COMVERSE TECHNOLOGY INC CMVT
February 07, 2012 - 1:01pm EST by
straw1023
2012 2013
Price: 2.63 EPS $0.00 $0.00
Shares Out. (in M): 207 P/E 0.0x 0.0x
Market Cap (in $M): 543 P/FCF 0.0x 0.0x
Net Debt (in $M): -301 EBIT 0 0
TEV ($): 242 TEV/EBIT 0.0x 0.0x

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  • Special Situation
  • Stub
  • NOLs

Description

Stub Position: Long 1 share of CMVT ($6.29); Short 0.13 shares of VRNT ($28.19) --> $2.63 per stub ($1.10 net of cash)
 
This is an event-driven special situation largely driven by tax issues. This situation has the crucial elements of a successful stub trade: (1) there is significant value to be realized; (2) an event (spin-off plus second-step merger) to unlock the value has already been announced and should act as a catalyst in the next 6-9 months; (3) shareholders of both firms strongly desire the split; and (4) current management has been intent on unlocking the value. 
 
The price action of the stub demonstrates capitulation. Curiously, the last straw was the Jan 11 announcement below. CMVT shareholders were holding out hope that after the accounting issues were dealth with, a PE firm was going to swoop in and buy CMVT (and possibly VRNT as well). This was not impossible, but was going to be messy for the buyer. As well, we do not know what valuation management was requiring for VRNT, either in whole or in part, and I suspect it might have been too high.
 
But management has clearly taken the next logical step to realize the value: break up the company. And I believe that although complex, they can do so either tax free or with minimal taxation that takes advantage of their ample NOLs. After the break-up, we will have three winds at our back: (1) after a half decade of chaos, I would guess there are some operating improvements that can be made and management will be able to focus on them; I am reminded of Taro Pharma here; (2) as pure plays, the pieces will receive proper value; and (3) each piece will be an ideal takeover target . . . once the IRS allows them to be acquired.
 
From the January 11, 2012 press release:  "Comverse Technology, Inc. (Nasdaq:CMVT) ("CTI"), a global leader in BSS, mobile Internet and value-added services, today announced its intention to distribute 100% of the shares of its wholly-owned subsidiary Comverse, Inc. ("Comverse") to CTI's shareholders on a pro rata basis. CTI is currently exploring, and expects to finalize and announce the structure that will result in the most efficient method of distribution, with the distribution expected to occur in the second half of fiscal 2012. In addition, CTI is exploring alternatives to eliminate its holding company structure either simultaneous with or shortly after the distribution of the Comverse shares."

Although intentionally vague, it is clear that CMVT is planning a spin-off of Comverse plus a second step merger in corporate-tax-speak. The best analysis I have read is found at the Willens Report. I will not violate his copyright by including his report, but the tax analysis I offer below is consistent with his analysis and was arrived at before I had read his write-up.
 
I am not going to spend a lot of time describing the operations as there have been previous write-ups that address this. But a short summary is below:
 
CMVT is a holding company with three subsidiaries: (1) Comverse -- 100% owned; (2) Verint -- about 55% owned -- publicly traded under ticker VRNT; (3) Starhome -- about 66.5% owned.
 
Comverse sells telecom billing and value-added service functions. Think Amdocs.
 
Verint is unrelated and sells enterprise software, specifically the hot area of business intelligence.
 
Starhome is much smaller than other two. Its solution is sold to carriers and aids in wireless international roaming. It is the kin of Comverse, not Verint.
 
There have been previous write-ups that give a better description. The history of this company has been tortuous and a large part of the reason for the stub pricing. The underlying products are undeniably competitive products, but gross mis-management and then the resulting turbulence has left this company battered and bruised.
 
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Verint (VRNT)
 
For this exercise I will assume that the convertible preferred held by CMVT are converted immediately into 10.7mm shares and do not continue to accrete.
 
mkt cap = (39.3 + 10.7) * 28.19 = $1,410mm
 
cash: $120mm
debt: $599mm
 
TEV = $1,889mm
 
Adj Rev '11 = $790mm
EBIT '11 = $135mm (added back all company adjustments except stock comp)
NOPLAT '11 = $100mm
 
There are some NOLs (PV = $75mm) so it is trading at 18x. The company forecast 10% growth for 2012.
 
One analysis for VRNT that was found in Barron's a few weeks ago was misleading at best. It stated that VRNT was trading at 10x forward earnings, but this is skewed by: (1) leverage, (2) no taxes now because of NOLs, (3) not including large stock compensation, and (4) funny accounting due to convertible preferred. On an unlevered basis, this company trades in the high teens while growing at 10% top line -- not super cheap as a standalone company.
 
At this valuation, VRNT as a standalone company is not terribly cheap. However, as a takeover candidate, it may be cheap. Business intelligence software firms like VRNT have been popular targets over the past few years. And VRNT management certainly seems willing to sell. However, as discussed below, one of the tax issues is whether VRNT will be off limits for 2+ years. I believe the gray area is a bit too dark for someone to pursue VRNT until two years after the spin-off/merger. However, if you think that VRNT could be sold without tax implications and that an acquirer would pay a nice premium, then going outright long CMVT may also make sense. 
 
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CMVT (sans VRNT)
 
mkt cap = 207mm * 6.29 = $1,302mm
 
cash: $481mm less $120mm at VRNT less $6mm minority interest in Starhome = $355mm
ARS: sold in q4 for $49mm
debt: $2mm
litigation liability: $87mm (on balance sheet at $101mm but paid in q4 with $9mm cash and 12.5mm shares --> $87mm total comp)
 
net cash: $315mm
 
VRNT stake: 27.0mm * $28.19 = $761mm
 
stub TEV = $1,302 - 315 - 761 = $226mm
 
Note that the stub contains three elements: (1) Comverse, (2) Starhome, and (3) the premium value in convertible preferred over current exchange.
 
