A large part of our short portfolio is former momentum stocks a year or two removed from their glory days that (i) have little chance of regaining their former growth glory, (ii) are not strategic targets, and (iii) are still highly over-valued. Unlike many of our other shorts, we are not trying to call the top in the stock (many are down 50% or more from highs) and the catalysts are relatively weak although not non-existent. However, we have found these to be low-volatility, easy-to-borrow, non-crowded, and profitable shorts. And it is much easier to sleep with these shorts rather than a short book with only Tesla, Zillow and Green Mountain! We presented RealPages (RP) as such an idea two years ago, and today we present Broadsoft (BSFT).
Broadsoft is an IP-based data/telephony software provider for carrier-level solutions. They have a range of solutions that serve almost every segment of the carrier-level network, but their focus are the "outer" switches that house the end-user functionality. In the pre-IP POTS days, this was known as a Class 5 switch. In the IP network, this has little meaning, but they are still called a Class 5 softswitch company. Their products are solid and well respected although carriers have a built-in preference for the larger incumbent TEMs as they want stability in maintenance and service.
BSFT came public four years ago at $9 and then went momo crazy and shot above $50. mm wrote up on VIC as a top-of-market short in 2011 and timed it almost perfectly. We have been short since before the top-of-the-market but have been adding to the short recently after lumpy results caused the stock to jump, but we see no change in the story.
The three main keys to this short thesis are:
- BSFT makes no profit and will not make a profit in the future. Carrier-level telecom equipment manufacturing (esp IP based) has been a bad business for years and will continue to be a bad business. The competition is fierce, competing products have become inter-change-able and the carriers (unlike enterprises, historically (although this is changing)) are very savvy at negotiating prices and mitigating their vulnerability to lock-in effects. It is difficult to think of a specific sector where so much development and acquisition money (large corp and venture capital) has had such poor returns over the past 15 years. Broadsoft has had $0 in EBITA for years. This is not going to change, even with moderate growth.
Industry contacts have told me that while BSFT software is well-respected, but they win a lot of their deals by being aggressive on price. Management has more-or-less confirmed this in discussing their win rate. They like to make it sound like they are winning deals on technology alone, but their margins (or lack thereof) indicate otherwise. They are pricing to grow top-line with their valid but not superior products.
Industry contacts have also stated that each deal requires a fair amount of custom work and is equal parts "project" and "product." This removes the operating leverage from the business model. They cannot hire cheap "box-pusher" salesmen to sell zero marginal cost software to new customers.
- Although Europe and Asia are growing very quickly now, they will soon be mature markets (just like the Americas currently). I see revenue peaking out (i.e. growing at 5%-ish) at about $300mm (Americas is currently about $100mm) in three years. There is limited growth runway ahead.
- Broadsoft is not a large-premium acquisition target at this price (3x current sales). Would-be acquirors have competing solutions so they serve no must-have strategic need and even with eliminating duplicate overhead, a 20% op margin on $300mm sales and a 15x multiple and a 33% tax rate would get us a $600mm takeout valuation in three years, and I think 20% op margin is aggressive for this business even with synergies.
Shrs: 29.7mm * $24 = $713mm mkt cap
Converts: $100mm market value ($120mm face; 1.5%; $42 conversion)
TEV = $620mm
Rev '14 = $210mm
EBITA '14 = $0mm (and this is consistent with past years)
The company non-GAAP financials are heavily skewed by regular stock-based compensation. Last year, there was $42mm of stock-based compensation (note: this was over 20% of revenue!). And this year they will have $40mm of stock-based compensation. The non-GAAP EPS outlook 2014 mid-point is $1.36 per share (with big-boy EBITA of $0). The difference is stock-based compensation. While IR would not give a "normalized" stock comp number, he has told me that there is nothing "irregular" about the 2013 and 2014 stock comp numbers.
As well, the stock comp is spread evenly across the corporate expenses (CoR; R&D; S&M; G&A). In other words, this is not compensation going mainly to management overhead that can be cut by an acquirer. All indications are that BSFT's stock comp is used as normal compensation in place of cash so as to drive non-GAAP numbers.
Roadmap to Financials
Whether bullish or bearish, keep in mind that BSFT's revenue and billings are lumpy. Do not look at a quarter or even several quarters of billings because they can be very misleading. Q1 '14 billings were up 6% y-o-y while Q2 '14 billings were up 30% y-o-y.
Further, the financials are very different by geography. The Americas revenue is down y-o-y in H1 '14 while Europe and Asia grew at over 50% from a much smaller base. The Europe and Asia businesses will continue to grow quickly for 2-3 more years while the Americas will plod along.
This is guesswork, but if I had to be pinned down, the normalized Americas is growing at low single-digits. And the Europe and Asian businesses will slow to similar growth rate before hitting the size of the Americas business. This would have give us a $300mm revenue business in 3 years growing at low single-digits.
In terms of margin, the financials demonstrate that there is no operating leverage in the business model.
The lumpiness of the quarterly results certainly poses a mark-to-market risk (or opportunity to add), but the main risk here is that I have made a mistake as to the desirability of BSFT as an acquisition target. I think this risk is much lower than 3 years ago when mm wrote up top-of-market short for VIC, but I think this is the risk.
I do not hold a position of employment, directorship, or consultancy with the issuer. I and/or others I advise hold a material investment in the issuer's securities.
Europe/Asia growth will decelerate and stop altogether. And market will increasingly demand profits.
Management makes a silly acquisition to continue growing top line.