Description

The company

Based in Pasadena CA, GUID is the world leader in software for digital forensic investigation. Its EnCase suite of software products is used by governments, law enforcement, consultancies and nearly a quarter of the Fortune 500. GUID's software is used to search, collect, preserve, analyze and authenticate digital data for use in criminal, civil and business procedures.

The Company sells software under two licensing models: 1) Perpetual licenses with recurring maintenance costs; 2) Pay as you go licenses charging a per-use fee. License revenue is roughly 60% of revenue while services and maintenance account for the balance. Off-the-shelf software is roughly 30% of license revenue while network-wide installations, both perpetual and on-demand, represents 70%.

Summary

GUID is the leader in software for digital forensics - a bright spot of growth in a falling economy. GUID has been called the de-facto standard for E-Discovery, a near-term opportunity growing 25-35% through 2012. The Company has a large and diversified customer base and management has been executing well despite the sour spending environment. The Board turned down an unsolicited $4.50 offer by a smaller competitor in late '08 and instituted an $8mm share repurchase program. The business is in the early stages of a business model transition to on-demand delivery which we believe will yield an even stronger competitive position and a more relevant offering in the current environment. The company generates cash despite continuous investment in growth R&D and management has initiated a restructuring program targeting 10-14% operating margins over the next 2-3 years. Based on a multi-method approach to valuation we believe GUID's stock is conservatively worth $5.82 per share representing 52.8% upside for shareholders.

Favorable Industry Trends

Put simply, the amount of digital data generated, transmitted and stored continues to compound at an exponential rate. Digital investigations are now a common and important factor in criminal and civil trials across the globe. The process for forensic collection, custody and analysis of physical evidence is very detailed and has been developed over millennia. The forensic process for collecting, transporting and analyzing digital evidence, or Electronic Discovery ("E-Discovery"), has had a difficult time keeping pace with the massive and rapid recent shift from physical to digital information. 2006 amendments to the Federal Rules of Civil Procedure further complicate the process. The rules have expanded the types of evidence subject to discovery and impose strict deadlines for the production of electronic evidence.

Firms are finding out the hard way that failure to preserve and produce digital evidence will result in significant fines. Today, if a company is the subject of civil litigation, ignorance when it comes to digital information is no longer an excuse. A company's legal counsel can no longer claim "they couldn't find it" when referring to an email (or any other document) no matter how obscure. Morgan Stanley for instance was ordered to pay over $15m in fines for claiming it lost emails related to ongoing cases.

There is plenty of confusion when it comes to E-Discovery and companies, governments and individuals undertake cumbersome steps to comply. Despite a range of technologies available, the traditional process of E-Discovery is typically reactive and manual vs. proactive and automated. E-Discovery for a single case can cost millions of dollars in consulting and legal fees and large corporations can have hundreds of cases ongoing at any one time. The revenue opportunity for E-Discovery technology and services has been growing at a >50% CAGR for the last few years and, according to Gartner, is expected to grow at a 25-35% annual rate through 2012 off it's current base of >$2bn.

The E-Discovery technology and services industry has, to date, been fragmented but is seeing the early stages of consolidation. Acquisitions over the last several years include DataFlight, SteelPoint, Zantaz, LTU, EVault, Case Data, and many others. The multiples have been anywhere from 2.0x - 9.0x sales for both profitable and unprofitable businesses.

The Investment Opportunity

Once a software product or process has been validated in court there is little motivation to risk a case on unproven methods. In this context, it's been a veritable land-grab for software companies to establish proven admissibility in court and GUID has attained its position as the de-facto standard. The Company's software is recognized by industry analysts such as Gartner, Forrester and IDC as a worldwide leader in digital investigations.

GUID's off-the-shelf offering, EnCase Forensic has over 30,000 trained users and is used by over 1,000 consultancies, government and law enforcement agencies. The Company's EnCase Enterprise platform has been installed at 650 customers worldwide and is used by nearly 25% of the fortune 500 and half the fortune 100. EnCase Forensic has been used in hundreds of thousands of cases worldwide, has been mentioned by name in over 70 published court cases and was validated under the Daubert and Frye tests.

