GlobalSCAPE (GSB)

Summary

We focus on smaller companies with Ft. Knox balance sheets and large & sustainable free cash flow yields and we are typically seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation, through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We also focus on small and micro-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

This idea is a small company with limited trading and is most appropriate for small funds and personal accounts.  Also, we waited for Q3 results to post this idea and they were very strong which drove a major increase in the stock price.  Despite this increase, we believe there is significant value remaining in GSB over a two or three year horizon at current share prices.

GlobalSCAPE (GSB) develops and distributes software, delivers managed and hosted solutions, and provides associated services for secure information exchange for consumers and enterprises worldwide. It offers managed file transfer (MFT) solutions, including CuteFTP, a client side software product that enables file transfers to or from an FTP server.  The company also offers server based managed file transfer programs, such as Enhanced File Transfer Server, which provides digital certificate management, remote management capability, and the ability to manage user accounts for security and control, as well as Enhanced File Transfer Server Enterprise, an enterprise file server that supports enterprise installations.  GSB’s core product is the Enhanced File Transfer or EFT which currently represents about 80% of total revenues.

GSB operates primarily in the Managed File Transfer or MFT industry.  The company is seeking to evolve its MFT focus into adjacent solutions spaces that create Total Path Security, which addresses data and information in motion and at rest.

GSB’s solutions facilitate the transmission of critical information such as financial data, medical records, customer files, vendor files, personnel files, and other similar documents between diverse and geographically separated network infrastructures while supporting a range of information protection approaches to meet privacy and other security requirements.  GSB products provide the ability to monitor these activities, as well as access the underlying data, securely and flexibly through a wide range of network-enabled, mobile devices, including tablets and smartphones.

GSB has helped the U.S. Army ensure secure delivery of mission-critical data around the world since 2005.  GSB has received substantial product license and maintenance and support orders from the U.S. Army, including a $2.7m order in April 2009 and other orders in May 2007 and September 2005.  In June 2013, the U.S. Army exercised year one of a two year option contract (worth $1.45m) to continue GSB’s support for the Standard Army Maintenance System Enhanced (SAMS-E) logistics program and extended the maintenance and support contract through July 2014.  Then CEO Craig Robinson was quoted, “the U.S. Army uses GlobalSCAPE secure information exchange solutions to move large amounts of logistical data around the world to support thousands of troops  and numerous military operations”.

GSB has an attractive asset-light business model with limited capital expenditures and working capital needs and GSB is generating strong free cash flows.  GSB has an ROIC over 100% based on Adjusted EBITDA/FCF divided by working capital plus net PPE.  GSB’s revenues and gross profits have been growing steadily over the past several years.  Like most software companies, GSB has very high gross margins (95%) so even modest revenue growth can result in significant incremental profitability and FCF.

GSB has been a strong and consistent generator of FCF for many years: over the 6.5 years from 2007 through YTD 2013, GSB has generated about $27m of cumulative cash from operations or close to 80% of the current enterprise value (EV).  Even during 2008-9, GSB generated strong cash from operations and FCF.  We believe this speaks to the strength of GSB’s business model and the “stickiness” of its revenue base among customers.  If GSB can sustain these levels of cash generation, we believe its share price will go significantly higher over time.

GSB has a “Ft. Knox” balance sheet, with $13m in cash and $5m in debt at 9/30/13, for net cash of about $8m.  GSB has 19m shares outstanding at about $2.20 per share for a market cap of about $42m less $8m of net cash or an enterprise value (EV) of about $34m.  Based on LTM Adjusted EBITDA and FCF of $5m, GSB is trading at 7x Adjusted EBITDA and a 15% unleveraged FCF yield.  LTM revenues are $25m so GSB is trading at about 1.4x LTM revenues.  We think these valuation metrics are highly attractive for a niche software company with 95% gross margins, 55% recurring revenues, years of steady revenue growth, cumulative cash from operations of about $27m in past 6.5 years (80% of current EV), a business model with ROIC over 100%, and a “Ft. Knox” balance sheet.  We think GSB’s total revenues could grow $2m+ per year over the next few years, driven by growth in maintenance and support revenues and generate significant incremental gross profit dollars given the high-margin business model.  We believe Adjusted EBITDA and FCF could climb to $6-$8m by 2015.  Based on $7m of Adjusted EBITDA and FCF in 2015 at a 10x multiple plus $15m in net cash, GSB could have a market cap of $85m and a share price of $4.50 per share (+100% from $2.20 today).

