Description

Datawatch Corporation (DWCH) is a provider of enterprise reporting, business intelligence, report mining, data transformation and service center software products that help organizations increase productivity, reduce costs and gain competitive advantages. I believe DWCH is a compelling investment offering a margin of safety with significant earnings growth prospects. At $2.95 DWCH has an enterprise value of $4.35 million and trades at .22x EV/ Sales, 5.0x EV/ Earnings and 3.2x EV/ Free Cash Flow (earnings plus depreciation and amortization less capital expenditures). On a CFO less capex basis, DWCH trades at 1.7x fiscal 2002 free cash flow.

Products

DWCH has 20,000 customers whose purchases are focused on the following products.

Monarch is DWCH’s biggest product with over 350,000 licenses in use. Monarch is used to convert legacy data in to a live database that users can export to an application like Microsoft Excel. For example, if you wanted a sales report that you wanted to examine in a flexible rather than static format a business analyst would use Monarch to move the data from a database query in to Excel. Monarch and its related family of products accounted for 59 percent of DWCH’s fiscal 2002 revenues. 95 percent of the Fortune 500 use Monarch. Monarch has no competitive products.

Monarch|ES is DWCH’s second biggest product. It is a web-enabled business information portal that allows users to access and analyze report data through a web-browser. Basically Monarch|ES allows users to access sales and financial reports culled, without programming, from a database through a company intranet. The software also provides graphic analytics of the information contained in the reports. Monarch|ES represented 26 percent of fiscal 2002 sales. Monarch|ES competes against Actuate, Quest and Mobius.

Q|SM is DWCH’s third biggest product. Q|SM is a fully Internet enabled IT support solution that can scale from a basic help desk solution to a full service call center solution that incorporates workflow and network management capabilities. If you work in a large organization that has an IT help desk they would use Q|SM to provide operational management of the help desk. Q|SM accounted for 15 percent of DWCH’s fiscal 2002 revenue. Q|SM’s competitors include BMC Software and Network Associates.

Visual Help Desk is a Lotus Domino based customer service application that enables support organizations to manage and organize their help desk or call center. This product is similar to Q|SM but was developed for the IBM platform and is a web-based solution. Visual Help Desk is also available on an ASP basis. DWCH received Visual Help Desk in its 10/2002 acquisition of Auxilor. Because Auxilor was acquired in this fiscal first quarter of 2003 sales have not been accounted for but were ~ $800,000 in the trailing twelve months. DWCH believes Visual Help Desk offers a new growth platform because of its low cost and it is a more flexible web-based solution. For what it’s worth, the Gartner Group expects this market to grow at rates greater than 20 percent through 2005.

VorteXML is the product that offers the most promise for future revenue and earnings growth. The server version of VorteXML was released in 12/2002 and allows users to convert existing legacy data to XML without the need for programming. This allows users to speed up and reduce the cost of enabling current applications for web services, implementing enterprise XML systems, and putting legacy output on the web (such as bill presentment). For those wondering why people would want to do this you only need to know that XML is a much more flexible and feature rich language than HTML for web development. For those of you who would like to know more, a pretty good non-technical primer is available here http://www.peterindia.com/XMLBenefits.html. There is a moat for this product as it is based on the same IP that Monarch is based on and not a single software company has managed to replicate it.

What makes me excited about this product is that VorteXML Server has already generated quite a bit of interest. In the 12/10/2002 press release for the product John Kitchen of Datawatch stated: "There's no other XML conversion solution like this in terms of pricing, ease of use, flexibility and power, and that is reflected by the thousands of VorteXML Designer downloads that we have experienced from our website in anticipation of VorteXML Server." VorteXML will be targeted at the small-to-medium sized business market that thus far haven’t had the capital necessary to deploy web services. With a VorteXML license costing $8,000 this large market will have an easy to use, low cost solution. As I will outline, it won’t take a significant number of licenses of this software to dramatically increase DWCH’s earnings.

