Description

Summary:

• Business overview: JDA Software is an enterprise software company whose core is supply chain management for large retailers and consumer goods manufacturers
• Current trading: due to a series of events over the last 6 months, JDAS is trading too cheaply at a 13% forward unlevered FCF yield
• Bull thesis: 6-9% organic growth, a 400 bps margin expansion opportunity, logistically sticky customer base, contractually recurring cash flows, customer capex budgets that remain depressed from the recession, and the possibility of a strategic or financial takeout
• Additional catalysts: high interest debt becomes callable in December (taking out bonds is 16% accretive to 2012 EPS due to the company’s positive net cash balance), overhang from a recent SEC investigation is removed (discussed in more detail below) and the fully integrated next generation software platform is released in Q1 2013
• Price target: at most a 9% forward unlevered FCF yield, or at least $45/share, representing >40% upside from current trading ($31.99)

JDA today represents three distinct businesses that were consolidated and integrated over the last 7 years: Manugistics, i2, and legacy JDA. JDA's primary competitors in large enterprise are SAP and ORCL, who offer slimmed-down supply chain management software modules that are extensions of their ERP offerings. On the lower end JDA competes with MANH, Red Prairie, and AMSW.A (via its Logility subsidiary). According to people we spoke with, JDA is considered "best of breed" for enterprise grade applications, counting 73% of the top 100 US retailers and 82% of the top 100 US CPG manufacturers as customers.

We estimate that organic growth has averaged 5% over the last 5 years, a period that includes the recent economic downturn. Management is guiding to 6-9% organic growth over the medium term, a number they arrive at by layering growth initiatives like Russia expansion and multichannel retail on top of 2-4% growth in the core business. Management claims to have baked conservatism into those numbers, having haircut all growth initiatives by 50% before arriving at its 6-9% forecast. JDA's S&M expense to license revenue ratio of 80%, maintenance attach rates of 20%, and maintenance renewal rates of 95%+ all suggest a sticky, growing revenue base. Large retailer capex budgets today are at roughly 80% of their pre-crisis levels, suggesting some potential for further rebound as economic uncertainty is removed and companies again invest in their capital equipment needs. Additionally, retailers we spoke with point to the increasing importance of effective supply chain management in fending off online threats (for example, software that enables selective price matching at the POS), which could result in a mix shift of capex budgets towards supply chain management. And finally, the release of JDA 8.0 in Q1 2013 will bring legacy i2, Manugistics, and JDA components onto a common platform, increasing JDA's ability to cross sell those components into its existing customer base.

Despite having $362M in cash, JDA currently has $275M in outstanding bonds that carry an 8% coupon. These bonds become callable in December 2013 at 104, and in December 2014 at par. The elimination of the $22M of interest expense associated with these bonds would be 16% accretive to adj. EPS. Although we believe the "right" way to look at JDAS is on unlevered FCF yield, at least one sell side analyst sets his target using a PE multiple and doesn't account for the takeout of these bonds in his earnings estimates.

As a result of past M&A, JDA has NOLs listed on the balance sheet at $286M, which on a discounted basis are worth at least $150M. These NOLs are in usable jurisdictions, and as a result JDA will pay at most $15M in taxes per year through 2016. Despite this, adj. EPS does not give credit for use of the NOLs, and sell side cash flow estimates wrongly assume earnings are fully taxed.

On Jan 17, 2012 JDA announced an SEC investigation into its revenue recognition policies and shares consequentially fell 17%. Revenue recognition in enterprise software is notoriously complex, but over the past 8 months management has steadfastly insisted that the investigation dealt with the timing, not the existence, of revenue, and that cash flows were unaffected. JDA concluded its internal investigation in August, finding that in some instances revenue booked in one quarter should have been booked in the subsequent quarter, cash flows were indeed unaffected, and that there was no evidence of fraud or intentional wrongdoing. Historical financials have been restated and all regulatory filings are again up to date. The absence of fraud and the sanctity of cash flows lead us to believe this investigation is of little material importance to valuation, yet some investors may be restricted from buying JDAS shares until the SEC delivers its final verdict on the matter, creating a temporary buying opportunity for those free from such restrictions.

There are three principal elements to the bear thesis. First, bears argue that customers are increasingly consolidating supply chain management and ERP vendors, thereby cutting out best of breed suppliers like JDA. Our calls have suggested that if anything, there is a movement back to best of breed as companies recognize the strategic importance of effective supply chain management. Management cites win rates vs SAP and ORCL in the 60s for one and in the 70s for the other. Second, bears argue that SaaS could be disruptive to JDA's business model. We simply note that enterprise grade supply chain management requires far too much customization to be run on a multi-tenant platform, and that 98% of JDA's product offering is already available through a web GUI, making it well suited for an off-premise hosted model. Furthermore JDA's cloud services billing model, which preserves the license/maintenance revenue split, avoids the "air pocket" typical of other vendors switching to a cloud-based model. Finally, some bears worry about what management does with its prodigious cash flows. We believe management has a well-articulated strategy of buying bolt-on technologies that can be pumped through its existing sales force, and aside from those has expressed openness to various forms of equity return of capital. There are also shareholder-friendly members of the board (for example Arthur Young of Blum Capital) that should provide voices of reason in any discussions around M&A.

There is some reason to believe JDA gets taken out, putting a floor on the stock and an upside node in the returns fan. Revenue and cost synergies are obvious, and there may also be tax synergies related to utilization of the NOLs. IBM has talked of beefing up capabilities in this area, and both SAP and ORCL would hate to see the best-of-breed supply chain management software vendor fall into enemy hands. The highly leverage-able stream of recurring cash flows is also highly attractive to private equity. Several public investing vehicles affiliated with private equity firms (for example, Golden Gate and Sageview/KKR) are listed as holders of JDA shares.

To adjust for historical working capital swings and recent restatement costs, we favor forward unlevered FCF yield as a valuation framework for JDA. At the midpoint management has guided to $682M of 2012 revenue, 26.4% EBITDA margins, $20M of capex, and $10-15M of cash taxes. Assuming mid-point of top line growth guidance (7.5%), modest margin expansion (50 bps/yr), negligible WC requirements, and flat capex/taxes, one arrives at $165M of unlevered FCF for 2013. This represents an unlevered FCF yield of 13% at a $31.99 stock price. We feel that a best-of-breed software vendor growing HSD with these characteristics should trade for at most a 9% unlevered yield, implying a $45 share price, or >40% upside from current trading. A strategic or financial takeout could provide even more upside, as JDA’s current 4.0x multiple of maintenance and recurring revenue represents a substantial discount to the historical 6-8x multiple paid by ORCL and SAP for similar businesses.

***This posting is solely for the evaluation of VIC members and is not a recommendation to buy or sell this stock.  This writing reflects the views of the individual author and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time.***

Catalyst

• High interest debt becomes callable in December
• Overhang from a recent SEC investigation is removed
• The fully integrated next generation software platform is released in Q1 2013
• Continued underlying organic growth and logical bolt-on acquisitions
• Continued build-up of cash and return of capital