Description

CAST SA is an owner-operator led, albeit not controlled, software company with a strong value proposition and diversified customer base. Revenue growth has failed to materialize over the past 18-months and as a result CAST’s share price has languished. Today, CAST is trading at a very modest 1.2x EV/revenue and management is still guiding to full year revenue growth of 10%. On its ~€35 million revenue base, CAST is roughly breaking even. This is unacceptable for a company that hasn’t grown and 90% of its revenues are derived from high-margin software licenses/subscriptions. Fortunately, CAST’s second largest shareholder is none other than Joe Liemandt, founder of ESW Capital. ESW has a 30-year track record of turning around and operating software businesses profitability. Joe has been acquiring shares of CAST as recently as four weeks ago. Should CAST not experience greater revenue growth or improve its overall profitability, then a takeout is in order and ESW is the obvious suitor.

Background

CAST SA is an enterprise software company. It’s developed software that automates the evaluation of a coder’s development features like complexity, reliability, security and size. Using the software, an IT manager can assess the productivity and quality of a developer’s work.

From CAST’s website, the company offers three primary products:

§  CAST Application Intelligence Platform (AIP) is its main platform. A result of over $130M in R&D investment over two decades, it’s designed to analyze multi-tiered, multi-technology applications for technical vulnerabilities and adherence to architectural and coding standards

• CAST Highlight is an ultra-rapid code-scanning SaaS offering that identifies potential IT risks and cost savings opportunities across large and small distributed portfolios. By delivering data and insights on the health of portfolios, CAST Highlight provides IT leaders with objectivity and clarity to make more informed business decisions, prevent risk and reduce complexity and cost.
  
  
• CAST Appmarq is a quality benchmarking repository. It contains software quality statistics, trend data and best practices collected from a number of industry sectors and regions.

The bulk of CAST’s revenue is from software licenses, subscriptions and maintenance with less than 10% from services and consulting.

75% of CAST’s revenue is driven by an internal sales force while partners drive the remaining 25%. Partners are all the big global IT consulting firms who not only use CAST products for third-party software development but also resell the software to customers. The partners are the logical evangelists for the products as they can show their customers the quality and productivity involved in their third-party software development.

After growing at low-double-digit rates since 2013, CAST’s revenue was flat in 2016. More recently, H1-2017 revenue was 8% lower than H1-2016. CAST’s current LTM revenue is just over €35 million.

For a company with a fairly small revenue base, CAST has ~200 unique total enterprise customers and boasts several blue-chip customers (e.g. AT&T, BNY Mellon and AMEX). It signs a fair number of million dollar licenses which makes revenue growth forecasts somewhat difficult. Despite the recent decline in revenue, CAST’s management still anticipates 10% revenue growth and attributes the decline in sales simply to clients postponing license purchases.

CAST’s recent lackluster growth coupled with the modest cash burn (business is breakeven on a normalized basis) is creating an opportunity to buy a good, scalable enterprise software business with a net cash balance sheet at a trailing 1.2x EV/revenue. Fortunately, that’s not all that CAST has going for it. More than just an attractively valued enterprise software business, it’s second largest shareholder is ESW Capital’s Joe Liemandt.  He last purchased ~170K shares in November 2017, bringing his total stake to ~26%. [Note: on Bloomberg Joe’s ownership will show up under devfactory, an ESW related company]

The ESW connection

ESW needs little introduction on this forum, but for those unfamiliar, Joe Liemandt is the founder of ESW Capital, an investment company with a 30-year track record of acquiring, turning around and operating software businesses. ESW Capital is part of a larger group of companies that includes Trilogy, one of the largest privately held software businesses.

ESW doesn’t invest based upon a top down view of which verticals are going to be successful. It’s price conscious and opportunistic. It never gets into bidding wars. As it relates to publicly traded software companies, ESW (Joe) have been known to make small purchases in publicly traded enterprise software companies and just watch them. If it turns into an interesting opportunity for greater investment, it will position itself to take a controlling stake. This happened most recently with Upland Software (UPLD-NSDQ) and Redknee (RKN-TSX). ESW’s ownership interest in CAST presents a similar scenario.

Moreover, based on a recent investor meeting with the head of one of ESW/Trilogy’s businesses, CAST’s software may have further strategic value to ESW. One of the first things ESW does when it buys a business is analyze the product from a quality perspective. ESW looks at things like: how many lines of code are there? Are best coding practices being applied? Is the redevelopment team applying best coding practices (patterns)? CAST’s AIP is an industry standard for this exact use.

Idea

There are two parts to this investment idea:

1.       Growth driven by the long-term industrialization of software development; and

2.       A more mid-term positive development in the financial metrics of the business.

If growth doesn’t materialize or profitability improve in the medium-term, then CAST will be ripe for takeover and ESW the obvious bidder.

Industrialization of software development

The need for greater industrialization around the software development process is a long-term tailwind for CAST’s products. Software is a manufactured product. Weaknesses in the end product like security flaws and bugs cause crashes and increasingly affect the productivity of users as software becomes an ever-greater part of our work lives.

We all have images of caffeine/sports drink-fueled coders doing 48-hour coding marathons. Hard to imagine that this leads to the highest quality code. You probably also know that finding skilled software developers has been a long-term issue for both software companies and enterprises with large internal software development teams and this kind of demand leads to higher turnover and migration.

All these things can create a lot of headaches for IT managers and CAST’s product suite addresses these issues. It's not unreasonable to assume CAST can achieve a normalized high single/low double-digit revenue growth going forward, a growth rate it experienced up until 18-months ago. Should we see revenue growth, multiple expansion will likely follow, making a mid-teen IRR reasonable to assume from today’s entry price.

Positive development in the financial metrics of the business

If revenue growth doesn’t materialize, under a more cost-focused operating model, like the one ESW/Trilogy employs, CAST should be capable of operating at 20%+ EBIT margins. Enterprise software businesses have far higher precedents but given CAST’s relatively small revenue base, margins in the ~20% area seem appropriate. Even from FY2017 expected revenue base, 20% EBIT margins would translate into just over €8 million per year. Net of cash taxes and capex, this is closer to ~€4 million. Based on today’s entry price, this represents a FCF yield of ~10% (net of cash). This is an extremely attractive yield for a good business but holds particularly true for a business in zero-yield Europe.

Worth noting, this normalized margin estimate may prove to be overly conservative. For example, Upland went from effectively earning 0% EBITDA margins prior to ESW’s takeover to now guiding to ~35% margins. Prior to ESW’s involvement with Upland, Upland and CAST had a similar recurring revenue base.

All in all, CAST is an interesting opportunity. It should grow and if it doesn’t, costs should be rationalized and the business should be run for cash. If neither growth nor cash flow materialize, then a takeover is in order. As the second largest shareholder and a proven playbook for enterprise software turnarounds, ESW is the obvious suitor.

Catalyst

- growth

- takeover