Evolving Systems is a microcap telecommunications software company that I do not believe will be public twelve months from now. If they are, they will have likely issued a large special dividend and be exhibiting strong pro-forma growth with more expected from the continued adoption of connected devices. Either way, I think the upside is at least 25%, possibly much more, while the downside is minimal.
Three of the things I screen for in small caps which I believe are good predictors of future gains are 1.) Insider buying at/near a high, 2.) Initiation of a Dividend, and 3.) Divestitures. Some may say that dividends signal a company has run out of growth, but I believe they, along with Divestitures, signals management understand capital allocation. Evolving Systems has exhibited all three of these in the past 12 months. It first showed up on my screens last spring with insiders buying at a high around $6.50 (Insiders were the Singer Family Trust, more on them later). They also initiated a $0.05 quarterly dividend (~2.75% yield) last spring and recently announced the sale of 39% of their 2010 revenue base.
For the sake of this write-up, I'm going to assume that the deal to sell their Numbering Solutions business to Neustar (NSR) is completed after being approved by shareholders today. In the slight chance that this doesn't go through, it isn't a total disaster -- the Numbering business was the more mature business that produced strong cash flow. What's left is a pile of cash and the less profitable, but more interesting and faster growing, Activation business.
Activation
The business that was not sold is the Activation business. This business is made up of 3 parts, the first is Tertio. Tertio is used by carriers to activate a new subscriber or make changes to an existing subscriber. There are over 70 customers around the world using this service. None of the Major US carriers use the service as they are focused primarily on international customers. AT&T was a customer before the merger with Cingular but the combined company consolidated with Cingular's solution which was provided by Synchronoss (SNCR). As a result of this, and constrained budgets and flattening subscriber counts, the Tertio business declined in 2009 and 2010. However, in 2H 2010 this business started to pick up again and in Q1 2011 bookings were up 51%.
The second Activation business is Dynamic Sim Allocation, or DSA. This is the main growth engine currently and is a very unique offering. They have 9 of the 11 carriers around the world with a DSA type solution using their product, so they are the definite leader. DSA allows providers to provision a SIM card at the point of sale without requiring the retail and back office infrastructure typically required. There are many benefits to this, but it allows for more efficient use of a carrier's numbers, requires less working capital, allows users to pick their own number, allows the carrier to up-sell additional services, etc. There is a good interview with the CEO and former CTO and white paper describing the benefits of DSA on Evolving's Website that I will refer you to for more information:
http://evolving.com/vanilla_plus.htmlhttp://evolving.com/pdfs/Ovum_Driving_Efficiencies_in_SIM_Card_Provisioning_WP_Jun10.pdfWhile DSA revenue is only about $1m/quarter currently, bookings grew at 20% in Q1 2011. In March of 2010 they had 7 million users and by December 2010, it had more than tripled to 25 million, so there is definite growth. And some of the contracts are structured to provide a limited number of activations, after which carriers must come back and purchase more. This is referred to as "First Use Activation" or FUA and such revenue should start to show up in the second half of 2011 and has the potential to be meaningful in 2012. This is very high margin license revenue that will flow straight to operating income.
The final activation component is a Machine-to-Machine, or M2M, product. This is brand new and doesn't have any revenue or customers yet, but uses their DSA technology to connect machines to the network as required to send information. Consider a utility pinging a smart meter whenever it wants to get a reading, or an HVAC unit alerting a central office when the temperature gets too high. These situations do not need to be connected all the time and carriers can save money by sharing resources. The company is considering selling this product as a subscription and it could start providing meaningful revenue in 2012.
Valuation
The sale of the Numbering business will net the company about $32m, which combined with their current $16m will give the company about $48m in cash, or $4.25 per share. So the activation business is only being valued at about $2.75/share or ~$30m which is slightly more than 1x revenue. The pro-forma income statement in the proxy from the Numbering sale shows that this business is barely profitable. However, management has stated that they have too much overhead after the sale of the numbering business and expenses will be reduced.
Management stated on the M&A conference call "We will now be a pure play activation company, making it easier for investors and analysts to understand and evaluate our business and making us a more straightforward fit for strategic combinations."
So what does a pure play activation company trade at? Synchronoss is the best comp and trades at an EV of over $900m with TTM revenue of under $200m. That's over 4.5x sales, which would put EVOL's activation business at almost $10/share before adding in the $4.50/share in cash. I'm going to be realistic and say EVOL's not worth that much today, but if and when DSA and M2M contracts start to cause an acceleration in the revenue growth rate, this becomes more realistic.
But if they're now "a more straightforward fit for strategic combinations," what is SNCR willing to pay? Last summer they bought a company called Fusion One for $40m which was expected to contribute $8-$10m in revenue in the 2nd half of 2010. This is over 2x annualized forward sales, before considering the potential $35m additional earn-outs Fusion One's owners may also receive. 2x sales gets EVOL to about $8.25 including the cash, or about 25% higher than the current price. The average technology/software company trades north of 2x sales, so I believe this is fairly conservative.
Plans for Cash
EVOL will not need their $48m in cash to run the business, so they are likely to do something with it. Management has already announced a $5m share repurchase and has hinted at either a special dividend, increased share repurchase, or M&A. I would prefer the special dividend, which at $2 or more per share would provide a nice pop to the stock. Special dividends have a way of laughing in the face of the efficient market hypothesis (see the many that were announced last fall like IBKR, OXPS, EPHC, DHIL which went up by the amount of the dividend after it was announced -- in IBKR's case they even said it was coming and I had a nice return owning calls in anticipation).
I expect an announcement of an increased share repurchase or special dividend could come in as little as a few weeks, shortly after the Numbering sale closes.
RisksOne risk is the Singer Children's Trust owns 23% of the shares. This is the same trust which owns a lot of Primus Telecommunications, and they have a very strong history with small telecom companies which end up getting acquired. And perhaps it might be a little too strong as they've been in trouble in the past for insider trading:
http://stocksthatpay.com/?p=9265There has been some recent insider selling as well which is a little worrisome. Most of these are from options which are expiring in the next 18 months and with being locked out from selling for the past 12 months, I can't blame them for wanting to ensure these don't expire if they get locked out again.
The biggest short term risk is that management said that results will be lumpy since they'll be more dependent on signing larger contracts, which implied the current quarter could be weak. With the share repurchase outstanding and the large cash balance, I don't think a weak quarter would drive it substantially lower, however.
Conclusion
Evolving Systems is a microcap telecom software company with $4.25/share in cash. The stock should be at least 25%, possibly much higher, and has little chance of downside. This provides a great risk/return from the current price and provides some free options on better outcomes.