Compuware Corporation (“CPWR”) is an enterprise software company comprised of three distinct divisions: Application Performance Management (“APM”), Mainframe Productivity and Performance (“Mainframe”) and an ~80% interest in publicly listed “Application Services” (“Covisint”, “COVS”).

Over the past two years, CPWR has undergone a dramatic transformation in leadership, governance, cost structure and business composition that has yet to be reflected in the stock price.

CPWR currently trades at a meaningful discount to its SOTP and strategic value and is embarking on a series of transactions in the near to intermediate term that should bridge this value gap.

We see upside in CPWR of ~$11.30-$13.89 and downside of ~$8.57 for a highly attractive 5:1 risk / reward ratio.

Company Description*

As mentioned, CPWR is made up of three core divisions, each of which I describe below.

APM (~50% of FY15e sales, ~11% growth, 12% EBIT margins)

The APM segment provides software solutions that allow companies to monitor and troubleshoot application performance along the entire user chain all the way from inside the enterprise out to the individual consumer. Given the increasing complexity of such applications and the rising importance of the customer experience, APM has become a bigger focus of corporations, rendering CPWR’s technology highly valuable.

Based on 2013 figures, the APM industry is a $2.4bn market with CPWR possessing ~12% share. The next closest competitor is IBM with 8% share. The industry is growing in the low double digit range.

Mainframe (~37% of FY15e sales, -8% growth, 73% EBIT margins)

The Mainframe segment provides software productivity tools to the mainframe industry as well as tools that allow companies to optimize and modernize their current mainframe infrastructures.

While the Mainframe industry has long been pronounced dead, the business is actually incredibly sticky given the mission-critical data that it processes for the financial services, healthcare and airlines sectors, amongst others. As such, switching costs are high. Compuware boasts retention rates in excess of 90%.

While CPWR is guiding to a mid to high single digit decline in the business, about 2/3rds of this decline is price, rather than customers moving off the mainframe, as IBM and CA use their position to bundle software as a means to gain business. Additionally, purchasing decisions are increasingly flowing to CFOs rather than CTOs who require further educating in order to appreciate the NPV benefit of CPWR’s products.

Ultimately, we think these price wars slow/cease as the industry reaches a steady state (mainframe companies were arguably over-earning earlier in the century) and as CPWR bolsters its offerings via M&A as described below.

The mainframe industry is highly consolidated and mature. As a result, it is unlikely to see any new entrants. Based on 2012 data, CPWR has roughly 50% share of the market, with IBM being the next largest competitor at 22% share.

Covisint (13% of sales, -7% growth, -10% margins)

COVS provides collaboration management tools that allow companies to work seamlessly with their customers, suppliers and others in order securely and seamlessly exchange information, execute business processes, etc. COVS was actually formed and developed by the big three auto manufacturers which are the largest industry segment/customer. The product is also widely used by the healthcare and oil & gas industries.

COVS has seen numerous hiccups and growing pains since becoming a public company in September 2013 including missed guidance and the replacement of its CEO. A fair amount of COVS’ FY 15 revenue decline comes from the deemphasizing of lower margin service revenue (a long-term positive) while the rest comes from admittedly poor execution.

We are believers in the technology and ultimately feel the business is getting back on track and stabilizing. Given its small size, COVS is likely better off owned by a larger competitor who can better scale the business, which we would see as a favorable outcome.

CPWR intends to distribute its remaining interest in COVS to shareholders by late September of this year.

*note, margins are pre the allocation of unallocated expenses

Company Background

Historically, CPWR has been known for two primary things: its technology and for being bloated and poorly run. Co-Founder Pete Karmanos ran the company like a jobs bank for Detroit and refused to make difficult decisions. As a result, excesses built up in the company’s cost structure and a divergent collection of businesses caused management to become stretched.

In mid-2011, Karmanos “retired” and was replaced by current CEO Bob Paul. In late 2012, Elliott Associates submitted an $11 bid for the company which effectively put it in play and sparked a strategic review. Ultimately, CPWR was not sold (despite interest from parties such as BMC – of which Elliott has a stake in) due to a modest bid-ask spread / unwieldy nature of the then configuration. Instead, the company endeavored to create more value on their own than could have been achieved in a sale as outlined in the catalyst section below.

