Description

 At $7.00 per share or better, Guidance Software (“the company” or “Guidance”) represents an opportunity to invest in a well-positioned software company that has turned the corner after the resolution of a public battle with its founder and former CEO.   At its current price ($6.50 per share), the company trades at less than 1.9x (ttm and forward) revenues --  a significant discount to intrinsic value, as well as the overall software universe.  With governance issues finally resolved, and reaching a tipping point in profitability, the company is gaining traction in its shift to cybersecurity, which should create shareholder value and lead to a doubling of the stock price – either in the public market or via a takeout – within the next two to three years. 

Business Description

Headquartered in Pasadena, CA, with approximately 420 employees, Guidance is the leading global provider of digital investigative solutions and endpoint data security.  The company essentially develops and markets software that enables its customers to search, collect and analyze electronically stored information to address HR matters, litigation matters, allegations of fraud, suspicious network endpoint activity and to defend and secure the organizations’s data assets.   The company’s presence and customer base is impressive: 34m endpoints, 78 of the Fortune 100 companies and 47% of Fortune 500 companies.   It’s offerings are centered around its Encase platform, which consists of a suite of the following main products:

Forensic Security

EnCase Endpoint Security:  Provides crucial IT cybersecurity functionality to enterprises and government agencies by detecting anomalies and malware.  Effectively automates the critical first steps in cybersecurity incident response from the moment of first alert

EnCase Endpoint Investigator: Enables the user organization to search, collected, preserve and analyze data on the servers, desktops, and laptops across its network. 

EnForce Risk Manager: A solution for protecting data risk and privacy, while meeting stringent compliance requirements.

Other

EnCase Forensic:  The industry-standard digital investigation solution that enables forensic practitioners to conduct efficient, forensically sound digital data collection and investigations

EnCase eDiscovery:  Enterprise-wide e-discovery solution that includes legal hold, identification, collection, preservation, processing, first-pass review, and early case assessment for addressing the end-to-end discovery needs of corporations and government agencies

EnCase eDiscovery Review: A private cloud-hosted, multi-matter review platform with advanced analytics and technology assisted review functionality

The company’s main competitors are AccessData, Clearwell (part of Symantec), and Kazeon (acquired by EMC)

Performance/History

Founded in 1997 by Shawn McCreight, Guidance’s forensic capabilities, are viewed as the gold standard of the industry.  Not only has the company compiled the deepest legal journal in the industry, but its eDiscovery product is recognized as the market leader by Gartner and other market research firms.  By using a land and expand strategy, the company has significantly increased its penetration in customers, positioning itself for the push in forensic/cyber security, which has benefited from industry and market developments such as legislative and regulatory requirements, the prevalence and impact of hacking incidents and spread of malware, and a general increased concern for cybersecurity.  The software is incredibly sticky, as once installed, it is virtually impossible to displace.

As a result, from 2009 to 2012, the company increased revenues from $75m in 2009 to $130m in 2012, while EBITDA went from -$14m to $5m.  During that time period, the company achieved several milestones, including the acquisition of forensic hardware products, the addition of cloud-based document review and production, and the introduction of EnCase Analytics.  However, due to several factors, including (a) salesforce mis-execution, (b) a failure to timely release new versions of its core product, (c) an entrenched board, and (d) a failure to capitalize on a tremendous market opportunity, sales took a three year-dip, declining to $107m in 2015.  As a result, in April 2015 the company brought on Patrick Dennis as President and CEO of the Company.  Unlike the prior CEO and the founder, Dennis had extensive experience in selling enterprise software, having been an SVP and COO of Products and Marketing at EMC Corporation, while also being responsible for the strategy and operations of EMC’s cloud management division.   Other management changes included a new CMO, GC and SVP of HR.

Though the Chairman and founder, Shawn McCreight, was publicly enthusiastic about the hire, the relationship between McCreight and Dennis and the board began to fray as Dennis started to turnaround the company, which ultimately led to a “restructuring” and eventual termination of McCreight (in January 2016) who did not appear to be on board with Dennis’ strategy, organizational changes and overall mandate.  Put simply, though McCreight was viewed as a talented and creative software developer and engineer, the board and Dennis felt a change was necessary for the company to move to the next level, which led to a relatively contentious public proxy battle.

Subsequently, on April 22, 2016, the company announced that it reached a mutual settlement agreement with Mr. McCreight.  Under the terms of the agreement, McCreight agreed to resign his board position, while the company agreed to appoint two of McCreight’s nominees to serve as directors.  McCreight also agreed to a standstill through January 2018.

Thesis

Solid, entrenched business with strong tailwinds

Guidance software’s products are viewed as the gold standard in its niche, and based on interviews with customers and competitors, extremely sticky and difficult to switch.  Moreover, companies are increasingly reliant on digital business models, and as a result, digital risk is only increasing.   Guidance provides a platform with in-depth 360 degree visibility that allows companies to address these risks in both a preemptive and reactive fashion.

Early stages of turnaround

After a tumultuous 18 months due to both the prior management team’s mismanagement as well as the proxy battle and attendant distraction, Guidance has recently shown tangible signs of turning around.  Specifically, this past quarter, the company announced Q3 results that exceeded consensus estimates, as the company reported revenue of $27.7m (versus $26.8m the prior year), driven by an increase in product revenue of 23.7% and increase in maintenance revenue of 2.8%.  This represented the third consecutive quarter of revenue growth.  Moreover, the company issued 2017 guidance of $112-$118m in revenues (versus an expected $108-$112m for 2016) and positive non-GAAP EBITDA of 8-10% of revenue.

The Company also announced a continued reduction in overhead as well as new partnerships with Outlier Security to provide managed services for enhanced cyber threat remediation and Atos to provide Guidance products its customers.

New management

As mentioned previously, though the company has always had terrific products that are both well-regarded and coveted by its customers, the company had become complacent and failed to capitalize on nascent market opportunities.  Under Patrick Dennis, the company has implemented new processes, focused on higher growth markets, and revamped its R&D program, bringing more products faster to market.  Dennis has also worked seamlessly with CFO (and former interim CEO) Barry Plaga to keep a lid on costs.

Cheap valuation

With 32m shares outstanding and a small net cash balance, the company’s enterprise value of $200m represents less than 1.9x forward revenues.  In contrast,  the average small cap software company (per Bloomberg) trades at around 4-5x forward revenues, while specific public companies that overlap with Guidance’s products also display the undervaluation (Fireeye: 3x, Fortinet, 3.5x). 

While EV/revenues is hardly a traditional valuation metric, it’s a good proxy for growth software companies given (a) the high renewal rate, (b) the lifetime value of a customer and return on sales and marketing, and (c) the growth opportunity.  In the case of Guidance, the company has already demonstrated profitability (unlike a lot of other software companies of the same size), and continues to take actions to drive margins. In theory, as some more mature software companies of scale ($100m+ in revenues) have done/shown, Guidance could slow down sales and marketing and probably achieve 20%+ EBITDA margins.

 Attractive acquisition target

Given its massive number of endpoints (34m), market focus (cybersecurity) and attractive valuation, we believe Guidance is an attractive acquisition candidate for both strategic and financial buyers.  Moreover, the removal of the overhang of the proxy battle and the elimination of McCreight (who was perceived as an impediment to a sale) from the board should make the company that much more attractive. 

Risks

Market share loss due to either loss of focus, sales force mis-execution or competitive dynamics

Failure to achieve growth targets as cost reductions inhibit forward progress

Board does not act in best interest of potential bid

Catalyst

M&A

Execution against business plan

Return of capital