D and sales and marketing to generate a positive return. A recent Bear Stearns software acquisition study showed that mature, low-growth software companies have been sold at 5x-7x trailing maintenance revenues to financial and strategic buyers. At current prices (1.5x EV/LTM Maintenance Revenues), a buyer for Captaris could effectively shut down the sale of new software licenses and shut down new development, and recoup their investment within 2 years by just servicing current customers. With over 22,000 active customers, I believe a buyer at these valuations would be able to make an extraordinary profit with this long-tail, highly profitable product.

Intrinsic Value Analysis:

• My estimate of the company's takeout value is $6.00 (1x Forward EV/Rev) and $7.00 based on a 5-year discounted cash flow model assuming a 5% revenue growth rate and that the company can return to EBITDA margins that it had in 2006. I also assume a 10% discount rate and 15x terminal multiple of free cash flow.

Risks:

• Increase competitive pressures from hosted software vendors such as J2 Global could cause price erosion or loss of customers.

• Continued weakness in new license sales as a result of deterioration of the financial services sector especially mortgage and real estate companies.

• Revenue leakage or lower than expected synergies from the integration of Castelle.

• Vector or other potential buyers decide to not pursue the acquisition.

• Quant funds could continue to cause near-term volatility
  

Top 10 Shareholders:

Shareholder	Position	Recent Change	% Owned
Vector Capital	2,689,960	2,689,960	10.1%
Ramius Capital Group L.L.C.	2,600,569	1,850,569	9.8%
Renaissance Technologies Corp.	1,913,300	116,300	7.2%
Dimensional Fund Advisors, LP	1,802,460	90,429	6.8%
Goldman Sachs Asset Management	1,508,155	(288,700)	5.7%
Riley Investment Management	1,493,092	-	5.6%
Barclays Global Investors	1,148,487	(434,720)	4.3%
Putnam Investment Management	836,032	(226,339)	3.1%
Munder Capital Management	814,500	14,500	3.1%
Columbia Management Advisors	784,516	42,546	2.9%
% held by Institutions	23,714,534		89.0%
% held by Mgmt (includes options)	1,787,367		6.7%

Disclaimer: My firm is a shareholder of Captaris. This is not a solicitation to buy or sell securities. Please do your own independent research and thorough due diligence before buying or selling any shares in Captaris (or any other stock). We may buy or sell shares of Captaris in the future and are under no obligation to provide any update or details on VIC (or elsewhere) on our trading activities.

Catalyst

1)Company is currently in discussions with a private equity buyer. Other strategic buyers may also emerge.
2) Recent acquisition will enable higher cashflow generation capability.