Description

INVESTMENT THESIS

Comverse Technology, Inc. (CMVT) is a holding company consisting of Comverse, Inc, a wholly owned subsidiary which houses the company's core Comverse Network Systems (CNS) business, 57% ownership of publicly traded Verint Systems (ticker: VRNT), 69% ownership of publicly traded Ulticom (ticker: ULCM), and 70% ownership of Starhome.  I estimate that Comverse has approximately $5.65 per share in cash and cash equivalents (see table under valuation section), or $4.80 per share after penalizing the company for a $175m class action lawsuit settlement stemming from an ongoing stock option backdating scandal.  Incorporating the settlement into my enterprise value for the CNS division, based on CMVT's current share price of $6.32, CNS is trading at 1.9x FY09 EBITDA and offers a 32%+ free cash flow yield.  This is an incredibly cheap price to pay for one of the market leaders in the large and growing global telecommunications market, with a large installed base of customers (that face very high switching costs) which provide a reliable and growing stream of recurring maintenance, service and support revenue.  The stock has come under significant selling pressure due to the prolonged restatement process (I project the company will become a current filer w/ the SEC by mid 2009), which have caused many hedge funds to punt the stock during 2008, in addition to general economic headwinds.  Management has stated that the holding company structure is not optimal.  Once the company becomes a current filer w/ the SEC, I would expect a sale of non-core assets, such as Ulticom and Starhome, or at a minimum a spin off of the equity ownerships in Verint and Ulticom to existing CMVT shareholders, which would greatly enhance the public float of these two companies.  For the purposes of this analysis, I will be focusing on the stand alone operations of Comverse's core CNS business, which provides messaging and billing software to wireline and wireless network providers around the globe.

OVERVIEW OF CNS (COMVERSE NETWORK SYSTEMS)

CNS is a leading provider of telecommunications software, systems and related services for voice and data enhanced services as well as pre-paid and post paid billing solutions.  CNS's installed base includes over 500 global communications content and service providers in over 125 countries around the globe.  CNS solutions are composed of four primary categories - 1) voicemail solutions; 2) advanced messaging solutions for telecommunication services; 3) enhanced solutions for the management and delivery of data and content-based services (video, email, SMS, etc.); and 4) billing and account management solutions.  While voicemail has become a necessity, these enhanced services are ultimately designed to help wireless carriers generate more traffic/usage, increase ARPU, differentiate services and enhance the communication experience for customers.

CNS's flagship application traditionally has been focused on the call answering market, as the company dominates the voicemail market through its flagship Trilogue solution, with the company having more than 50% market share over its nearest competitors such as Alcatel-Lucent, Ericsson, LogicaCMG and Unisys.  With a majority of the top-tier carriers as clients, CNS has been able to ride the telecom spending wave over the past few decades.  While the carrier voicemail market is mature, carriers still must continue to spend on additional capacity as global subscribers continue to grow.  A carrier can only postpone buying additional capacity for three to six months without risking customer disruption (network busy, etc.).

While the company's traditional voicemail platform has been its bread and butter, over the past few years the company has transformed its focus toward the faster-growing wireless data products, IP applications, and converged billing opportunity. 

With the CNS division having an oligopoly-like control of the traditional voicemail market, CNS has refocused its energies on the nascent IP market.  With consumers and enterprises alike continuing to transition from traditional telephony to IP-centric solutions and services, Comverse has been leveraging its voice presence into this next-generation IP market.  CNS's flagship solution is InSight, a single, modular IP-based messaging platform that provides voicemail and a host of enhanced value-added services.  InSight offers the ability to integrate data (video and multimedia), network, and smart handset capabilities under one roof.  Core components, including the multimedia message store, address book, media and presence servers, and subscriber profile database serve all associated applications, thus providing an attractive single point access to all types of messages and personal files.  Value-added services around voicemail such as online access to messages, visual voicemail, forwarding capabilities, email, and multimedia, should provide ample cross-selling and up-selling opportunities as stronger content, faster connections (3G) and enhanced benefits should drive more wireless carriers to adopt beefed-up messaging services.  For example, adoption of the InSight platform significantly benefited from the introduction of the iPhone's visual voicemail feature, as carriers around the globe were forced to upgrade their systems in order to remain competitive.  With less than a third to a half of Comverse's installed base of carriers on the InSight platform, there should be ample cross-selling and up-selling opportunity on the horizon as carriers must continue to differentiate themselves over competitors with value-added services, particularly as customer appetite for music and video wireless services continues to increase.

