Description

eLoyalty (Nasdaq: ELOY) is a Lake Forest, IL-based enterprise customer relationship management (“CRM”) services and solutions company with a reasonably stable, growing core business and two free options that have the potential to be quite valuable. The company was formed in 1994 as a call center business unit within Technology Solutions (Nasdaq: TSCC) and was spun off as an independent public company in February, 2000. The stock has fallen from a high of $305/share in 2000 to its current price of $5.31/share.

Capital Structure / Valuation Metrics
ELOY has 7.33 million shares outstanding for a market capitalization of $38.9 million. The Company has $21 million of 7% Series B Convertible Preferred stock outstanding and $26 million of cash for an enterprise value of approximately $34 million. The company is nearing breakeven on an operating basis and trades for .42x sales.

The Business
The company’s core business has historically been been management consulting and systems integration, with a specific focus on optimizing customer interactions (ELOY specializes in designing call centers and deploying marketing analytic/lead management solutions). ELOY’s strategic focus on this niche area provides its customers with a differentiated offering vis-à-vis larger, less focused competitors such as Accenture, Cap Gemini, Ernst & Young, Deloitte Consulting, Bearing Point Consulting and IBM IGS. Consulting services involve evaluating, selecting, building or integrating CRM systems for approximately 75 clients, including United Health, ATT Wireless and Allstate. Revenue generation in this business is largely time and materials-based and therefore dependent on the number of consultants employed, their utilization level and hourly billing rates ($155/hr on average). The consulting business generated $13 million of revenue in Q3/2004, down slightly sequentially due to fluctuations in client spending, lower average billing rates, and reduced utilization.
The Company has suffered over the past several years (revenue has declined from $146.7 million in 2001 to a current run rate of $80 million – it bottomed at $62.6 million in 2003), as the demand curve for enterprise software inflected sharply downward and pricing collapsed, declining 30% over the last three years. The profibability of the business has also deteriorated, with gross margins declining from 37% in 1999-2000 to 26% last quarter in the consulting business. Because management does not see a dramatic recovery any time soon, it has over the past couple years re-oriented the business more toward to a recurring, managed services model that (i) benefits from industry trends to outsource technology to third party providers and (ii) is less dependent on the period to period changes in spending from its concentrated client base.
The Company has grown its managed services business, organically (34% Q3 y-o-y) and thru the recent acquisition of Interrelate, to 25% of revenues, compared to 15% in 2003. Managed services involve a range of contact center services from routine maintenance and technology upgrades to hosted customer data management and campaign management services. The attraction of this work over pure consulting work is it typically involves annual contracts and does not have the same underlying revenue volatility as consulting services.
Eloyalty has used its knowledge and market position in call center management to develop two offerings that could present large upside “options”.

Option #1 – Cisco’s converged Internet Protocol contact center solution
ELOY is one of Cisco’s leading reseller partners in rolling out the Cisco Internet Protocol Contact Center (“IPCC) managed services offering. IPCC is a Voice-over-Internet-Protocol (“VoIP”) solution that allows enterprises to merge data and voice networks thereby lowering costs by eliminating redundant infrastructure, simplifying administration and maintenance and consolidating IT staffs.
Companies are beginning to implement IP telephony solutions. According to Infotech, approximately 80% of the enterprises that have already implemented IP telephony have indicated that the quality resiliency and scalability of the technology has either met or exceeded their expectations. The Radicati Group recently released a study predicting the share of corporate telephone lines that use VoIP will increase from 4 percent to 44 percent by 2008. The study, entitled "Corporate VoIP Market, 2004-2008," specifically excludes contact centers from its parameters, but predicts overall corporate spending on VoIP technology to rise from an estimated $1 billion this year to $5.5 billion by 2008. While I am reluctant to put much faith in such studies, it seems clear there is going to be meaningful growth in this area.
There are other large competitors in this space, including IBM Services, AT&T and Avaya. CISCO has a partner-centric business model and Eloyalty is the often the “first call” with complex implementations, and first and second line maintenance (typically five year service relationships). The adoption of VoIP in the enterprise is clearly in the early innings and ELOY is making progress. In Q3, ELOY signed three new concact center managed service agreements and expanded relationships at five existing customers. In addition, it was selected for one new IPCC implementation in the quarter. If this business accelerates as anticipated, ELOY will benefit significantly.

Option #2 – Behavioral Analytics Product
Perhaps the most compelling reason to own the stock is the prospects for ELOY’s behavioral analytics product. ELOY has a 3-year exclusive license from NASA for a behavioral model that assists in analyzing language patterns and personality. ELOY’s initial target market is large financial services companies where customer retention (i.e. churn) is a key and very costly issue. For example, Allstate’s call centers receive 250 million calls per year. Currently, there are call recording vendors that audit calls and attempt to “word spot”. The theory is that unhappy customers will utilize certain words in conversation that are effective predictors of their propensity to churn. ELOY’s product involves recording every phone call and utilizing computers to analyze linguistic patterns. The model, which is being tested with a number of customers currently, is highly reliable [I have seen it work in person and it is pretty amazing]. In those cases where a call goes poorly, ELOY’s model alerts a customer retention specialist who will be more effective than the frontline customer service rep. ELOY intends to sell the product as a subscription whereby they are paid an hourly rate to “listen” and “analyze” call center interactions. I believe this product has huge potential and that ELOY is making solid progress with three ongoing pilots, having converted one customer earlier this quarter into a multi-year full implementation rollout. Importantly, the company is sharing upfront capital costs with its customers so as not to burn through cash in the hope this product takes off.

Investment Pros
1. The Company has a strong balance sheet with no debt, $26 million of cash and a $23 million preferred owned largely by strategic VC investors; management is very focused on carefully managing costs and protecting the cash.
2. The Company’s Q3 guidance was encouraging; current operations are near break-even and ELOY expects to be profitable going forward. Utilization levels are rising, although there is stil pricing pressure. Importantly, the company is seeing increasing demand for products such as IPCC and Behavioral Analytics.
3. The business would be an easy and attractive acquisition for any of the Big 5 consultancies, given its strong competency in the call center area. The managed services annuity stream is increasingly valuable.
4. More than half the shares are owned/locked-up by insiders and sophisticated VC investors, including Sutter Hill Ventures, Technology Crossover Ventures and Brookside. Sutter Hill Ventures has recently been purchasing stock in the market and one of their Parnters (Tench Coxe) serves as Chairman of ELOY.

Investment Cons
1. The market cap is quite small at $39 million (true float is even less) and volume is modest (11,000 shares/day – double print) so it is not easy to build a meaningful position.
2. The core consulting business has high customer concentration (top ten clients were 67% of Q3 revenues); AT&T wireless was an 11% customer in 2003 and it is unclear what happens to this business.
3. While the existing business has a margin of safety, one is depending on Option #1 or #2, or both, working to make real money.

Catalyst

Continued growth in managed services business; Takeoff of Cisco VoIP business; Growth in behavioral analytics business