Overview

Cover-All Technologies ("COVR" or the "Company") is a $33m market cap software company serving the insurance industry that has been profitable for the past 13 quarters. They sell 5 year licenses for their product that includes a significant amount of recurring maintenance revenue.  The experienced management team has delivered on their promises in the past and has plans to aggressively grow the top line and expand margins over the next 4-5 years.  However, ignoring the potential growth, the stock is currently not expensive at 8x TTM EPS and under 10x TTM FCF.  If management hits their targets, the shares should trade between 2x and 4x higher in 3-5 years. 

Market Opportunity

Cover-All's products predominantly serve the commercial property and casualty insurance industry.  This is $500 billion industry in which insurance companies spend on average 4-5% of their revenue on Policy Administration Systems.  COVR's $15m in revenue is a small fraction of the total market; while most of the spending is by internal IT departments, they compete against many outside companies as well.  COVR's well-developed (as described by independent research firm Celent[1]) My Insurance Center (MIC) product can do these tasks for 1-2% of revenue, while at the same time reducing in half the time to market for new products.

Due to past consolidations within the insurance industry and the long tail of claims, insurance companies can have as many as 500 legacy systems.  COVR's CEO, John Roblin, likes to describe a map of these systems as an Airline route map, without any hubs.  COVR's solution replaces all these legacy systems with a single, customizable system. So while this saves IT costs, COVR prefers to sell to the C level execs on the ability to more quickly bring new products to market, thereby growing their revenue.

A typical commercial auto policy can have as many as 600 required pieces of information and over 1000 different potential forms to fill out.  What is required varies by state and requested coverage.  COVR's MIC ensures that agents collect the correct information for the state and that the policy gets priced/rated correctly.  In addition, COVR keeps track of all the various changes in state regulations and updates the software on a monthly basis with as many as 150 changes at a time. 

Revenue

COVR has four sources of revenue.  First is a software license sale covering use of the MIC product for 5 years.  These sales are lumpy and in quarters where they receive a big license sale, the company is very profitable.  While the exact timing of these sales is not predictable, I expect this portion of revenue to grow by about 10-15% per year.  If a company doesn't want to install the software on their own system, they can instead let it be hosted by COVR and pay ASP (Application Service Provider) fees for its use.  I expect these fees to grow at a similar rate as the licensing fees.

Along with the 5 year license, COVR has product maintenance and support revenue that averages about 25-30% of the cost of a license per year for the term of the license.  This covers product upgrades as well as updating all the changes to state regulations, etc. on a monthly basis.  This revenue should increase faster than licenses as it is recurring in nature and should compound over time.

And finally, the company also sells professional services which include the customization of their software for each customers unique uses, conversion from prior systems, integration with state regulators, etc.  I expect this revenue to grow a little slower than licenses (before taking into account their recent acquisition, more below).

The company discusses recurring revenue as annualized amounts of the prior quarter's maintenance revenue, the minimum contracted ASP revenue, and about $250k/quarter in professional services revenue.  They entered 2010 with about $7m in recurring revenue calculated in this method.

Moore Stephens Business Solutions Acquisition

In April, COVR acquired Moore Stephens Business Solutions (MSBS), a company that provided business intelligence solutions for the insurance industry.  MSBS's products and services help insurance companies make sense of their products by making the data housed in all the different systems analyzable.  The plan is to cross sell COVR's products to MSBS's 20 customers and to implement features of MSBS's offering into an add-on to COVR's MIC product.  MSBS had $6m in TTM revenue and COVR paid about $2.5m for the business.  This revenue is mostly professional services.

Note that Moore Stephens, COVR's Auditor, and MSBS, are not related, despite having similar names. 

Future Growth

COVR plans to grow in the future through introducing new products, adding new customers, cross selling more services to existing customers, and through 1 or 2 small bolt-on acquisitions (similar in size to MSBS).  I believe all of these are likely.  The company is already in development of new products that will be released later in the year.  These new products have expanded functionality and some customers have already committed to upgrading as soon as they are available.  MSBS had 20 customers, none of which used COVR's MIC, and none of COVR's 35 customers used MSBS's Business Intelligence Solutions, so there are many additional cross-selling opportunities.

Financials

COVR's balance sheet is strong, with over $4m in net cash after adjusting for the MSBS acquisition.  They have been profitable for 13 quarters and free cash flow positive for most of those as well, so they have no immediate need for additional cash.

The business has gross margins approaching 50% and operating margins that average over 20%.  The quarter to quarter margins fluctuate with the size of the licensing revenue in the quarter.  These margins should expand over time due to additional operating leverage, however in the near future they are likely to stay at these levels as the company re-invests in the business.

The company expenses software development costs which improves earnings as compared to cash flow.  In recent quarters, cash software development costs have run ~$300k more than amortized costs as the company has stepped up their development for future additional products.  They have a flexible work force in India which they can scale up and scale down as required by new business wins or product development.

Valuation

COVR is currently trading at approximately 8x trailing earnings or 7x after backing out the cash.  Because they have tax-loss carry-forwards and little depreciation, the EV/EBITDA ratio is similar.  Excluding the cash, shares trade at under 10x TTM FCF of $3.1m.

Management has a target of $40-$50m in revenue in the next 3-4 years, which likely will require some small acquisitions.  Operating margins should expand over that time due to the operating leverage in the business.  Assuming a 40% tax rate and various operating margin and multiple assumptions, I get the following range of values based on $40m in revenue:

I have not backed out the $20+ million in cash they should generate over the next 4 years (about $0.80/share) and assume that the share count expands to 30m from 25m today.  I think a 30% margin and a 15x multiple is likely which is a $4 share price, or a triple from the current $1.30 over the next 4 years.

Relative Valuation

While I never rely exclusively on relative valuation, I do like to look at other public company comparisons to see trading multiples.  In COVR's case, there is no direct competition and a group of publically traded software companies that compete with them shows no consistent valuation trends:

⁽¹⁾Growth is prior 2 year revenue growth

⁽²⁾EBIX made 8 Acquisitions over past 2 years

Source: Bloomberg, SEC filings

One concern from looking at the relative valuations is that many of the stocks in the sector are "cheap" on an EV/Sales or EV/EBITDA basis.  Some of this can be explained by a lack of revenue growth and a high proportion of revenue in lower margin businesses. CSGS looks most attractive of the publically traded competitors; however their margins are weak for their level of revenue.

Risks

COVR is a low volume stock, without any trades on some days, so liquidity is a risk as with any other microcap company.  

License sales are lumpy and are likely to disappoint some investors at some point in the future.

Director Mark Johnston recently stepped down and has been a seller of stock "for personal reasons."  He likely has another 300k shares to sell, he has told management that he intends to keep 1m shares.  He acquired the stock years ago by selling a product to the company.  The company never used it and sold it back to him, partially financed through a note that he eventually defaulted on and had to return shares to the company to repay.  I do not view his departure as a loss, however the potential overhang from stock sales could be an issue.

RENN Capital Group / Russell Cleveland owns 30% of the stock and is committed to the company.  However there is always a risk they could exhibit control that benefits them at the expense of other shareholders or decide to sell their large stake.  Their shares came through financing the company and converting the debt to stock. 

[1] http://www.cover-all.com/wp-content/uploads/2009/09/2009Celent.pdf

Continued execution and new deals.

Management is committed to doing non-deal road shows to raise awareness of the company.

Potential listing on national exchange once share price breaks $2.