Description

Quick Summary

COVS provides cloud-based identity as a service solutions/portal as a service (IDaaS/PaaS) to the automotive and manufacturing industries for large customers including GM, Ford, Hyundai, Coca Cola and Carson Wagonlit.  The company was started in 2000 by GM, Ford, DCX, Nissan, Renault and Peugeot who invested $500mln to develop a secure, online way to manage their supply chains.

Due to a messy spin from Compuware and years of underperformance, the stock has declined dramatically from its IPO at $10 to below $2.  Furthermore, the business has been undergoing disruptive transition as the company attempts to move away from its low margin services offering and remove low-margin healthcare applications customers.  

While the company has been in a transition period through 2014/15 as they changed the management team and invested in the sales force, the most recent quarters have provided evidence that the turnaround is succeeding.  Adjusting for the company's shuttering of its non-core healthcare business and COVS core subscription revenues appear to have turned the corner and are growing substantially.

As the company continues to prove out this turnaround, the stock should be poised for material upside.  For FY 3/31/16, COVS should have ~70mln of ongoing subscription revenue.  This subscription revenue is very sticky (mid 90s retention rates) as its solution is mission critical to the majority of its customers.  If COVS can successfully turn the business, then this revenue is worth a very high multiple, suggesting a return to ~$6.50  or 180% upside.  That appears to be enough upside to justify the significant risk of ~30% downside.

Capitalization and Valuation

COVS has 40.5mln diluted shares for a $93mln market cap at $2.32.  At 6/30 the company had 47.2mln of cash.  I expect cash burn of 12mln for the rest of FY 16. Thus I use adj net cash of 35mln and an adj EV of 58mln or 0.8x FY 16 subscription sales.

Upside

COVS has undergone a messy transition as the company has dramatically shrunk its loss-making service offering and "fired" its unprofitable healthcare customers.  This shuttering of the healthcare business has hidden the significant turnaround that COVS has successfully undertaken as reported revenue and subscription revenue growth has been materially lower than ongoing business subscription revenue growth.

For example, in Q1 16 total revenue growth declined 14% y/y due to a 54% decline in services revenue growth.  More importantly, subscription revenue growth appeared to be only 1%. However, if we remove the healthcare subscription revenues from both Q1  15 and Q1 16, the subscription revenue growth of the continuing business increases to 12%. 

For FY 16, total revenue is expected to shrink ~7% and stated subscription revenue growth is expected to be 5-10% but ongoing business revenue should grow 20% Y/Y. 

Management confirmed this on the Q1 16 CC:

Q1 fiscal 2015 subscription revenue included about $2 million worth of business that we have since exited. And of

course, we replaced that revenue with new, higher margin business as we have noted in recent calls. Accordingly, a

more appropriate description would be to compare our current results against the same set of businesses a year ago,

which will then identify the quarter-over-quarter underlying results from the past year of about 12% increase in

subscription revenue.

We expect year-over-year subscription growth of about 5% to 10% versus last year. Of course, when you

adjust this guidance to reflect the businesses we have exited, and as I outlined it for the first quarter, the underlying

growth for the year would be about 20%.

This continuing business growth is being achieved by a reinvigorated sales force as well as COVS key partnerships with Cisco and Tech Mahindra.  These partnerships have both helped COVS maintain its position with existing clients (extended key GM relationship to 2020) as well as open the door to new potential customers.   On the Q1 call CEO Inman said about the Cisco partnership:

Also our largest partnership Cisco, they continue to build momentum with their Service Exchange Platform or SXP.

We've got several pilots underway, all of them in large enterprise accounts as you would assume. And they have a

pipeline in excess of $100 million.

The company also has significant growth opportunities both through further penetration of its existing and adjacent customer base.  For example, as a result of siloed purchasing decisions, COVS only currently works with 2 of 5 divisions at Ford.  Because one of the largest problems that COVS faces is customer awareness of its solution, the opportunity to further penetrate its existing customer base should be low-hanging fruit.  Again from the Q1 CC:

Despite our pedigree and long history of success with our automotive customers, we find that we are completely underpenetrated in this sector. So as we speak, we are engaged in some significant opportunities to leverage our platform to new business critical uses with these customers. And the opportunities and challenges that our automotive customers encounter are also prevalent in the boarder manufacturing sector.

Longer-term, upside potentially exists from the Connected Car and Internet of Things increasing demand for COVS solutions. At a recent IOT conference, COVS laid out its vision for IoT which was well received:

John Gleeson of Covisint provided what I and some of the other audience members at Presentation Theater on the IoT Evolution Expo exhibit floor thought was one of the more riveting presentations. In it, he talked about how Covisint wants to become the platform of choice for IoT and identity-centric solutions by making sure only those with authority to access certain endpoints and other IoT resources are able to get it. And he explained how Covisint can do that by acting as a central authority for access to such devices and solutions. (http://www.iotevolutionworld.com/iot/articles/408780-iot-evolution-week-review-att-cisco-covisint-numerex.htm)

With regards to profitability, while COVS has not been profitable, much of that has been due to its loss-making services business.  Over the long-term, COVS mgmt has presented an operating model with ~70% gross margins and 20% EBIT margins as the higher-margin subscription revenue grows and leverages the relatively fixed opex.  

If the turnaround continues, subscription revenues should growth to greater than 80mln in a FY 17.  A growing SaaS company should trade at least 3x subscription revenues which would be ~$6.50 for COVS.  Further upside clearly exists from continued growth and/or a more aggressive SaaS multiple.

Downside

COVS has a strong balance sheet to protect the downside.  The company has 47mln of cash for at least a 3 year runway at current burn rates and it is likely that the cash burn shrinks dramatically as the turnaround continues. 

The company also has 60mln (1.50 per share) of TTM continuing business subscription revenue which should get some kind of multiple due to its stickiness.  If we assume 2 years of continued burn at the high end of  and only 0.75x sales on TTM continuing subscription revenues then COVS would be worth $1.60 or 45% downside.  0.75x subscription sales is a very conservative multiple for a this sticky revenue stream but it must be assumed that COVS would be very distressed in this scenario.

Conclusion

Overall I think COVS is a very interesting turnaround situation that his been undervalued by the market due to the messiness of its transition.  While there is a great deal of uncertainty as to what the future will look like, I believe COVS presents the potential for significant upside with minimal downside risk.

Catalyst

Future quarters have less drag from discontinued business making subscription growth more apparent