Description

Chordiant (CHRD) is a niche software company with good technology and a sticky and growing list of blue chip customers. Company had good business momentum since current mgmt team joined 2 years ago, but hit a bump in the latest Q due to factors largely out of their control. Stock sold off from $17 to $5.8 in four months. The fact that top 3 holders are all quant funds probably didn’t help the cause. CHRD is one of the cheaper software companies – 11.5x TTM earnings with 44% market cap in cash, 4.5x EV/TTM EBITDA, 14% FCF/EV (EBIAT + D&A – capex), 0.8x EV/sales. Risk/reward at this level is very favorable – stock may have another 15% downside in the NT, but could easily double when business stabilizes or in a take-out.

(Note that I am using pro-forma numbers ex option expenses in the write-up, a common practice in tech land. If you are not comfortable with the approach, this stock is probably not for you.)

Company Description: CHRD sells CRM solutions to big corporations in 3 verticals -- financials services (50% of sales), insurance/healthcare (40%) and telecom (10%). Typical clients are organizations with millions of customers, high volume transactions and irreplaceable legacy systems. Think the software used by a bank teller or a call center representative.

What I like about this company:  For a $200M market cap company, CHRD offers superior solutions and has a very impressive and growing list of blue-chip customers. In the financial services sector, they have 10 of top 20 global banks (C, JPM, HSBC) and 3 of top 5 European banks (Barclays, Lloyds, ABN). In insurance sector, they have half of the top 10 global insurers (MetLife, AIG). In telecom sector, they have 10 of top 40 global Telco’s and just signed Vodafone to their largest contract in company history. CHRD also had a strong record of selling more to its customers after the initial contract, which is a good indication of very satisfied customers.

Main competitors include in-house development effort, SAP in Europe, and Siebel/Oracle. According to the company, SAP has good back office support but poor front end offerings. Siebel’s offering is an out-of-box template that does not allow much customization, clearly a major negative. It also needs to create a duplicate database on top of customer’s own database. In short, CHRD appears to have very good win rates against these formidable guerillas of the space.

The software implementation is pretty complex (often consolidating 10+ legacy systems), takes long set-up time (3-12 months), and can run into 8 figures in $. This leads to long sales cycles and volatile license bookings, and unfortunately hurts CHRD in tough economic times as these big capex decisions get pushed out (which is what happened this time around). On the other hand, the complexity also means the user base will be sticky -- would Citigroup scrap the system after spending $20M and training thousands of its employees how to use the software interface? Not very likely. This sticky and lucrative blue-chip user base will be a very valuable asset, as it provides future maintenance revenue at high margin, cross/up-sell opportunities, especially for strategic buyers such as ORCL and IBM.

So what happened? Despite the strong product offering, CHRD had a checkered past and was not consistently profitable, mostly due to poor operational control leading to SEC investigations and various restatements. In early 2006, the board brought in a new mgmt team led by a new CEO, who was previously CFO at Verity (VRTY) which was sold to Autonomy. Under the new leadership, CHRD appeared to have turned the corner – resolved the accounting issue, sought outside partnership to bring deals (notably IBM brought in a $10M Cigna deal), signed mega-deals ($10M+) in 5 of last 6 Q’s. Backlogs more than doubled, and CHRD now has 6 customers with $30M+ in total spend vs. just one 2 years ago. Stock responded, more than doubling from $7 to $16 in the next 18 months.

Unfortunately, although CHRD diversified its customer base, financial companies still account for 50% of its revenue (down from 80% a few years ago). With all the well-known things occurring in the financials space and general corporate spending pullback, it doesn’t take a rocket scientist to figure out that the company will have a difficult year in ’08.

Indeed, less than 2 months after giving out a rosy ’08 guidance, mgmt cut revenue guidance by $25M out of $150M and earning by 20c (out of 60c), and stock dived to under $6 (and sinking as I type) in 4 months. The fact that top 3 shareholders are all quant funds probably added to the selling pressure.

I have no idea how ’08 will shake out. I take comfort that backlog is actually at the highest level of company history, and mgmt guidance does not include any potential mega deals, even though they just closed one 2 months ago. The Vodafone deal was closed in a sales cycle of 6 months, as the internal sponsor previously had very good experience with CHRD’s offering at another company. Mgmt indicated that after that deal closed, they are approached by North American telco’s for the first time, much like the Cigna deal quickly brought them to other deals in the health care space.

In short, I believe recent problem is more of a macro issue (echoed by tech bell-weathers like CSCO and ORCL), and does not in any way imply CHRD’s competitive position had eroded. It is just a matter of time that these big corporations start to spend again.

Very cheap stock. CHRD is one of the cheaper software companies. At $5.80 with 33.9 shares outstanding, CHRD has a market cap of $196M. Company has $87M cash and no debt. I estimate the NOL to be worth $25M conservatively ($150+M NOL). So we have a company with $84M EV that generated $19M EBITDA in TTM and $14.5M in FCF (EBIAT + D&A – capex). Company actually reported $24M operating cash flow in ‘07. Company is guiding for a relatively flat revenue in ’08 and EPS (again, no mega-deals assumed, which could add some upside). Stock is trading at under 12x trailing EPS with 45% of market cap in cash.

EV/sales is probably a more relevant metric, as CHRD’s op margin can be much higher as part of a larger company (10% op margin vs. 40% for ORCL). CHRD’s lack of scale hurts profitability. Looking at CHRD’s P&L vs. ORCL’s, they have very similar gross margin at 74% vs. 77%. CHRD has 10% higher R&D, 5% higher Sales & marketing, and 12% higher in G&A. So a lack of scale gets to a 10% op margin for CHRD and 40% op margin for ORCL. So a company like ORCL could theoretically come in and turn CHRD into a 20%+ EBIT margin biz with some easy cost synergies.

Another way to look at valuation is to look at EV/Sales and EV/maintenance sales, vs. recent transaction multiples. Based on a list of 30+ software company transaction since 2002, median transaction multiples are 3.3x EV/sales and 7x EV/maintenance sales, while CHRD is trading at 0.6 EV/trailing sales and 1.6x EV/maintenance sales. For reference, much of the software space is now over 2x sales. At 2x EV/sales, CHRD would be worth $11. At 3x sales, CHRD is worth $15.

In terms of downside, the stock may have another 15% downside to $5, at which point it will trade 2x cash, 3x EBITDA, 25% FCF yield, 0.4 EV/sales. On the upside, if they can stabilize licensing revenue in a more normalized environment, I see $12 in 12-18 months (15x non-GAAP ’09 EPS + cash).

My guess is that this company will not be independent in 2 years. It makes a very attractive acquisition candidate financially and strategically. Possible acquirers include ORCL, which should remain active, and IBM, a current major partner of CHRD.

The CEO put it quite well in an interview last year.

In three years Chordiant will be in one of two places: either Chordiant will be a $300 million to $500 million a year company, and very profitable or Chordiant will be part of a much larger organization. The reason I say that is, if you look again at the people that we sell to, again blue-chip customers, there is a high amount of business impact in the customization, branding and integration of our software with the customer’s business process. These accounts have many buying divisions, and they are very important customers to the top four or five companies in our industry. We are increasingly on their radar.

Risks:

·         Continued challenging environment. Volatile licensing revenue especially with heavy exposure to financials sector.

·        Company blows the cash on an ill-advised acquisition.

Catalyst