Description

Edgewater Technology (EDGW)

Summary

Edgewater Technology (EDGW) is an under-valued IT services company that provides advisory and product-based consulting services to its highly diversified client base.  EDGW trades at about 22% of revenues, 3.5x adjusted EBITDA, and a 23% unleveraged FCF yield.  Importantly, EDGW has an unleveraged balance sheet with a large net cash position (30% of market cap) that we believe can grow over time (absent share buybacks or niche acquisitions).

EDGW has shifted its focus in recent years to product-based consulting services whereby they implement Oracle, SAP, Microsoft, and other software with a focus on upper to middle global 2000 companies.  We believe EDGW is an important partner for these major software vendors, who rely on EDGW to implement their software and interact with end-user customers.  We believe there will be continued solid demand for this software and for EDGW’s services.  We also like that EDGW’s revenues are well-diversified with its top 10 customers representing less than 25% of total revenues and no single customer representing more than 5% of revenues.

We have invested in several software companies through the 2008-9 downturn due to their recurring maintenance revenue streams which are highly stable, even in depressed economic conditions.  Their software products tend to produce material cost reductions, efficiency improvements, and revenue enhancements and strong ROI’s for customers.  Oracle, Microsoft, and SAP are very attractive strategic partners for a small company like EDGW.

EDGW has 12m shares outstanding and trading volume is modest, so this idea might be appropriate for PA accounts or small- and micro-cap players.  However, some major investment firms have been able to assemble meaningful stakes over time (e.g. Gabelli entities own almost 20% of outstanding shares).  EDGW’s shares are currently valued at about $2.80 per share for a market cap of $33m.  EDGW had net cash of about $10m as of 9/30/11 for a total EV of $23m.  LTM revenues are about $100m and LTM adjusted EBITDA is $6.3m.  LTM FCF (cash from operations less capital expenditures) is about $7m.  We assume EDGW can sustainably generate $5m- $6m per year of FCF, resulting in an unleveraged FCF yield of about 23%.   As a result, EDGW generates about 40 to 50 cents of FCF per share and has a balance sheet with close to $1 per share in net cash as compared to its $2.80 share price. 

We believe that EDGW is being given no credit for major improvements in its business model since the 2008-9 downturn.  The shift to a product-based, channel partner focus has resulted in a highly cash-generative business which is likely to be much stronger and more resilient than its prior focus on custom consulting.  The custom consulting business was severely impacted during the 2008-9 downturn and is now a much smaller part of the overall revenue base.  We believe investors will gradually come to appreciate the strength of EDGW’s revised, product-oriented business model, and its strategic relationship with three of the largest software companies in the world. 

Furthermore, we would not be surprised to see consolidation in IT services industry by strategic or private equity players and EDGW’s value-added position between end-user customers and Oracle, SAP, and Microsoft would make it a highly attractive acquisition.  Sapient (SAPE) and Perficient (PRFT), two larger, publicly-traded IT services companies, trade close to 1x revenues and 11x adjusted EBITDA compared to 0.2x and 3.5x for EDGW, and both are focused on growth through acquisitions.

Business Description

EDGW was previously focused on custom building of software for its customers but has morphed into a channel focused player.  Mgmt believes that the custom building aspect of software industry is moving overseas to lower cost locations and the customers today want a “one-stop-shop” approach with SAP, Oracle, or Microsoft software off the shelf.  Over 80% of EDGW’s current revenues are channel-related with Oracle, SAP, and Microsoft vs. about 30% in 2007.  EDGW provides services under the following brands: (1) Edgewater Technology provides business advisory and technical consulting services to clients implementing transformational products that provide a high rate of return; (2) Edgewater Ranzal is a recognized expert in EPM product-based consulting in the Oracle Hyperion channel; (3) Edgewater Fullscope is an award winning Microsoft Dynamics AX partner that provides product-based ERP services for manufacturers; and (4) Edgewater SAP provides EPM product-based consulting in the SAP channel, working with tools such as BPC and BusinessObjects.

We believe that EDGW is one of Oracle’s top five IT service provider partners in the U.S.; one of SAP’s top service partners in the Northeast U.S.; and a leading service provider for Microsoft’s Dynamic CRM software in the U.S.  EDGW has strategic alliances with Oracle, SAP, Cognos, VMware, Microsoft, IBM, Informatica, Google, and others.