In the last year, GSB has focused on stronger expense management and improved operating leverage, resulting in major improvements in Adjusted EBITDA and FCF.  Nine months FY13 revenues were $18.1m versus $17.2m in prior year, and nine months Adjusted EBITDA was $4.1m versus $1.7m in prior year, primarily driven by reduced operating expenses.  LTM EBITDA and FCF are about $5m.  We expect modest growth in Adjusted EBITDA and FCF in the next few years. 

GSB also has significant deferred revenue, which results primarily from advanced bookings of maintenance and support (“M&S”) services to be provided in the future, and this is a key indicator of its potential future revenue trends.  GSB obtains the bookings when it sells software licenses to its customers, which is an indicator of their front end commitment to its product, and as renewals of the existing M&S agreements, which is an indicator of its customers’ ongoing satisfaction and confidence with its solutions and services based on their personal experience.  GSB noted that deferred revenue increased to $10.7m at 9/30/13 from $9.8m at 9/30/12 or about 9%.  We believe that a portion of this increase was driven by the U.S. Army, a long-time GSB customer, exercising an option to renew its M&S agreement for another year.

We believe, over the next few years, GSB shares offer an attractive risk-reward considering the stable business model, recurring revenue base, “Ft. Knox” balance sheet, high ROIC and cash generative business model, and modest valuation.  Further, we believe GSB could be an attractive acquisition for a strategic or financial acquirer.

GSB’s revenues are diversified over a large base of thousands of customers with no one customer representing more than 10% of total revenues.  We believe GSB’s largest customer is likely the U.S. Army, which recently renewed its M&S contract with GSB in June 2013 through June 2014.  GSB software products are used by over 20,000 U.S. Army personnel.

GSB’s strategic focus is centered upon the following key areas:

• Entering broader information exchange markets while maintaining leadership in the MFT industry;
• Growing recurring revenue;
• Developing and enhancing existing software solutions;
• Extending its presence in the secure content mobility market;
• Increasing international sales through third party distributors;
• Growing enterprise and government sales; and
• Developing the corporate brand and market recognition.

There is a sad backdrop to the investment.  GSB’s former CEO Craig Robinson (age 49) was doing an excellent job at improving GSB’s profitability and FCF through strong cost controls and solid revenue growth from M&S contracts.  Tragically, CEO Robinson passed away in September 2013 during minor surgery.  Despite this setback, GSB seems to have regrouped and has named James Bindsell as Interim CEO.  Bindsell has been with GSB since 2010, most recently SVP of Client Operations, and has held leadership positions at Fujitsu, Symantec, and AXENT Technologies.  He appeared very solid on the Q3 conference call.

GSB has built up a large installed base of users for its main Enhanced File Transfer product, including the U.S. Army, which uses GSB software to encrypt communications regarding logistics in its military operations.  Due to its large and increasing installed base of customers, GSB has enjoyed a steadily growing M&S contract revenue base which currently represents about 55% of total revenues.  These M&S revenues are recurring in nature, with high renewal rates (management has not given a specific %) and management expects M&S revenues to represent an increasing share of total revenues over time.