For years, consultancies and outsourced service providers have been using GUID's off-the-shelf software to conduct manual E-Discovery search and collection work for their own clients. This was in competition with GUID's own consulting services as well as sales of GUID's EnCase Enterprise and E-Discovery licenses. Firms outsourcing E-Discovery litigation can face consulting fees in the millions of dollars for a single case. They're essentially paying for a consultant(s) to come in, temporarily commandeer a user's PC or laptop or mobile device, connect it to a laptop pre-loaded with GUID's EnCase Forensic, and mirror the drive for search later in the process (again using Forensic). As this is a cumbersome, laborious and expensive manual process companies can realize a significant ROI through purchasing automated tools and in-sourcing.

GUID offers EnCase Enterprise which facilitates an un-intrusive search of every node on an organization's network from a central location. A small servlet is installed remotely and runs invisibly in the background of all network connected devices (desktops, laptops, Blackberrys, etc.) enabling a researcher to conduct targeted searches of data beneath the disk's abstraction layer. The opportunities for these powerful capabilities are vast and GUID's engineers built a module (among others) specific to E-Discovery on top of this platform. An EnCase Enterprise installation typically costs from $50-$200k while the E-Discovery module can cost many multiples of this. This is obviously a large capital expense but has a significant ROI, especially for a large multi-national organization. While GUID continues to close deals, it has run into headwinds in the current software spending environment.

To address the tough capital spending environment GUID introduced a pay-as-you-go option for its E-Discovery solutions. This delivery method provides GUID's sales force with a powerful sales tool. There is a nominal up-front cost to install EnCase Enterprise and the E-Discovery module, a customer pays only for usage out of their operating budget and can file a claim for insurance reimbursement as it's typically on a case-by-case basis. While the ROI of buying a perpetual license is much higher, the on-demand software model provides for significant cost reductions as compared to an outsourced provider. Our studies suggest that the traditional cost to retrieve data form one typical custodian costs $10k-$15k vs. $750-$1,500 using GUID's pay-per-use offering. This pricing advantage has several important industry implications.

The E-Discovery industry growth rate is expected to be 25-35% through 2012. While this may whet an investor's appetite it is significantly below the 50% growth rate the industry has experienced over the last several years. We believe the reduced industry growth rate is a positive for GUID as the primary contributor to a slowing growth rate is customer in-sourcing. GUID had seen this trend early and moved to capitalize by introducing their PPU offering. While the industry growth rate contracts the trend toward in-sourcing is expanding changing the industry dynamic. GUID's primary competition comes from consultants that use The Company's own software to manually conduct search and collection activities for their own clients. While in-sourcing has the potential to cut out the middle man it also has the potential to significantly increase middle man margins even at significantly reduced rates. For example, GUID could partner with a consultancy and use the alliance as a conduit to on-demand sales. The consultancy would then install the pay-per-use software at a client and could charge a significant spread between the cost payable to GUID and the amount invoiced to clients. Due to the automated nature of the work, a meaningful improvement in profitability would result even with a dramatic reduction in rates charged to consultants' clients.

Recent History

Management has executed with relative grace in this difficult operating environment. The company achieved record revenue in 2008's fourth quarter though the first quarter of 2009 saw some headwinds. We believe these first quarter headwinds were due primarily to the business model transition to incorporate the on-demand offering which was introduced late last year. Despite a 1Q revenue shortfall, E-Discovery customers nearly tripled over last year's first quarter going from 9 to 26 and we believe this is a key indicator that there is significant pent-up demand for an on-demand solution. Management gave a relatively positive outlook for the rest of the year and the shares have behaved well.

There is little doubt in management's confidence in the long-term prospects of the business. The Company authorized an $8mm share repurchase program in August 2008, turned down a $4.50 per share offer from a competitor in October 2008, and individual directors have made open market purchases of the shares.

To remain conservative, management has instituted an expense restructuring program while keeping growth R&D spend in-tact. Though management cut the head of investor relations along with other administrative positions the CFO has been actively communicating with investors. GUID's most recent presentation at the June RBC Capital Markets tech conference has generated significant interest in the name. During the presentation management laid out their long-term business model including the expectation of an adjusted 10-14% operating margin.

