|Shares Out. (in M):||19||P/E||0||0|
|Market Cap (in $M):||378||P/FCF||0||0|
|Net Debt (in $M):||-100||EBIT||0||0|
|TEV (in $M):||277||TEV/EBIT||0||0|
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LTM revs: 290mm
LTM ebit: 13mm
Maintenance revs: 145mm, ~95% retention
Subscription revs: 30mm, growing at 40%+
Corporate HQ: 120k square feet on 28 acres in Santa Barbara right next to the water. Probably worth over 50mm.
QAD is an ERP software developer for manufacturing companies. It is the leading niche player in the manufacturing industry with 10% market share which should grow rapidly through sales of its superior cloud offering. The business model is attractive because of the high level of recurring revenue and high level of customer retention. ERP within the manufacturing space is also extremely complicated and the software is mission critical to customers, which creates significant barriers to entry. The current entry price represents an attractive entry point with 50%+ upside to fair value as described below.
QAD makes ERP software for manufacturing companies. It has ~3k customers, mostly large public companies, deploying the software at ~6k sites. QAD software has been sold traditionally on a perpetual per-seat license with annual maintenance and support agreements priced at ~20% of a license. Maintenance contracts are renewed at ~90% because customers need training, support, and updates. The existing customer base buys new licenses as they add employees, acquire new divisions, and open new plants. QAD is in the process of transitioning to primarily a cloud subscription model that is priced at 3-4x the equivalent maintenance contract rate. The shift has masked the overall growth rate of the business, but with a 3 year revenue break-even point for QAD, the shift should lead to superior profitability over the life of the customer. Because ERP software is the mission-critical lifeblood of a modern manufacturer, customer retention is extremely high, sales cycles are long, and it is very difficult to take or lose market share.
Management and Ownership
QAD is managed, controlled, and 60% owned by Pam and Karl Lopker, who founded the company in 1979. Under Lopker leadership, long-term customer relationships are prioritized at QAD. Pricing is stable and fair, and the product investment / improvement is prioritized. Expense management is a bit loose, to the benefit of employees. Capital allocation is conservative: balance sheet is kept debt free while cash is used for dividends, share repurchase, and tuck-in acquisitions.
The Lopkers are unpopular with some investors because they do not maximize near-term margin and, most importantly, they refuse to sell the company (and have a blocking position) even though it has traditionally traded at a huge discount to its private market value. The Lopkers don't want to sell because they correctly reason that selling this type of software company is nearly always bad for customers and usually bad for the employees. Under a buyer, they surmise that QAD would quit gaining new customers, lose some of their existing customers, and that the acquirer return on investment would have to be earned through price increases and cost cuts.
While the Lopker world view is at odds with most shareholders, it is not irrational. Interestingly, their view is quite similar to that of Dave Duffield, CEO of Workday, who, after seeing PeopleSoft wrestled from him by Oracle and subsequently run into the ground, structured a WDAY dual share class to prevent a sale. The market does not seem to penalize Workday for the unlikeliness of a sale, and neither should it penalize QAD significantly, because, as will we discussed in the next section, QAD's growth is about to accelerate as never before and now is the absolutely wrong time to sell.
Competition and Opportunity
Generally speaking, manufacturing business logic is hard to get right and there are only three ERP companies with a manufacturing module that is competitive for large global manufacturing companies: SAP, QAD, and Oracle. SAP is the behemoth that dominates ERP. The depth, breadth, capability, and customization of its offering is unmatched, but comes at a high cost of implementation and ownership, as a highly trained IT staff is necessary to customize and maintain an implementation. QAD has designed its offering to meet the narrower use case of a global manufacturer, and is therefore able to position its offering as easier to use, cheaper to implement, and cheaper / easier to support. Oracle's manufacturing ERP software came from its JD Edwards acquisition (derivative of PeopleSoft) and is more similar to SAP's position than to QAD's.
Customer acquisition has been an Achilles Heel for QAD. The relative size and status of SAP and Oracle has them provided a durable marketing advantage that can only be partially overcome by better product and service. As eluded to above, an ERP system is so ingrained in crucial business processes that switching ERP providers presents a material business disruption which companies are reluctant to undergo. Thus, it has been very hard to convince an ERP customer to switch vendors, even when the customer is not particularly happy, and market shares have been relatively stable. Historically, it could be argued that QAD has failed to acknowledge the limitations of its size and the industry structure and has over-invested in sales and marketing.
Cloud changes the picture dramatically. Constrained by the immense profitability of their core offering and the reliance of that model upon on-site implementation and maintenance services, neither SAP nor Oracle has embraced the cloud. NetSuite, a fast-growing cloud ERP provider, lacks a competitive manufacturing model. For manufacturing companies choosing an ERP system with the strategic cloud imperative, QAD stands out.
QAD estimates its current market share to be about 10% of target accounts (large global manufacturers). While it is likely that formidable cloud competition eventually emerges, cloud momentum should allow QAD to aggressively gain share for the next few years. A doubling or even tripling of market share is in play, with each cloud customer more valuable than an on-site one.
QAD trades at ~1x revs and ~20x EBIT. Because the company has always invested heavily in growing the customer base, EBIT margin has never looked that great, and has incrementally been pressured by the transition to a subscription revenue model. The company aspires to mid-teens EBITDA margins, which we believe is achievable longer term. The company could clearly show much higher margins today but has chosen to invest in growth..
A sensible way to value the company is on the basis of recurring revenues. For FY2015, QAD will do about 170mm in recurring revenues, 140mm of maintenance revs and 30mm of cloud revs, which should grow at mid to high single digit rates in the near-term and potentially accelerate with cloud adoption. Maintenance gross margins are high (75%+), and cloud gross margins, while burdened by hardware and a higher level of support, should exceed 60% as scale is reached over the next couple years. These recurring revenue streams require little sales and marketing, and R&D is highly discretionary. Given the stickiness of ERP, where a typical upgrade cycle may be ~7 years and the incumbent is highly advantaged at each upgrade, these streams are highly valuable.Using a 3x multiple on these recurring revenues and assuming away other revenue streams (license, prof services) as an offset to marketing costs yields an EV of ~500mm, or a share price of $33. This is probably an overly conservative approach.
Frustrated with their valuation, QAD recently bowed to the Wall Street banking gods and issued 2mm shares in a follow-on offering at $20 per share (1mm more shares were offered by the Lopkers for a total of 3mm). At the cost of dilution, the company hopes that the offering will increase liquidity in the A shares, draw more investor attention, and increase analyst coverage (Stifel, William Blair, and Cannacord brought the offering and initiated). While I am skeptical of such a strategy, I do sympathize with the company's frustration that recent positive trends have been largely ignored and the shares languish at an absurd valuation. Perhaps more visibility will do the trick. I take more confidence that QAD's large market share gains driven by cloud migration will grow revenues and profits materially higher, and that such progress will also eventually be rewarded with a large multiple re-rate.
QAD will continue to face challenges due to its relative scale. A medium term risk is that more formidable competition emerges, either from client / server incumbents or new cloud players that figure out manufacturing. A long term risk is that technology disrupts the traditional role of ERP.
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