GSB has invested in two companies in recent years.  In 2010, GSB invested about $3m in Core Trace  to develop its appShield product (see below) and in December 2011 GSB acquired Tappin for $9m in cash and earn-outs of up $8m.  About $2m of the Tappin earn-outs have been paid to date and the rest are not expected to be paid, based primarily on revenue levels from Tappin that are below targets.  Tappin is an important strategic acquisition which should eventually enable GSB to provide its customers with secure file transfer software on mobile devices.  GSB has been working with various OEMs, including Seagate, to basically have the Tappin product embedded in their OEMs products, and Seagate has included Tappin in one of its latest releases.  GSB has yet to realize significant revenues from Tappin, but we think there could be potential down the road.

GSB invested in Core Trace in 2010 which was working to develop GSB’s appShield technology into a viable product for the computer endpoint industry.  However, this investment did not work out and Core Trace sold its assets in early 2012 for an amount that did not allow GSB to recover its investment.  In 2012, GSB wrote off the investment in Core Trace, which resulted in a $3.3m non-cash impairment charge.  In Q3 of 2012, GSB’s prior CEO Jim Morris resigned and then-COO Craig Robinson assumed the CEO role.  Robinson was successful in reducing GSB’s operating expenses in H2 of 2012 and H1 of 2013 which has resulted in improved profitability and FCF generation.  As discussed, Robinson tragically passed away in September 2013 but GSB’s team, led by interim CEO James Bindsell, seems highly focused on sustaining the positive trend in financial results, and Q3 results were strong.

Other Segments

GSB generates almost 80% of total revenue from its flagship EFT Server product but is working to diversify its revenue stream into adjacent areas.  GSB also offers managed email attachments, software as a service, and cloud based subscription solutions for information sharing solutions but these are small contributors to total revenues at this point.

Strongly Improved Results for YTD 2013

GSB’s financial results for nine months 2013 have been much stronger than in 2012.  Management has stated its focus in 2013 will be on “increasing revenue growth while remaining focused on the bottom line”.  Since mid-2012, GSB has better controlled operating expenses, resulting in stronger earnings and Adjusted EBITDA. Nine months FY13 revenue was $18.1m vs. $17.2m in prior year.  Nine months FY13 EBIT before items was $2.9m vs. $0.1m due to higher revenues and reduced operating expenses.  Operating expenses were $14.6m in FY13 versus $16.2m in FY12 or down 10%.  Nine months FY13 Adjusted EBITDA was $4.1m vs. $1.7m.  LTM Adjusted EBITDA was $5.1m. 

Quotes from the Q2 FY13 conference call give us encouragement for strong revenue growth and controlled expenses in H2 of FY13.  Then-CEO Craig Robinson stated “we have emphasized increased earnings as a primary business objective for 2013 and are pleased with our performance in that area during the first half of the year”.  He also went on to say, “I believe we are well-positioned to build upon these results with faster revenue growth during the remainder of 2013”.  Obviously, these statements are no guarantee of success but we think they indicate good prospects for a strong H2 in FY13.

Strong cash generative business model and attractive FCF yield

GSB has a highly cash generative business model which is asset-light with limited capital expenditures and working capital needs and a high ROIC.  Furthermore, GSB currently trades at an attractive 16% unleveraged FCF yield, with decent prospects for near term growth in FCF in 2013-14.  GSB has a high ROIC business model (over 100%) based on free cash flow (cash from operations less capital expenditures) versus the investment in net working capital and net PPE.  Consequently, with even modest revenue growth, we think GSB can generate significant incremental FCF from current levels.

Strong Competitive Position

We think GSB has a strong competitive position in the secure file transfer software industry.  There are only a few other key competitors, including Sterling Commerce and Axway.  GSB’s core software product, representing close to 80% of its revenues, is the EFT (Enhanced File Transfer) product and in early 2013, GSB released an upgraded 2013 EFT product.  GSB’s software products are deployed over a large customer base which is likely to continue using its products, as long as they are upgraded and competitive with the marketplace alternatives.  The high renewal rates for maintenance and support contracts indicate satisfied customers and a strong competitive position.  Highlighting its military grade-rated security, GSB has signed several separate contracts with the U.S. Army since 2005 and over 20,000 Army personnel use GSB’s software products and services.  GSB recently received a Champion rating from Info Tech Research Group’s Vendor Landscape for managed file transfer.