Elliott eventually settled for board seats and remains influential today. While they don’t have 13Ds filed, Starboard Value has publicly released a letter outlining their thoughts on the company (which can be found here) as did Sandell Asset Management (which can be found here) and I believe each is likely continuing to exert pressure on the company today. This pressure has already resulted in meaningful change which should result in further shareholder value creation over time. More specifically:

Management – As mentioned above, Bob Paul took the CEO helm in mid-2011. In June 2013, Joe Angileri took over as CFO, replacing Laura Fournier, which was largely seen as an upgrade given consistent guidance misses in the past. Bob and Paul have been working incredibly hard to grow and stabilize the business and create shareholder value. I believe they understand the numerous levers at their disposal and have the capacity to create and continue creating value at CPWR

Board Composition – Of the twelve members of CPWR’s board, half have joined since April 2013 or later, including two Elliott representatives. In fact, up until June 2013, Pete Karmanos still chaired the CPWR board, making more significant change difficult. This dramatic board makeover explains not only the steps the company has recently begun taking to unlock value, but also gives us confidence in the company actually executing and carrying out its strategic plans.

Business Composition – By the end of September, CPWR will be comprised of just two businesses, down from six earlier this year. (In January 2014 CPWR reached an agreement to sell its Professional Services, Changepoint and Uniface to PE firm Marlin Equity Partners for $160mm). This transaction simplified the CPWR story, made it more understandable to investors and has allowed the company to focus on its core assets.

In short, while CPWR currently trades like the “Old CPWR”, it is clearly anything but, which ultimately should begin to get reflected in the stock price.

Catalysts

An investment in CPWR provides multiple ways to win. In the coming months there are numerous planned as well as potential events that should play out that will highlight and/or increase the intrinsic value of CPWR. These include:

1. COVS Spin-Off – CPWR intends to distribute to shareholders its remaining interest in COVS via a tax-free spin by the end of September of this year. Such a spin would be accretive to growth and earnings at pro-forma CPWR, will highlight CPWR’s pro-forma 5.8% dividend yield and will increase the float/investability of a standalone COVS.
2. Continued & Further Cost Rationalization – Management is on course to deliver on its $110-120mm cost rationalization plan by the end of FY 15 (ending in March). This represents approximately a 20% reduction in run-rate OpEx and will result in estimated ~31% EBITDA margins for the remaining company, over a 1000bps increase versus prior years. We believe there is the potential for ~$25mm in incremental cost saves above this over time as systems are put in place that will enable further cost reductions, particularly at the unallocated expense line.
3. Sale-Leaseback of Headquarters – We believe CPWR is currently in a process to execute a sale-leaseback of its fully owned, 1.1mm square foot headquarters in downtown Detroit. We estimate CPWR should net approximately $110mm for the property. Given its cost to build, we do not anticipate any tax leakage on the transaction and rather, the company will likely generate a meaningful capital loss tax asset in the process which could come in handy down the road.
4. Distribution of Excess Cash – Post the headquarters monetization and COVS distribution, we estimate CPWR will have excess cash, above the capital needs of the business, of ~$235mm. Based on comments from the FQ1 15 earnings call, we believe the company will return this capital to shareholders via a rapid share buyback program which should result in a 12% reduction in the shares outstanding. Excerpt from the call: (Bob Paul, CEO) All of the strategic initiatives we mentioned last quarter are on-track. We remain committed to a meaningful stock buyback program in Q3. Ahead of this, we believe we will be in a position to bring to resolution a number of other strategic items to this quarter. These include   the completion of the Covisint spin. The optimization of certain balance sheet items and the commitment to evaluate credible offers that would create value for shareholders.
5. Separation of Mainframe and APM Segments – CPWR is currently exploring the feasibility of a break-up of the remaining company post the COVS distribution. The remaining two businesses – Mainframe and APM – have vastly different growth and margin profiles and possess minimal synergies. We believe a separation into a “YieldCo” (Mainframe) and “GrowthCo” (APM) is both logical and likely and would unlock significant value. Based on recent commentary, we believe a decision is likely to come soon with a separation to come by the end of FY 15.
6. Subsequent Leveraging Transaction Post-Spin and Separation – Post the spin-off of COVS and separation of Mainframe/APM, we believe the potential exists for the Mainframe business to undertake a levered recap (versus its net cash position today). Given its minimal CapEx needs, recurring revenues and high margins, we believe a leverage ratio of 2-4x net-debt-to-EBITDA is prudent. Assuming 3x leverage and a 10% FCF yield on the Mainframe/YieldCo entity, the company would be able to buyback ~50% of the pro-forma shares outstanding and/or payout a special dividend to shareholders. We believe this is a highly misunderstood opportunity as most investors assume the company will simply lever current CPWR at 3x. We believe this is ill-advised as 1) Mainframe can support the entire debt structure of the current company 2) More accretion can be created at the Mainframe level as the business will be valued on FCF, not sales. We believe the company understands and appreciates this distinction.
7. Subsequent Accretive M&A – While the Mainframe industry is highly consolidated, there are hundreds of smaller players that would be attractive tuck-in acquisitions for CPWR. We believe there would be meaningful cost-take out opportunities in such deals and they would allow CPWR to bolster its product offering to stem the pricing pressure cited above.
8. Subsequent Sale of Constituent Pieces – As separate standalone entities, we believe there is a possibility that either or both businesses are ultimately acquired. Mainframe would make for an attractive consolidation target for one of the larger players in the space while APM would be a scarce asset in an attractive and growing industry. Given prior interest in the company, we believe this is a reasonably likely outcome.
9. Sale of Entire Company – Lastly, given the amount of value that can be readily created on a standalone basis, the meaningful synergies that would be available to a strategic buyer, the significant streamlining that has already occurred (making for a cleaner acquisition) and prior interest/diligence on the company, a sale of the entire business cannot be ruled out. In fact, if a sale does happen, based on commentary from the F15 Q1 call, we believe it would likely occur in the next few months, which presents an interesting call option. Excerpt from the call:

Upside / Downside

On a consolidated basis, CPWR does not look particularly cheap at 12x FY15 EBITDA and a 6% FCF yield. However, these metrics fail to account for two things: the pending distribution of COVS as well as the cost reduction plans that the company is currently executing against. Rolling forward one year and adjusting for COVS, CPWR trades at 8x FY16 EBITDA and has a 7.5% FCF yield.

However, this does not tell the whole story. Given its disparate collection of assets, a SOTP valuation is the most appropriate way to value CPWR.

In light of its highly free cash flow generative nature, we chose to value Mainframe on a FCF/implied dividend yield, APM on an EV/sales basis (given its early stage profitability levels) and COVS at its trading value. We incorporate various potential capital return and M&A outcomes as well.

It is also important to point out that CPWR currently pays a highly-sustainable, $0.50 annual dividend which allows for a ~5.4% yield as you wait.

The following is based on FY15 estimates, except for Mainframe, which uses FY16 for the sake of conservatism.