Valuation

GUID has 24.2mm shares outstanding and trades for $3.81 per share resulting in a $92.0mm market value. With $37.0mm net cash and no interest baring debt, GUID has a $55.2mm enterprise value. While sales have grown at a three year CAGR of 32.3% to the end of 2008, we expect the sales growth rate to take a breather (i.e. be flat) in '09 as The Company digests the new pay-per-use business model and software spending bottoms out. Despite negative GAAP net income to date the business does generate positive EBITDA and cash from operations and is run to roughly free cash flow breakeven as it pursues growth opportunities. The business was founded with capital from angel investors and has been run conservatively since then. Therefore, costs and expenses remain lean and the business generates cash despite investing heavily in growth R&D. Operating margins are slightly positive after adjusting for share based compensation but we believe that as revenue grows management will focus on leveraging operating expenses and achieve low-teens operating margins over the next 2-3 years.

We use a multi-method approach to valuing GUID and arrive at a near term value of $5.77.

From a DCF perspective (Exhibit 1) we believe that a conservative fair value for the business is $6.50.  To remain conservative we use a 10 year sales CAGR of less than 6.0%, GAAP operating margin (including share-based compensation) breakeven in 2012, a 10.0% cost of capital and a 2.0% perpetual growth rate.

From a multiples valuation perspective (Exhibit 2) we assume that if GUID can achieve our 2011 sales projection of $107.2mm and meet the mid-range of the long-term operating margin model of 12%, the shares would command a sales multiple of 1.2x; reasonably similar to software companies with the same business model and margin structure. This values the shares at $5.03 today with a 10% CAGR over the next two years.

An average of these two methods produces a target of $5.77, comfortably (as in 51.3%) above what you can buy the shares for today.

An analysis of downside in this investment reveals some interesting theoretical backstops. First, as it's very difficult to kill a recurring revenue business, if GUID traded for just 1.0x recurring revenue ($20.0mm maintenance and assume $5.0mm pay-per-use) they'd have an equity value of $2.60. What's more is that GUID has spent roughly $40.0mm in R&D since 2004 which is just below the company's current $55.2mm enterprise value. It becomes clear why GUID got an all cash offer for $4.50 per share in October of 2008. At the high end, we believe that GUID received an offer upwards of $12 per share from Autonomy in early 2008.

With a target of $5.77, a lower-bound of $2.60 and a current price of $3.81 the reward for owning this name is $1.96 while the risk is $1.21 reflecting a 1.6:1 ratio in favor of a long-position.

Concerns

GUID's top brass has undergone almost a complete reshuffle. The former President became the CEO in December 2007 when the then CEO retired. The current CFO was an "upgrade" late last year. The director of sales was replaced by the director of marketing and the position is now "Director of Sales and Marketing" and three board members turned over last year. Though less public, our checks point to several other management layer changes in the last several quarters. After numerous conversations with management we are comfortable in that the CEO has been with the company for several years and there won't be any more significant executive changes. Also, insiders lead by the founder, Chairman and CTO own well over 50% of the stock. We believe that this is the reason the business wasn't taken out in the low/mid-teens several quarters ago. While we believe that insiders becoming more open to takeout discussions at a reasonable price it is a concern. Further, while we applaud the investment in an on-demand offering a shift to integrate a new business model can be disruptive to the sales and accounting teams and potentially cannibalize perpetual offerings. Though we've yet to see real signs of cannibalization we are keeping a close eye on key indicators. Finally, the software spending environment is weak and the E-Discovery space is crowded. An eye toward the macro environment cautions us on position sizing in this name given the relative illiquidity.

Catalyst

We believe there is a high likelihood that GUID signs an alliance with a major consulting firm for E-Discovery in the near-term. This would significantly leverage GUID's existing sales force and provide for a much broader opportunity. There are indications that GUID's management realizes the benefits of such an alliance. The Company signed an E-Discovery alliance with CACI International, a large government IT systems integrator to the DOJ and other agencies. Also, continued pay-per-use customer wins will continue to validate management's bet on this innovative delivery model. Further, potential acquirers may come knocking yet again as the industry dynamic continues to shift toward in-sourcing. Not only has GUID recently received and rebuffed a $4.50 offer, we believe that they also rejected an offer upwards of $12 from Autonomy in the early part of 2008. Finally, the passage of time coupled with execution on the margin front will be a key catalyst to drive the shares to our target price.