Comverse's real-time billing and prepaid solutions deliver dynamic control of telephony services and can manage many millions of active subscriber accounts simultaneously.  As such, Converse has the ability to authorize, rate, charge and control voice calls, data sessions and emerging payment transactions in real time.  The built-in capability to impose real-time credit limits on accounts reduces the operator's risk when deploying new services.  Prepaid billing was originally considered a low-tech option for cost-conscious consumers but has gained acceptance as an intelligent way for consumers to take advantage of the best deals once they become available, as they are not locked into a contract.  While prepaid billing solutions are not as widespread in the United States, these solutions are very popular in overseas markets, with prepaid subscribers representing a vast majority of the subscriber base in some European countries and emerging markets, where Comverse has had particularly strong success.  Comverse's primary competitors in the billing market are Amdocs, Convergys and Oracle.

Looking forward, Comverse's prepaid/postpaid solutions will enable the company to penetrate the converged billing market, which is slated to become one of the larger segments in the billing market, as Tier 1/2/3 carriers continue to move in the direction of converged billing systems due to the lower costs and clear technology benefits.  With content and multimedia delivery becoming increasingly more complex, carriers are ill equipped today to handle the billing needs for many of the enhanced solution sets customers are demanding today. 

Source: Brean Murray, Carret & Co. initiation report on June 4, 2008 and Friedman Billings Ramsey initiation report on September 19, 2006

RECURRING REVENUE

While Comverse has not broken down its revenue stream between recurring and new business, based on a number calls with customers and industry experts, I believe approximately 60% of CNS's revenue is recurring, consisting of maintenance and a 1-1 attach rate for services/consulting work.  Another 15-20% of revenue is attached to capacity upgrades within Comverse's installed base of customers, which is largely driven by the market growth rate of global subscribers.   A customer has the flexibility to postpone capacity upgrades for one or two quarters, however, beyond that, it risks disrupting quality of service.  Approximately 15-20% of Comverse's revenue is related to new sales, which would be the most sensitive to economic downturns.  However, Comverse's strong focus on emerging markets should help offset some of the weakness the mature markets are currently facing.

SNAPSHOT OF OTHER BUSINIESSES

Verint Systems provides analytic software for business intelligence, call centers and security.  Verint has over 5,000 customers in more than 100 countries, including over 70% of the Fortune 100.  Verint was part of Comverse Technology in its early years, with capabilities in PBX-based wiretapping.  Over time, the company expanded its communications interception, video surveillance and analytics capabilities.  In 2002, Verint was created as a separate public company, with Comverse Technology maintaining majority ownership.  The IPO was designed to create shareholder value following the terrorist events of September 11, 2001 and resulting focus on enterprise and government security, including the Homeland Security initiative.  Verint has approximately 2,500 employees across 18 countries.  Comverse owns 57% of Verint.

Ulticom is a provider of signaling solutions for wireline, wireless and Internet communications.  Ulticom's Signalware products are used by equipment manufacturers and communication service providers.  The signaling software enables the deployment of enhanced services associated with mobility, messaging, payment, and location-based functionality.  Ulticom's business was originally acquired by Comverse Technology in 1995 as a small telecom software programming shop.  Ulticom went public through an IPO in 2000, with Comverse maintaining majority ownership.  Comverse owns 69% of Ulticom.

Starhome B.V. provides software to mobile network operators that facilitate mobile device functionality during roaming.  Starhome was created internally as a part of Comverse Technology.   Comverse owns 70% of Starhome.

Source: Brean Murray, Carret & Co. initiation report on June 4, 2008

TIMELINE OF EVENTS

MARCH 2006 - Comverse announces creation of a Special Committee of the Board to review stock option grant practices.   Postpones filing of FY05 (January 2006 year end) earnings pending review and potential restatement of historical earnings.

APRIL 2006 - Special Committee recommends forced resignation of Kobi Alexander (Chairman & CEO), David Kreinberg (CFO), and William Sorin (General Counsel).