ERP work is generally for 6 to 12 mos periods and larger projects and represents the backbone of the customer’s entire IT infrastructure.  EDGW is primarily focused on ERP through the Microsoft Dynamics AX product, which is oriented toward manufacturing companies.  EPM software is business intelligence software which provides enhanced information which makes the customer more efficient.  EPM work is generally for 3 to 6 mos.  In many cases, EDGW gets sales leads from its software vendor partners and makes the sales pitch with them.

EDGW has 420 employees, of which 75% or more are billable consultants.  It has a large North America footprint and recently established a presence in the U.K.  EDGW provides a range of services to its customers under three basic categories: (1) business advisory services (business strategy, best practices, and transformational change); (2) product-based consulting (enterprise performance mgmt or EPM, enterprise resource planning or ERP, and customer relationship mgmt or CRM); and (3) technology consulting (architecture/roadmaps, analysis & design, custom development, web solutions, etc).  EDGW generates attractive revenue per consultant (a key performance indicator for its industry) with service revenue per consultant of $261k in 2005, $300k in 2007, $340k in 2008, $348k in 2009, $324k in 2010, and $329k in YTD 2011. 

EDGW acquired Fullscope (Dynamics AX ERP) in December 2009 for $15m in cash plus earn outs and Meridian Consulting International (Oracle HSF) in May 2010 for $1.8m plus earn outs in order to strengthen its product-based solutions,   EDGW also internally developed IP assets (Dynamics AX Chemical Accelerator).  It is worth noting that the Fullscope acquisition was closed at end of 2009 and the timing of  the assumed working capital liabilities in early 2010 distorted cash from operations for 2010, making it look several million dollars lower than it actually was on a continuing operations basis.  Over the past six years, EDGW has invested over $45m in acquisitions to build out its current business model, but the current EV of EDGW is only $23m.

EDGW has a broad range of customers and specializes in several verticals, including manufacturing (Cognex, Sanimax, Kraco, Bausch Lomb), healthcare (Covidien, Penn Medicine, Miami Children’s Hospital), insurance (Trustmark, Horace Mann, Delta Dental), hospitality (Extended Stay, Hilton, Carnival), retail (Michaels, Motorcoach, Autonation), financial services (Marsh, Sumitomo Bank, Discover, Mastercard), utilities/mining (Northeast Utilities), and emerging (Lennox, Acxiom, Fluror, Iron Mountain).   During 2010, EDGW recorded revenue from 391 customers (of which 103 were new customers) as compared to revenue from 249 customers in 2009 (of which 63 were new customers).

We believe EDGW is benefiting from a strong technology upgrade cycle in product including ERP and EPM and Microsoft Dynamic CRM software.  We think expenditures in these areas have been deferred and customers are now in a “catch up” mode.  We believe the end-user customers receive attractive ROI’s and efficiency benefits from these software solutions and this should continue to help drive EDGW’s services business over the next few years.

Strong Cash Flow Generation and Solid Business Model

EDGW has a very solid business model with limited capital expenditure and working capital investment requirements.  EDGW’s business has a high ROIC of 50%+.  Mgmt believes adjusted EBITDA is a good proxy for FCF.  LTM adjusted EBITDA is close to $7m. We think adjusted EBITDA could grow in 2012 to $8m or more.  We believe EDGW should eventually achieve adjusted EBITDA margins of 10%.  Based on $8m of adjusted EBITDA for 2012, we expect the net cash position to grow by at least $5m to $15m or more by year end 2012.  Capital expenditures over the past few years have been less than $1m per year.  EDGW has an NOL of about $25m which should result in minimal cash taxes for several years.

Strong Relationships with Software Vendors and End-User Customers Provide a Strong Competitive Position

We think EDGW’s well-established relationships with major software vendors Oracle, SAP, and Microsoft and employees’ detailed knowledge and experience in specific verticals with these software products are an important competitive advantage.  EDGW is a top IT service provider for each of Oracle, SAP, and Microsoft.  Software vendors do not want to deal with several different systems integrators and this favors EDGW’s scale.  Also, EDGW’s highly diversified customer base (the top 10 customers are less than 25% of total sales) is also valuable, since the large software OEM’s depend on companies like EDGW to sell and implement their software, especially to small and middle market enterprise players.