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Stub valuation
 
Comverse
 
The 2011 financials are mis-leading because they over-state revenue and cash flow is significantly less than earnings as a result of deferred revenue coming off the books. However, management has stated that they expect to be able to stabilize at a true $700mm revenue (i.e. book-to-bill > 1) and 10% operating margins. This is supposed to be conservative as this is how they are targeting their cost structure. Achieving higher revenue would add a lot to bottom line due to high op leverage. Note that Amdocs runs at 15% op margin and trades at 12x unlevered FCF. Assuming the $70mm of EBIT is accurate, we should note that because of almost unlimited NOLs at Comverse, they will not be paying taxes probably ever. So, applying a 12x multiple to $70mm, we get $840mm. As an acquisition candidate, we could expect increased margin with the scale, and $1.2bn may not be crazy.
 
The book-to-bill will remain less than one for some time and so a 12x multiple is not realistic. However, based on size of deferred revenue ($500mm) and past rates, the bleed should wind down in about 18 months. If so, then a 8-10x multiple today on $70mm FCF is realistic.
 
The first major risk to this idea is that the business does not stabilize and runs down while producing little cash flow. This is unlikely due to the nature of the product. The business suffered because of its self-inflicted wounds and so new orders stopped as carriers waited to see what happened, but there were no large scale defections. This is a testament to the stickiness of the product. And now, the turmoil has passed. These billing and value-added service solutions for telecoms have very high switching costs. Carriers cannot simply interchange them as they undergo extensive testing before use. As well, the competitiveness of Comverse products has not suffered. Its billing solutions are arguably the best in the industry. There are pockets of growth, but overall, telecom carrier solutions is no longer a high growth area but simply growing with existing customers as new services are offered or existing services are upgraded will provide stable business.
 
Starhome
 
The 2011 numbers indicate $44mm in revenue and $8mm in EBIT. At 65% ownership, this is worth about $50mm to stub value.
 
So, I would argue that the stub TEV should be north of $600mm rather than the $240mm at which it trades.
 
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Tax Issues
 
There are two clear ways to proceed in terms of separating the company. First, let me discuss the road they are not taking:
 
1) Spin off VRNT from CMVT. The obvious reason they are not doing this is because if they simply distributed VRNT shares, they would trigger a large tax bill both to CMVT (gains of about $450mm because distributing $761mm of value with $300mm of basis) and to shareholders, who would have dividend tax on the distribution. This is a non-starter.
 
1 modified) Recap VRNT by giving CMVT 80% of voting power without adjusting the economic share. Then spin-off the VRNT shares. Later, VRNT could exchange the super-voting shares for ordinary shares. Note that both actions (giving CMVT 80% voting power and getting rid of super-voting shares) would require shareholder approval, but in this case, this does not seem troublesome. VRNT shareholders would do it to effect a split. And then the super-voting shareholders would do it for liquidity. This may seem contrived, but the IRS has OK'ed such a move in the Metlife-RGA spin-off. See the Metlife transaction in the attached article:

 
I do not understand why they do not go this way, and the only reason I can think of is that they want the NOLs sitting at CMVT to go to VRNT, not Comverse. However, if the IRS denies tax-free status to the proposed spin-off plus merger, then I would expect them to pursue this route.
 
So, the path that they are pursuing is two steps:
 
- first, spin off 100% owned Comverse from CMVT. 
 
- This alone is not tax free since CMVT is a holding company. So, effectively simultaneously, they will merge CMVT and VRNT. Note that because VRNT owns greater than 50% of combined CMVT/VRNT entity, the Morris Trust rules are satisfied. As well, the merged CMVT/VRNT is clearly a bona fide operating company so that now the spin-off of Comverse is tax free. And all NOLs are preserved and use-able.
 
The problem with this method is that the Starhome stake is now at the new VRNT, not where it should be, which is Comverse. This is a small inconvenience and could be corrected with a small tax bill. For example, Comverse could simply purchase Starhome stake from newVRNT for $50mm and VRNT would pay corporate taxes on this $50mm less the basis. So, this is a $15mm inconvenience.
 
I do not think this is a terribly controversial structure, and I believe the IRS will approve. On the positive side, the two companies have absolutely no business reason to be together, and the two have operated as separate entities for a long time.
 
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The next issue is: When can Comverse or newVRNT be acquired without triggering a retro-active tax event? This is tricky and we do not have enough information to answer. This is governed by Section 355(e).
 
Although not strictly determinitive, in most cases, 2 years after spin off forms a safe harbor. The question here is whether these companies could enter into discussions as soon as six months after the spin-off/merger. There can be no "plan" and there must be a "fit and focus" purpose to the spin-off/merger. In this case, the "fit and focus" test is fairly easily passed. However, we do not know the exact nature of discussions that CMVT had with potential acquirers and whether this removes the possibility of a quick sale or even eliminates the 2-year safe harbor as well (this is very unusual for a publicly traded company using credible bankers).
 
Insiders have more information on this point because they know the exact nature of discussions that CMVT had over the past few quarters.
 
I am not counting on a favorable outcome of this issue, and I am valuing based on both entities remaining standalone entities, but it is a nice possibility and could drive a premium in both equity prices.
 
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Risks
 
There are two core risks: (1) My tax analysis is flawed and there is no manner to split Comverse from VRNT that is not too costly; (2) Comverse business is less stable than I believe and slides badly.
 

Catalyst

In Q2 or early Q3, I expect the company to finalize the restructuring plans after receiving feedback from IRS.
 
In Q3 or Q4, the actual spin-off plus merger (or other restructuring) will occur.
 
In 2013 or 2014, both entities become acquisition candidates.
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