MAY 2006 - Comverse announce changes to senior management team and Board of Directors.  Roz Alon, an independent director, was named interim CEO; Avi Aronovits, VP of Finance and Treasurer, was named interim CFO; Paul Robinson, VP Legal and General Counsel, was named Executive VP, Chief Administrative Officer, General Counsel and Corporate Secretary.

JULY 2006 - Kobi Alexander was charged by the US Department of Justice with multiple charges of conspiracy to commit various types of fraud and other related offenses relating to the timing of Comverse's stock option grants.

AUGUST 2006 - SEC files civil injunctive action against Kobi Alexander, David Kreinberg and William Sorrin.  Comverse severs these former executives connections to the company, rescinds all unexercised options, and invalidates any other securities granted to them.  

• Kobi Alexander is indicted and flees to Namibia, where he is currently the subject of extradition hearings to return him to the US.

• David Kreinberg cooperated with the US Government, agreed to pay civil penalties and has not been sentenced.

• William Sorin served prison time and paid civil penalties.

NOVEMBER 2006 - Five new independent directors elected to Comverse board.  In connection with the ongoing investigation, Comverse identifies errors in revenue recognition, misclassification of certain expenses, and stock option grant irregularities.

APRIL 2007 - Andre Dahan named President and CEO of Comverse.

SEPTEMBER 2007 - Comverse announces preliminary revenue and income from operations results for 2QFY07 (quarter ended July 31, 2007) and provides updated backlog and balance sheet information.  Comverse also reiterates that it still expects to become a current filer with the SEC by the end of FY07 (January 31, 2008).

NOVEMBER 2007 - Comverse announces an expected delay in becoming a current filer w/ the SEC due to discovery of inconsistent revenue recognition practices associated with VSOE (vendor specific objective evidence) accounting standards.  The Company stated that the software revenue recognition issues will likely only impact the timing of revenue recognition (license revenue recognized upfront vs. maintenance revenue recognized over the life of a contract), rather than calling into question the validity of the transactions or revenue streams.

JANUARY 2008 - Kobi Alexander files a $72 million lawsuit against Cmverse for severance, unexercised stock options and bonus pay.

JANUARY 2008 - Comverse announces completion of the Special Committee investigation which confirmed the existence of option backdating and earnings manipulation.  Remedial measures were put in place to address these issues, including enhancing corporate governance, internal controls, training and compliance.

MARCH 2008 - Comverse receives a "Wells Notice" from the SEC due to past stock option grant practices and certain unrelated accounting matters.  The Wells Notice provided notification that the SEC staff intends to recommend that the SEC bring a civil action law suite against Comverse due to alleged violations of US securities law.

APRIL 2008 - Comverse files an 8K stating that Ulticom is in the process of considering a sale of its business by merger or otherwise to unaffiliated third parties.

JUNE 2008 - Comverse names Joseph Chinnici as CFO and John Spirtos as SVP, Corporate Development & Strategy.  Mr. Chinnici previously served as CFO of Ciena Corporation and Mr. Spirtos previously served as SVP, Corporate Development at Neustar and as President of Broadwing Communications.

AUGUST 2008 - Comverse files an 8K which incorporates a letter sent to employees from CEO, Andre Dahan addressing progress on the realignment introduced in January 2008 and a business update, which indicates slowing momentum in the second quarter due to underperformance at Netcentrex, delayed decision making in the core business, and a large, unfavorable move in the Israeli Shekel exchange rate vs. the US dollar.  Due to the complexity surrounding the VSOE revenue recognition process, Comverse is unlikely to meet its internal target to be a current filer by the fall of 2008.

OCTOBER 2008 - Comverse files an 8K which discloses consolidated cash and debt information as of July 31, 2008.  Comverse also announces that during the 12 month period ended July 31, 2008, the company incurred $75 million in connection with investigations by the Special Committee and other accounting matters related to the restatement.  Despite this, Comverse still managed to grow its cash and cash equivalents balance to $1.5 billion vs. the $1.43 billion reported as of July 31, 2007.

NOVEMBER 2008 - Kobi Alexander wins a Namibian court bid to postpone an extradition hearing until March 4, 2009. 