Experienced  & Disciplined Management Team Focused On Long-Term Value Creation

EDGW is led by CEO Shirley Singleton and CFO Tim Oakes.  They appear to be conservative, disciplined, long-term operators who may not be flashy but are executing a solid, long-term oriented strategy with a low-risk approach that we like.  Mgmt aggressively reduced its cost structure in response to the 2008-9 downturn and shifted its business model towards product-based consulting services.  We believe they are on the right track to building substantial shareholder value over time through the end-user relationships and the software vendor relationships they have built.  Mgmt is highly focused on improving their current below-average EBITDA margins closer to industry standards.

We also believe they will be careful and prudent in deploying capital into any strategic acquisition and would expect that, if there was one, it would hopefully have a rapid payback.  We believe both the Fullscope and Meridian acquisitions were strategically smart and strongly accretive.   We believe that mgmt is strongly motivated to drive shareholder value and believes the business is significantly under-valued at current prices. 

Large Share Repurchase Program

EDGW recently announced a major share repurchase program for up to $8m or almost 25% of the current market cap and during Q3 repurchased $3m of common stock.  We expect mgmt to continue with its share repurchase program, especially if the stock remains at current prices.

Industry Consolidation Prospects

We believe that EDGW’s relationships with a highly diversified group of end-user customers are a valuable asset.  We think there are several potential strategic purchasers who are interested in expanding into the value-added services that a company like EDGW provides to small and medium-sized enterprises.  Mgmt has pointed out that the big four accounting firms which divested their technology consulting businesses in the wake of increased governmental scrutiny, are all re-entering the technology consulting business.  For example, Price Waterhouse purchased Diamond Technology for over 12x EBITDA in 2010.  Further, there are industry competitors like Sapient (SAPE) and Perficient (PRFT) who trade at very large premiums to EDGW (close to 1x revenues and 11x adjusted EBITDA) and have shown a strong interest in expanding through strategic acquisitions.

Strong 2011 Results Should Bode Well for 2012

Nine month results for 2011 were strong, with service revenue up 14% to $58.4m,  improved gross profit margins (from 35.6% to 37.9%), and adjusted EBITDA increasing from $2.1m to $5.4m.  Cash from operations also showed strong improvement, from ($0.9) m to $5.8m.  We believe these general trends can continue into 2012 as EDGW benefits from a streamlined cost structure and continued demand for its product-based IT software services in partnership with Oracle, SAP, and Microsoft.  EDGW has achieved several quarters of organic sales growth in service revenues.

Strong Balance Sheet Expected Steady Build Up in Cash Position.

EDGW has a low-risk Ft. Knox balance sheet.  EDGW’s balance sheet at 9/30/11 had net cash of $11m or 30% of market cap.  EDGW was able to remain cash flow breakeven even in the very depressed economic conditions of 2009.  We expect net cash position to build at $5m-$6m per year, absent share buybacks or niche acquisitions. 

Conclusion and Target Price

Based on 10x our FCF estimate of $5m for 2012 and including a $15m estimated net cash position at year-end 2012, EDGW could trade for $65m market cap or $5.25 per share or more vs. $2.80 per share today (+88%).  Based on 6x our adjusted EBITDA estimate of $8m for 2012 and including $15m of net cash, EDGW would have an EV of $63m or about $5 per share (+78%).  If EDGW’s management team continues to execute and its IT services niche performs as we expect, we think our target prices (or more) will be achieved.

Industry Comparable Public Companies

Catalysts

1. Low valuation of 23% unleveraged FCF yield and 3.5x LTM adjusted EBITDA and 22% of LTM revenues.
2. Strong free cash flow generation - net cash position should build in 2012 to $15m or more at year end (almost 50% of current market cap).
3. Share repurchases and dividends from excess cash and FCF generation.
4. Possible acquisition of EDGW by a strategic or financial purchaser.
5. Increased analyst coverage and recognition of EDGW’s improved business model and important relationship with major software OEM’s..
6. Low risk balance sheet with net cash position of $11m (almost $1 per share) as of 9/30/11.

Risks

1. Economy turns down sharply and demand for IT services drops.
2. EDGW misallocates capital into a poor acquisition.
3. Major changes in relationships with key software vendors (Oracle, SAP, and Microsoft).
4. New technologies or services materially impact EDGW.
5. Adjusted EBITDA in 2011 includes some process royalties which will not recur.

Disclaimer

Disclaimer:  We own shares of EDGW.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst