Description

Elevator pitch - GSB is a high margin, asset-light enterprise software company trading at approx. 8.5x - 9.5x 2020 Adjusted EBITDA minus Capex, which I think sold off too much during the market turmoil and investors will re-rate this stock come Q1 and Q2 earnings. Their main software solution deals with the secure transfer of files between employees and companies working remotely. I think this is a defensive business who’s margins should hold up well, and could possibly grow even during this COVID recession as they can generate a lot of earnings with no incremental employees and everyone working remotely. Please see past VIC write-ups for more background on the company; this write-up will focus on the developments from the past year. Overall I think the stock at $8.25 could easily return to its recent highs of close to $11 (+33% return) which was where insiders took profits as recently as Feb 2020. 

Why does this opportunity exist?

I like small-caps that come with simple theses. GSB is still an under-the-radar enterprise software company, as it has no analyst coverage, conducts no earnings calls, and it’s market cap is still under $200M. Given the recent euphoria for profitable software businesses I’m still a bit surprised the company never gained a larger following; although it trades on the NYSE and OTC. GSB was last written-up by Chuplin1065 on October 25, 2016. Quite simply the author absolutely nailed the investment thesis; so I’d strongly suggest reading that post first. GSB’s primary business is selling and supporting managed file transfer (“MFT”) software for enterprises. MFT software facilitates the transfer of data from one location to another across a computer network within a single enterprise or between multiple computer networks in multiple enterprises.

In the past I expected GSB to be sold to a larger enterprise software company by now. But instead of selling, the major private-equity investor Robert Alpert became the interim CEO after the prior CEO unexpectedly died (April 2019), before ultimately being named the permanent CEO in late January 2020. Back in November 2019 GSB did a major dividend recapitalization, allowing the top holders to return much of their original basis, while still having exposure to the upside. 

My pitch is that this COVID-19 selloff is an opportunistic time to pick up shares in this free cash flow generating company which I believe is more profitable than it appears at first glance, and is too cheap to ignore right now. 

During 2018 and 2019 excess operating costs were ripped out of the business, taking Adjusted EBITDA margins from 19% in 2017 to over 50% in 2019. Much of this is due in part to the fact that GSB made the decision to refocus on their core products and let go almost 40% of their employees in 2018 and have kept their headcount low ever since. 

Despite this upheaval, revenue growth in their core managed file transfer (“MFT”) products took off in 2019 (+17%). I have no special insight into how Q1 went for GSB, but I’m taking an educated guess that their file transfer product is probably in need with millions of workers across the country being forced to work remotely with almost no notice. I expect the stock to continue to re-rate in 2020 as investors realize GSB has not been materially hurt from the COVID crisis. 

What happened in 2018 - 2019?

The big event of 2018 was the “reduction in force” which generated significant operating savings. They cut about 40 employees from a workforce of about ~140. 

GlobalSCAPE Announces Reduction in Force as Part of Continued Cost Realignment

The Company has been executing a strategy to streamline its organization around its flagship offering – Enhanced File Transfer™ (EFT™).  These changes apply globally, although the changes are mainly focused in North America.  Part of this strategy is to enable GlobalSCAPE to better focus on its customers running EFT while remaining agile enough to adjust to market demands.

The company attributes its turnaround to the newest edition of its flagship file-transfer software, which meets new data compliance regulations passed in the European Union, Canada and California. Enhanced data security has become a priority for governments around the world as cyberattacks and large data breaches have become commonplace. New regulations tighten the rules around transferring data to protect from theft — and Globalscape is capitalizing.

The firm’s new file-transfer software “directly addresses privacy mandates” set by governments, and “uniquely addresses the shift occurring in our industry,” Alpert said in a statement.

Revenue growth remains strong, and accelerates despite headcount reductions

My fear at the time of the downsizing was that the private equity CEO was being too draconian, cutting muscle (not fat) and would hamper the business. This clearly hasn’t happened. Revenue growth was strong in all of 2019 and especially in their highest margin revenue segments. 

GSB earns most of its revenue from the sale of products and services that compose its Enhanced File Transfer (“EFT”) platform.The EFT platform provides enterprise-level security while automating the integration of back-end systems which are features often missing from traditional file transfer software. 

Almost all clients who initially purchase a perpetual license to use the EFT platform also purchase a maintenance and support (“M&S”) contract for which they pay GSB recurring fee that is typically 20% to 30% of the perpetual license fee per year. As you can see from the chart above, gross margins for M&S are ~90% vs. in the 70% for the software. Growth for M&S has been +20% in 2019, leading to gross margin expansion of 82% to 85% since 2017 and very high incremental EBIT margins which have led operating margins to explode higher. 

Since there’s no analyst coverage and the company doesn’t break out all their pro-forma adjustments in their PR, the table above adjusts the Q4 OpEx for one-time costs. 

From the Q4-19 Press Release

“One item investors should consider is that fourth quarter and full year financial results are affected by costs incurred related to December's special dividend and a special company-wide bonus paid to all employees," Alpert continued. "For the fourth quarter, we reported $3.6 million in net income, $4.4 million in EBITDA and $0.19 in earnings per fully diluted share. When taking into account the costs previously mentioned, we would have reported $4.9 million in net income, $5.8 million in EBITDA and $0.26 in earnings per fully diluted share. For the full year ended 2019, the Company reported $13.3 million in net income, $19.7 million in EBITDA and $0.72 per fully diluted share in earnings. However, when taking into account the costs, we would have reported $15.0 million in net income, $21.6 million in EBITDA and $0.81 per fully diluted share in earnings."

GSB did a dividend recap in 2019; CEO sold shares at high, but maintains large stake

Back during November 2019, GSB addressed its underlevered balance sheet, by putting in place a $55M credit facility, and authorizing a special cash dividend of $3.35 per share of common stock. They simultaneously authorized the repurchase of up to $5 million worth of shares. Given that 2019 Adjusted EBITDA was approx. $21M it’s a manageable debt load. Two months ago in early February 2020, the CEO sold a block of 500K shares for $10.60. I saw this as understandable profit taking given the home-run investment GSB has been for Alpert. His firm still controls approx. 17.5% of the shares, with current directors and executive officers as a group (8 ppl) controlling about 25% overall.

Eventually, I expect a sale of the company so the top holders can get out of their position but I don’t think this is a 2020 event, nor is it a necessary catalyst for the stock to re-rate higher. With the stock now back around $8, almost -25% lower from the CEO sale and more than -30% lower from the special-dividend adjusted high price, I think GSB is an attractive investment again at these levels. 

Full Financial Model for GSB

Below is a sample of the full financials for GSB, with pro forma adjustments I made for 2019. Given the unprecedented economic turmoil happening right now because of COVID-19, I’m going to be following the Q1 earnings release very closely (likely to come in May). However in the interim, I like to be conservative and look at smallcaps on trailing figures to understand the earnings power. It is very possible that revenue growth falls off a cliff as companies cut back capital expenditures. But I’m willing to make an educated guess that with millions of employees being forced to work from home, and with IT departments scrambling with little time to prepare, GSB’s secure file transfer software is not something companies will cut. I believe the company can do $23M in Adj EBITDA run-rate before the end of 2020, less about $2 million in maintenance CAPEX, getting you good value for a solid business trading at about 8.5x - 9.5x Adj. EBITDA-CAPEX (give or take) today.

Catalyst

Company has no analyst coverage so the stock re-rates on earnings. Q1 should be reported in May 2020.