Selectica SLTC
November 02, 2007 - 4:40pm EST by
roc924
2007 2008
Price: 1.97 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 55 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Selectica is a software company trading at a very low valuation despite significant recent improvements in the company’s outlook. The stock sells for 0.6x annualized June 2007 quarter sales, excluding cash, a very low multiple for a software company with likely profitable growth. Strong potential for a $3 stock in a year or two exists, driven by likely 1) improvement in operating results and profitable growth, 2) stock buyback program resumption and 3) management stock purchases. Under a reasonable home run scenario, the stock is about a triple.
The stock is down over 60% since 2004, tracking the company’s deteriorating financial results. A chief competitor, Versata (formerly Trilogy) sued Selectica twice for patent infringement, most recently in 2006. A stock option investigation added to company woes. Both issues created uncertainty for customers and investors. Prior management consistently missed financial targets, chiefly their goal of reaching break even, adding to investor frustration.
 
The future is much brighter. Selectica cut costs significantly and is now at or near profitability, replaced the CEO and CFO, entered a new and fast growing market (CLM), and resolved the patent lawsuits and the stock option investigation. Growth in the core CPQ business is likely. The strong software sector provides an added tailwind.
 
The opportunity exists for several reasons. The last sell side analyst stopped covering the company five months ago. Recent operating improvements are obscured by restructuring, legal and stock option investigation expenses. Some investors could be understandably skeptical of recent progress, having watched the company’s difficulties under prior management’s tenure.
 
There are two prior VIC reports that provide great background. New developments:
1)      Rapidly growing business of meaningful size (CLM)
2)      Foundation set for likely improvements in the core CPQ business
3)      Already at, or very near, cash flow break even, excluding option investigation and legal expenses that should wind down by the December quarter, or earlier
4)      Road blocks to customer purchases removed
a.       Patent lawsuit settled
b.      Stock option investigation completed
c.       Financial statements published
5)      New, outside CEO and CFO (the prior CEO was promoted from the CFO position)
6)      Sufficient time has passed to wear out all but the most steadfast investors.
 
 
Summary of investment positives
1)      Discounted valuation
2)      Operating results should improve significantly, with resumed revenue growth and a swing to solid profitability
3)      New management
4)      Likely resumption of stock buyback
5)      Likely management stock purchases
 
1. Valuation
 
Capitalization (000s, except stock price)
 
Stock price
$1.95
Shares out
28,400
Market cap
$55,380
Cash*
$40,000
Enterprise value
$14,980
 
 
Federal NOL
$155,000
State NOL
$94,000
Present value of NOLs
Varies depending on assumptions; see table below
 
 
*$52.4m as of 6/30/07, less $10m Versata payment and estimate of $2m negative cash flow for Sep quarter.
 
 
 
Valuation in a year or two: risk reward seems favorable
($millions, except ratios, share, and per share amounts)
Scenario
Deterioration
No
Improvement
Significant Improvement
Home Run
Probability
5%
20%
40%
35%
Annual revenue
 10
 16
 30
 40
Operating income
 (4)
 (1)
 3.0
 7.0
Net income at 41% tax rate
 (4)
 (1)
 1.8
 4.1
P/E
 
 
 15
 20
EV/sales
 -  
 0.5
 0.9
 2.1
 
 
 
 
 
Enterprise value
 -  
 8
 27
 83
PV NOL^
 -  
 -  
 18
 35
Cash
 35
 40
 44
 48
Market value
 35
 48
 88
 165
Shares
 28.4
 28.4
 28.8
 29.9
Per share
 $1.23
 $1.69
 $3.07
 $5.53
Expected value / share
 $3.57
 
 
 
^NOLs expire at various dates through 2027. I used a 10% discount rate and federal and state tax rates of 35% and 8.8%, respectively.
 
Notes:
  1. The probability and magnitude of downside appears very limited. There are a variety of ways to look at potential downside for this stock and here is one. Cash of $40m plus CLM business value of $15m is $55m, or $1.95 per share. The company’s valuable CPQ technology provides an additional downside cushion.
    1. Cash of $40m. The company is very close to break even, revenues are already improving as evidenced by the June quarter results, and the company’s cash balance should at least stabilize at $40m. Cash of $40m is based on June 2007 cash of $52m less a $10m payment to Versata and estimated $2m burn in the September quarter from legal and option investigation expenses.
    2. Valuable CLM business. Selectica’s CLM business is growing well over 100% y/y and is at over a $5m run rate. This business is likely worth at least $15m, or 3x run rate revenue. A valuation of 3x revenue is reasonable for a software business with this growth profile. A valuation of $15m compares to a purchase price of $1m in 2005 and approximately $10m invested in the business since then.
    3. Valuable CPQ technology. Selectica’s CPQ software is used by companies like Dell, BMW, IBM, and GE Healthcare. IBM is using Selectica’s technology as part of IBM’s new Simple Order product, which IBM will sell for about $5m, of which Selectica’s portion is $1m.
 
  1. Operating expenses are mostly fixed with a small variable sales and marketing component. With GM% in the mid 70s, operating leverage is high.
 
  1. Although a big improvement from today’s level of revenue, the $40m home run revenue scenario (in a year or two) is not unlikely. Before the multitude of issues hit the company, Selectica generated $30m in revenue from its CPQ business in FY05. A return to near this level in a year or two appears reasonable given the reasons outlined in the next section. The company’s CLM business, which the company did not have in FY05, was at a $5m revenue run rate in the June quarter and growing rapidly. CLM revenue doubled in the June quarter versus the prior quarter.
 