DECEMBER 2008 - Ulticom files an 8K which discloses updated cash and cash equivalents balance as of October 31, 2008.  Ulticom had cash and cash equivalents of $283m vs. $285m at October 31, 2007 and $282m at July 31, 2008.  Ulticom had no long-term debt outstanding.   

Source: Company filings and Brean Murray, Carret & Co. initiation report on June 4, 2008.

VALUATION

Comverse Technology, Inc. (CMVT) is a holding company consisting of Comverse, Inc, a wholly owned subsidiary which houses the company's core CNS business (messaging and billing), 57% ownership of VRNT, 69% ownership of ULCM, and 70% ownership of Starhome.  Management has stated that the holding company structure is not optimal.  Once the company becomes a current filer w/ the SEC, I would expect a sale of non-core assets, such as Ulticom and Starhome, or at a minimum a spin off of the equity ownerships in Verint and Ulticom to existing CMVT shareholders, which would greatly enhance the public float of these two companies. 

I calculate the enterprise value of the core CNS business as follows:

Below are my projections for the stand alone CNS business:

The last piece of income statement data that we have is from the 8K report Comverse filed on September 10, 2007.  According to the filing, for the three and six months ended July 31, 2007, CNS generated revenue of $288m and $572m, respectively.  The company also reported a significant sequential increase in product bookings, which leaves me comfortable in my FY07 revenue projection of $1.2b.  Non-GAAP operating margin improved from 3.0% in 1Q07 to 6.7% in 2Q07 and the release stated that "Comverse is on track to achieve its near-term objective of achieving double-digit adjusted (non-GAAP) operating margin, and we believe this goal will be reached over the next couple of quarters."  I believe the company did manage to exit the F4Q07 (January 2008) with operating margins of 10%+, but have since taken a step back due to the slowing business momentum and unfavorable movement in foreign exchange rates highlighted in the company's 8K release on August 14, 2008. 

To sanity check my free cash flow estimates above, we can analyze the change in the company's cash and cash equivalents balance between July 31, 2008 and July 31, 2007, which the company released in an 8K release on October 21, 2008.  During this time period, Comverse managed to increase its cash and cash equivalents balance by approximately $70m, despite having incurred expenses of $75m in connection with the Special Committee investigation and the ongoing restatement process.  Based on the 8K that Ulticom released on December 11, 2008, we know that Ulticom's cash balance was relatively unchanged.  Given the relatively high leverage on Verint due to the acquisition of Witness, it is unlikely that Verint's cash balance has increased significantly.    Therefore, it appears that the $145m increase in cash ($70m + $75m of special charges) over the past year can largely be attributed to the CNS division.  As such, I believe there is ample cushion in my $100m free cash flow estimate for FY09.

Incorporating $175m of class-action law suit settlements into my enterprise value for the CNS division, based on CMVT's current share price and a 9% operating margin assumption, CNS is trading at 1.9x FY09 EBITDA and offers a 32% free cash flow yield.  This is an incredibly cheap price to pay for one of the market leaders in the large and growing global telecommunications market, with a large installed base of customers (that face very high switching costs, think heart surgery) which provide a reliable and growing stream of recurring maintenance, service and support revenue. 

There is also ample room for margin expansion as the company believes it can achieve mid to high teens operating margin in the medium term.  Given the larger mix of high-margin software revenue vs. competitors such as Amdocs, there is potential for operating margins to exceed 20% in the long run.  Comverse's strong competitive positioning in emerging markets should allow it to grow its business much faster than the mid-single-digit industry average.  I am conservatively projecting that operating margins improve to 12% in FY10 and 14% in FY11 based on revenue growth of 5% in each year.  Applying a 6x - 8x EBITDA multiple range to my FY11 estimate, I get to a target price in the range of $12 - $14 after penalizing the company's net cash calculation for a $175m class action lawsuit settlement (~$4.80 per share of net cash post adjustment).  

Due to its large and sticky installed base at many large carriers around the globe (AT&T, O2, Orange, British Telecom, Sprint Nextel, Alltel, Verizon, etc.) and strong converged billing platform, I believe that CNS is a very attractive acquisition target for a number of strategic buyers such as Amdocs, IBM and Oracle.

Catalyst

Getting current w/ filings will renew interest in the company and allow for sale of the company to proceed...