• Base Case = $11.30/share, +22.6% upside
  • Mainframe: $5.37/share
    • FCF Per Share of $0.56
    • ~10% FCF yield/7.75% dividend (80% payout ratio, in-line with DCF Value)
  • APM: $4.65/share
    • $365mm of Sales
    • 2-3x APM sales, in-line with (slower growing) software peers
    • Discount to precedent M&A transactions
  • Covisint: $0.65/share
    • Current trading value (30mm shares owned)
  • Residual cash:  $0.60/share
  • $235mm buyback using “excess cash” at 5% premium on the pro-forma stock price ex-COVS
    • Excess cash defined as: $275mm cash less + $110mm in headquarter value - $43mm COVS cash - $50mm Mainframe working capital needs - $75mm APM working capital needs
• Upside Case = $13.89/share, +50% upside
  • Mainframe: $8.11/share
    • FCF Per Share of $0.90
    • 10%-12.5% FCF yield/9% dividend
    • Levered recap at 3x leverage post-separation; ~50% of shares retired assuming 10% pro-forma FCF yield and 10% premium on the pro-forma Mainframe entity
    • Higher yield than above to reflect increased leverage
  • APM: $4.65/share (unchanged)
    • $365mm of Sales
    • 2.5-3x APM sales, higher end (slower growing) of software peers
    • Discount to precedent M&A transactions
  • Covisint: $0.65/share (unchanged)
    • Current trading value (30mm shares owned)
  • Residual cash:  $0.60/share  (unchanged)
  • $235mm buyback using “excess cash” at 5% premium on the pro-forma stock price ex-COVS (unchanged)
    • Excess cash defined as: $275mm cash less + $110mm in headquarter value - $43mm COVS cash - $50mm Mainframe working capital needs - $75mm APM working capital needs
• M&A Case = $15.18/share, +65% upside
  • Mainframe: $8.12/share (unchanged)
    • FCF Per Share of $0.90 (FCF accretion due to leveraging transaction described below)
    • 10%-12.5% FCF yield/9% dividend (80% payout ratio)
    • Levered recap at 3x leverage post-separation; ~50% of shares retired assuming 10% pro-forma FCF yield and 10% premium on the pro-forma Mainframe entity
    • Higher yield than above to reflect increased leverage
    • Note, this scenario does not assume Mainframe is subsequently acquired which, depending on synergy assumptions, could add meaningfully to the share price
  • APM: $6.50/share
    • $365mm of Sales
    • 3.5x APM sales, in-line with precedent transactions
    • Discount to precedent M&A transactions
  • Covisint: $0.65/share (unchanged)
    • Current trading value (30mm shares owned)
    • Note, this scenario does not assume COVS is subsequently which can add further to the value
  • Residual cash:  $0.60/share  (unchanged)
  • $235mm buyback using “excess cash” at 5% premium on the pro-forma stock price ex-COVS (unchanged)
• Downside Case  = $8.57/share, 7% downside
  • Mainframe: $3.75/share
    • FCF Per Share of $0.51
    • 12.5%-15% FCF yield/11% dividend (80% payout ratio)
  • APM: $3.28/share
    • 2x APM sales, low-end of (slower growing software peers)
  • Covisint: $0.49/share
    • 25% discount to trading value
  • Net cash:  $1.04/share
  • No capital return

Investor Fatigue – CPWR has been an event name/”in play” for nearly two years. Given minimal apparent action on the value creation front, investors are naturally fatigued of the story. However, from a catalyst standpoint, CPWR is arguably riper now than at any point in its history. Investors with fresh eyes and no legacy “CPWR baggage” can enter and take advantage of all of the hard work the company has incurred over the preceding years.

Minimal sell-side coverage – CPWR is not well covered. There are currently two credible sell-side shops covering the name – Susquehanna and Evercore – which prevents the story from being more widely known amongst the non-event driven crowd.

Conglomerate Corporate Structure – The pairing of a “YieldCo” (Mainframe) and “GrowthCo” (APM) creates difficulty in valuing the consolidated company. While Mainframe generates >100% of the free cash flow of the entire business (and therefore funds the entire dividend), APM is worth nearly half of the market cap despite generating little cash currently. As a result, this value gets masked when combining the two businesses, and their varying financial profiles, under one roof.  A separation would allow yield oriented investors to own Mainframe while growth oriented investors could the APM business and would otherwise force the market to more properly each of the CPWR components.

Risks

Acceleration in Mainframe Revenue Decline – This risk can be ameliorated via position sizing, the conservative assumptions above and an appreciation for the highly stick nature of CPWR’s customer base.

Stagnation in APM growth – We believe CPWR is well positioned versus competitors both in on-premise and cloud products and should benefit from the secular growth of the industry

No Corporate Actions Taken – We view this is an incredibly remote case given public comments made by the company and the composition of the shareholder base.