 
2. Operating results should improve significantly
 
Efficient cost structure with high operating leverage. The company has cut costs significantly and is cash flow breakeven at about $4m/quarter of revenue, excluding stock option investigation and Versata lawsuit expenses that should wind down by the December quarter. Revenue growth from $4m/quarter should lead to solid operating profits in the near term with the company’s very high incremental operating margin of 50%+.
 
Revenue should improve. Several recent positives should help drive future revenue growth in both the CLM and CPQ business. For both businesses, resolution of the stock option investigation, settlement of the patent lawsuit and publication of financial statements should smooth the sales process and help sales.
 
Contract Lifecycle Management (CLM). The CLM business is already growing, up 100% q/q and over 200% y/y in the June quarter to $1.4m, albeit off a low base. Growth should continue:
  1. Recent CLM wins with Fortune 100 companies, including Motorola, should help catalyze future CLM sales. These customer wins provide important customer references. Furthermore, Selectica’s product is being implemented by Accenture and Huron, both of which provide references.
  2. The CLM market is growing at 10-20% according to industry analysts.
  3. The competitive environment for CLM should improve somewhat with the acquisition of Nextance by Versata last September. Versata reportedly reduced/eliminated the Nextance sales force, cut expenses and will instead focus on harvesting the maintenance stream. Nextance had been recording about $10-15m per year in the CLM market.
 
Sales execution (CPQ). This business generated $30m in revenue in FY05 before Selectica’s problems hit full force. A return to this level is not unlikely. This segment was particularly hard hit since it was the subject of the patent lawsuit, but this overhang is now removed. Other sales drivers:
  1. IBM’s new Simple Order product for service providers contains Selectica’s configuration engine. IBM sees an average deal size of $5M, of which $1m would be Selectica’s portion.
  2. Versata will now introduce its customers to Selectica as part of the settlement agreement.
 
3. New management
The company hired a new CEO, Bob Jurkowski, in August. He has placed more structure around Selectica’s sales and marketing, focusing the organizations on key targets, and is supportive of the CFO’s cost reduction focus. Bill Roeschlein, the CFO, joined Selectica in September 2006. He is very focused on cost reduction and was instrumental in bringing the company’s cost structure to break even. Terry Nicholson also joined Selectica in September 2006 and heads the CLM business. Doug Bell joined Selectica in November 2006 as VP of Marketing.
 
4. Likely resumption of stock buyback
The 10b5 stock repurchase plan expired during the last fiscal year and Selectica could not renew the program until it concluded the stock option investigation. A resumption of the program seems likely given the recent completion of the option investigation and management commentary on prior conference calls.
 
5. Likely management stock purchases
Bill Roeschlein and Terry Nicholson both committed to buying stock on the 3Q07 (Dec) conference call. The trading window has been closed with the stock option investigation. With the option investigation recently concluded, the trading window should open following the 2Q08 earnings report in early November. Furthermore, in January 2007, the company implemented stock ownership guidelines for non-employee directors and executive officers. Under the guidelines, executive officers are expected to own more shares than they currently own (details in the 10K).
 
 
Shareholders
Activist investor Steele Partners owns about 9% of the company. Management ownership is small, although I do expect them to buy shares if the stock price stays low.
 
 
Business Description
 
Selectica has two software businesses, Sales Execution (aka CPQ: configuration, pricing and quoting) and Contract Lifecycle Management (CLM).
 
Sales Execution (CPQ) (87% of FY07 (Mar FY-end) and 68% of 1Q08 (Jun) revenue)
 
Product description: Web-enabled software that automates the quoting, pricing and configuration processes. The software interfaces with a customer’s existing CRM and/or ERP systems. Examples of pricing functions include the management of discounts, pricing based on margin, and pricing based on configuration, channels and customers. Configuration includes consideration of part compatibility in various configurations and quotes/pricing based on configuration.
 
Examples of prior or current customers: IBM, GE Healthcare, Cisco, Tellabs, 3Com, BMW, Dell
 
Competition includes BigMachines, Tacton, FirePond and Ariba.
 
 
Contract Lifecycle Management (CLM) (13% of FY07 (Mar FY-end) and 32% of 1Q08 (Jun) revenue)
 
Selectica entered the CLM market with its purchase of Determine for $1m in May, 2005. CLM generated revenue of $1.4m in the June quarter, up over 100% q/q and 240% y/y. Backlog was up 30% q/q. From the 10K: “Our contract lifecycle management (CLM) products enable customers to create, manage and analyze contracts in a single, easy to use repository and is offered as an on-premise or hosted solution. Our software enables any and all corporate departments (e.g. Sales, Services, Procurement, Finance, IT and others) to model their specific contracting processes using our application and to manage the lifecycle of the department’s relationships with the counterparty from creation through closure.”
 
Recent customer wins include Motorola, ONN Semiconductor, a leading telecom equipment manufacturer and one of the country’s largest healthcare providers.
 
Competition includes Oracle, SAP, OpenText / Hummingbird, Emptoris, Upside, Imany and Ariba (Procuri). SAP is a new entrant with its CLM product introduction in early 2007. Selectica sees Upside in low end, small deals around $30k. Imany is focused on life sciences: Selectica hasn’t focused here and doesn’t see Imany. Selectica used to encounter Versata / Nextance, but Selectica has not seen Nextance since Versata dismantled the Nextance sales force.
 
Risks
Customer concentration: 61% of sales came from five customers in FY07 (Mar)
Patent risk

Catalyst

Financial results improvement. Re-instated stock buyback. Likely management stock purchases.
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