Improved Operating Results Under New Management Team

Since Craig Robinson took over as CEO in mid-2012, there has been a stronger focus on operations, with reduced operating expenses and higher revenues resulting in strongly improved EBIT before items and Adjusted EBITDA before items.  This increased focus on expenses to generate operating leverage has also improved cash flow generation, as Adjusted EBITDA increased to $4.1m for nine months FY13 versus $1.7m for nine months FY12.  We expect revenues to show steady growth over the next few years which should result in improved Adjusted EBITDA before items.

Compounding Effect of Large Base of Maintenance & Support Contracts which Provide Recurring Revenue

GSB has a large base of customers who are on maintenance and support (“M&S”) contracts which can be renewed each year.  M&S revenues currently represent about 55% of GSB’s total revenues and these M&S revenues are recurring in nature.  The company has said its renewal rate is very high (has not disclosed exactly what % rate).  We think these customers are likely to continue using GSB’s software products.  Importantly, M&S revenues have grown over 20% in both FY11 and FY12 and M&S revenues are becoming an increasingly large portion of GSB’s total revenues.  There is a very attractive compounding effect over time with M&S revenues due to the compounding effect of high renewal rates over an increasingly larger base of customers.  M&S revenue growth should provide a steady base of growing revenues for GSB over time.

Recent Growth in Deferred Revenue Could Indicate Solid Future Revenue Growth

GSB’s deferred revenue has grown 9%+ on a year-over-year basis as of 9/30/13, which should bode well for future revenue growth.  GSB has noted in press releases that growth in deferred revenue can be a good indicator of future revenue growth since deferred revenue represents contracts which have been booked on the balance sheet for future periods but not yet amortized through the income statement. 

Attractive Upside Potential

In 2012, GSB generated approximately $4m of FCF (cash from operations less capital expenditures).  We believe GSB can grow Adjusted EBITDA and FCF in 2013-14 based on increasing maintenance and support revenues and strong expense controls which should increase Adjusted EBITDA and FCF.

We believe GSB could generate FCF of $7m in 2015 with net cash of $15m+ by year end 2015.  We believe GSB could trade for $70m or 10x FCF in 2015 plus $15m of net cash at year end 2015 or $85m or $4.50 per share, more than 100% higher than present $2.20 per share.

Potential for Share Repurchase or Dividends

GSB has paid modest special dividends in both FY12 and FY13 as net cash has built up on the balance sheet.  We believe management focused on the current depressed market valuation of its stock and will likely be more aggressive in reaching out to investors in 2014.  We believe management is not significantly focused on acquisitions at this time but rather on improving core products, services, and operations and thus accelerating organic growth.  We believe that if GSB’s share price remains depressed and its improving operations are not being recognized in the market, there could be a major share-repurchase program and/or a major dividend program.

Solid Balance Sheet and Expected Steady Build-up in Net Cash Position.

GSB has a “Ft. Knox” balance sheet with a net cash position of $8m at 9/30/13.  We believe management has positioned GSB to generate about $5m of FCF per year in 2013-4 and we think GSB could end FY14 with a net cash position of $12m+, about 35% of the current EV.  Alternatively, management may use the strong cash position to repurchase shares, pay dividends, or complete accretive acquisitions.  We think the potential build up in net cash over FY13-4 will highlight the strong cash generating capabilities of the business model and could attract investor attention.

Conclusion and Target Price

Based on 10x our FCF estimate of $7m for 2015 plus a projected $15m+ net cash position at year-end 2015, we believe GSB could trade for an EV of close to $85m or $4.50 per share or more versus $2.20 per share today (+100%).  If GSB continues to execute and its security software business performs as we expect, we think our target price can be achieved.  Further, GSB’s industry-leading software and strong customer base could prove attractive to a strategic or private equity acquirer.