Revenue and Earnings

First, the bad news. Since fiscal 1998 revenues have declined from $25.1 million to $19.4 million in fiscal 2002, for a total decline of $5.7 million or 23 percent. In the last two fiscal years, revenues have declined from $22.4 million in 2000 to $19.4 million in 2002. All of the most recent decline is due to a reduction in license fee revenue from $16.9 million in 2000 to $13.8 million, while annual recurring maintenance fee revenue has held steady at about $5.6 million. On a positive note, revenue in 2002 grew six percent from 2001, all due to an increase in license fee revenue.

In 2002, Monarch family license sales (including Data Pump, VorteXML, and Redwing) increased by $1.6 million or 17 percent contributing to an overall increase in license fee sales of 12 percent. The main contributor to this growth was the release of Monarch version 6 with most of the added revenue coming from new licensees not existing clients upgrading. With new feature added the upgrade cycle could have some life. License sales for Monarch|ES and Q|SM declined by 19 percent and 8 percent respectively. The company attributes the drop in demand to the soft economy and the related drop in software capital expenditures. The company also believes that Q|SM is a mature product and won’t provide significant license fee growth but offers stable maintenance and service revenue. More promising is the fact that Q3 2002 license revenues increased 29 percent YoY and Q4 license revenues increased 13% YoY, so the trend is positive going in to 2003.

DWCH has a two-pronged strategy to increase sales in 2003. First, for their enterprise products Monarch|ES and Auxilor they are hoping to overcome constrained budgets by introducing “starter kits”. They believe they can lock in future revenue by offering a basic implementation of Monarch|ES at $25,000 and Auxilor’s Visual Help Desk at $15,000. Second, they want to strengthen their relationships with third-party sales forces – VARs, consultants, integrators and OEMs – and rely less on direct sales. They achieved some benefit from this strategy in 2002 with these channels contributing 31 percent of revenue versus 25 percent in 2001. The company believes there is a good OEM opportunity with VorteXML.

One of the exceptional things about Datawatch is that the majority of its sales come from license fee revenue. In fiscal 2002, 71 percent of DWCH’s revenue was license fee sales and this revenue came with a gross margin of 80 percent. Gross margin on DWCH’s $5.6 million in maintenance fee revenue is 52 percent. With DWCH’s revenues skewed toward license fees DWCH would be an exceptionally accretive acquisition to any mid-sized software company.

On the earnings front, DWCH has never really been profitable until fiscal 2002 when the benefits of a fiscal 2001 restructuring program initiated by CEO Robert Haggar kicked in (more later). Operating expenses were reduced by 21 percent in 2002 with the biggest hit coming from research and development. While this may be a concern it is important to note that DWCH’s biggest product, Monarch, and the potentially big product, VorteXML, were both developed by an external company, Math Strategies, and licensed exclusively through 2009 by DWCH. The result of the restructuring was a profit of $864,000 in fiscal 2002 or fully diluted EPS of 31 cents.

The story gets interesting when you combine the restructured operation with the potential for even minimal growth provided by VorteXML. For example, if DWCH sells only 100 licenses of VorteXML Server at $8,000 per license and an 80 percent gross margin DWCH could realistically earn $640K or 24 cents per share on this small increase in sales. I don’t know what level of additional VorteXML sales would bring additional operating expenses for DWCH but Alan McDougall, the CFO, confirmed that at 300 licenses there wouldn’t be any incremental costs. Given that there have been thousands of downloads and the fact that DWCH has 20,000 clients I don’t believe 300 VorteXML licenses would be too aggressive an estimate for 2003. I would also remark that $8,000 is not a significant capital outlay so I don’t see constrained budgets affecting sales. As long as DWCH can keep license revenue for existing products level with 2002 there is significant leverage here. I would also note that DWCH will have additional revenue from their acquisition of Auxilor’s Visual Help Desk in 2003. As a final note, DWCH paid down their debt in 2002 so they won’t incur $121K in interest expense in 2003, they also had $88K in restructuring costs and their rent drops by $170K in 2003 so there is some wiggle room on the expense side. (big numbers huh…)

DWCH won’t be paying taxes for a while either with the Company having federal tax loss carryforwards of approximately $7 million, expiring in 2020, and approximately $8 million in state tax loss carryforwards, which commence expiration in 2008. I should point out that the company is not optimistic about their ability to realize their deferred tax asset and have created a valuation allowance for the full amount.

