Description

American Software (ticker: AMSWA) is a mid-market Enterprise Resource Planning (ERP) software company that currently trades at roughly 2x its core earnings. AMSWA’s primary verticals include consumer packaged goods, chemicals, oil & gas, pharmaceuticals, and manufacturing. The company’s products include both core ERP systems and supply chain modules; the latter of which are sold through AMSWA’s 85%-owned publicly-traded subsidiary Logility (ticker: LGTY).

In fiscal 1999, AMSWA began to run operating losses as it invested heavily in development, sales, and new business initiatives. Roughly two years ago management began a restructuring process to return the company to profitability. This process culminated in the sale of the company’s money-losing hosting business, AmQUEST, which netted the company $20mm. The continuing operations have now been profitable for five consecutive quarters. Cash generated from operations, as well as proceeds from the AmQUEST sale, have left the company with a current net cash balance of $52.4mm (net of the 15% minority interest in LGTY), or roughly $2.25/shr. The operating business has generated $0.27/shr in TTM cash EPS (excluding interest income – calculation of cash EPS detailed below), which implies a multiple of 2.0x core business earnings ($2.80/shr - $2.25/shr cash = $0.55/shr for core biz, $0.27/shr = 2.0x)

A quick primer on ERP and supply-chain software: ERP systems are complex pieces of software that link a company’s various functional departments, i.e. finance, manufacturing, sales, purchasing, etc. Ideally, ERP systems are designed to facilitate the information flows between the various departments in a business so that, for instance, an order placed by a sales person automatically generates materials requisitions in purchasing, manufacturing orders on the shop floor, a bill for the receivables department, the appropriate journal entries in the finance department’s general ledger, and other necessary entries company-wide. Typically, a core ERP system is designed to accept additional modules, each of which adds various levels of functionality. One of these add-on areas is supply-chain management (SCM). SCM modules connect a given companies system to the ERP systems of its vendors, thereby linking the entire supply chain and facilitating just-in-time inventory management.

There are numerous vendors of ERP software, and each typically focuses on certain vertical market segments. ERP is a slow-growing business, however, switching costs for customers are high given the software’s complexity. Once installed, ERP software typically provides a decent annuity stream to its manufacturer. SCM, on the other hand, is a much higher-growth subsegment of the ERP space.

AMSWA’s products run on multiple hardware/operating system platforms, including IBM System/390 Mainframe, IBM AS/400, Unix, and WinTel. The company’s basic business model is to operate the core ERP business as a cash cow, while reinvesting in the SCM business to drive top line growth. Both segments of the business are now profitable. In general, AMSWA generates about $1 of service revenue for each $1 of license sale, and roughly $0.18 of annual maintenance in perpetuity thereafter. The company’s products are well-regarded, and renewal rates on the maintenance contracts are in the mid-90% range. AMSWA has been affected along with all other ERP vendors by the downturn in technology spending, however, license revenues have now increased for two consecutive quarters after bottoming in Oct 2001. Management is competent for a business of this size, and has done a good job righting the ship. As of April 2002, 500,000 shares remained on an authorized stock buyback totaling 2.2mm shrs. As is typical with many software companies, returns on capital are tremendous and the company is a net generator of working capital (i.e. negative net working capital position).

Given the current spending environment, visibility is limited. As a result, I am using TTM operating results as the basis for my valuation. This should prove conservative, as the last year has been a brutal one for software vendors and AMSWA now appears to have turned the corner on its license revenues.

Core cash EPS (earnings excluding cash income and adjusted for excess D&A) are derived as follows:

Fiscal 2002 (TTM) reported EBIT = $5.15mm
Less: $2.06mm taxes (@ 40% tax rate)
Less: $0.19mm minority interest (based on 15% minority interest in LGTY’s reported earnings)
= $2.90mm core reported net income
+ $3.50mm favorable D&A/capex spread (TTM excess D&A)
= $6.40mm net income
23.4mm shrs implies $0.27/shr

I believe that a 14x multiple is appropriate, as implied by 5% growth in perpetuity and no need for excess capital reinvestment above the current rate run-rate. Given this multiple the following valuation is implied:

14 x $0.27/shr = $3.78 for the core business
+ $2.25/shr cash
+ $0.04/shr present value of NOLs
= $6.07/shr

This implies potential upside of 117%.

Note: Another potentially interesting trade occasionally arises by going long AMSWA and shorting out its 85% interest in LGTY (ratio of roughly 0.482 LGTY shrs per AMSWA share). The stub currently trades for $1.80/shr ($2.80 – 0.482 x $2.07). The primary problem with this trade is that given AMSWA’s high ownership interest in LGTY, and LGTY’s resulting illiquidity, the short side can be difficult to execute.

The LGTY stub has core cash EPS of roughly $0.20/shr and cash value of $1.40/shr; I believe the stub’s core business deserves a significantly lower multiple (conservative 10x) given the lower growth profile of the core ERP business without the SCM piece.

This implies the following valuation for the stub:
10 x $0.20 = $2.00 for the core stub business
+ $1.40/shr cash
= $3.40/shr

This implies potential upside of 89%.

Although the upside on the unhedged trade is currently better in my view than on the hedged (stub) trade, the pieces diverge fairly regularly and can make the stub trade more attractive.

Catalyst

Ridiculously low valuation, additional stock repurchase authorization, turn in capital spending for software, increased visibility/profile