First quarter earnings and conference call will be some time next week. The company does not make forward projections.


Ownership and Restructuring

In what I would characterize as unusual, James Wood, former Chairman of A & P, basically acquired DWCH through the purchase of 43 percent of the stock in late 2000 and early 2001. He then appointed Richard de J. Osbourne, former Chairman and CEO of Asarco and a fellow director of Schering-Plough, as Chairman of DWCH in January 2001. Together, Wood’s WC Capital and Osbourne’s Carnegie Hill Capital control roughly 50 percent of DWCH. Based on a reverse stock split my guess is that their average cost is in the neighborhood of $4.50.

In July 2001, Robert Haggar who was instrumental in the success of DWCH’s international operations (42 percent of sales, unusual for a company of this size) took over as CEO from Bruce Gardner as CEO of DWCH. In Q4 2001 Haggar, restructured the company through reduced headcount and reduced dependence on external software developers and maintenance and support staff. As mentioned before, this led to total operating expenses being reduced by 21 percent in fiscal 2002.

I should also point out that in the last four months CEO Robert Haggar has purchased 4,000 shares between $2.90-$3.73 and Chairman Richard de J. Osbourne has purchased 4,900 shares at $3.22-$3.40 per share.

Currently there are about 266,000 options with exercise prices between $1.10-$3.52 and about 62,000 of these options are exercisable.

Valuation

Market cap > 2,696,708 fully diluted shares out at $2.95 = $7,955,289
Cash = $3,605,044
EV = $4,350,245

Fiscal 2002 Sales = $19,440,000
EV/ Sales = 0.22x

Fiscal 2002 Earnings = $864,000
EV/ Earnings = 5.0x

Fiscal 2002 FCF > Earnings + Depreciation and Amortization – Capex = $864+$930-$439 = $1,355,000
EV/ FCF = 3.2x

Fiscal 2002 FCF > CFO – Capex = $3,072-$439 = $2,633,000
EV/ FCF = 1.7x

If we assume that sales of existing products remain flat, we account for $800,000 in sales from Auxilor and 200 VorteXML licenses for fiscal 2003, revenue would be $21,840,000. Assuming no net margin on Auxilor sales and only 40 percent on VorteXML the income statement would look like this:

Revenue $21,840,000
Less: Software costs $3,197,800
Less: Maintenance and service cost $2,833,480
Less: Sales and Marketing cost $7,575,400
Less: R & D cost $1,420,000
Less: General and admin cost $5,208,000
Net income $1,605,320

This model ultimately assumes a 10 percent increase in S G & A and R & D to go with a 12 percent sales increase. I believe this is extremely conservative.

Depreciation and amortization = $930,000
PP&E = $300,000
Capitalized Software = $400,000

Cash fiscal year end 2003 = $5,441,364

Assume a modest 10x earnings = $16,053,200
Plus cash = $5,441,364
Divide by 2,740,000 shares = $7.85

This is 149 percent above the current price and I believe it is a very conservative scenario.

Risks

You will obviously have to be very patient if you want to acquire any stock as it trades about 3,000 shares a day and has price volatility associated with illiquidity.

Sales of the three core products could drop more than the increase in VorteXML sales leading to no earnings growth. VorteXML could also turn out to be a dud.

With growing earnings and free cash flow management could go on a spending binge. I believe this risk is largely muted by the controlling shareholders wanting a decent ROI.

Catalyst

Significant growth in EPS with the introduction of VorteXML Server.

Potential acquisition by a mid-sized software looking to make a highly accretive acquisition.