Description

Hummingbird is an under followed enterprise software company with an 11% free cash flow yield - whose cash-flow should grow nicely over the next 3-5 years - and is using the free cash to buy back shares. The company operates in two segments (1) Enterprise Content Management (ECM) and (2) Connectivity. ECM is 75% of sales and is where the long-term growth of the company will come from. ECM enables companies to capture, store, and manage unstructured data – which is all the data that you can’t put into a traditional database. This includes, for example, email, spreadsheets, word documents, presentations, and mission critical engineering drawings. The rate of growth of this kind of content is significant – in fact Filenet believes it is growing over 90%. So, think of ECM as giving a company a very efficient way to access a central repository of all of this information. It includes web content management, document management, search, records management, collaboration, and business process management. Hummingbird has a very strong share of ECM in the legal vertical and is also strong in government.

Connectivity is a legacy business for HUMC and is a flat to declining business. It has dropped to about 25% of sales. Connectivity software gives clients the ability to access UNIX and mainframe data using a window’s based PC. As more and more data is now residing on windows based servers this product has become less important. However, the maintenance stream generates a lot of cash for the company as they don’t need to invest much in it.


Enterprise Software industry is attractive now

Enterprise software is arguably the most attractive area of technology due to the long-lived, durable cash flow streams that the business produces. Usually, however, the price one must pay to get this cash flow stream is very high, making an investment in this area unattractive. But due to a sell-off in software stocks this year we are now able to buy names in this space at prices well below their intrinsic value. In the case of Hummingbird you are able to buy into a high quality software company with a very “sticky” (more on this in a bit) product with high barriers to entry at an extremely attractive price.


Attractive Economics

Software stocks have been punished over the past year as momentum funds sold them due to the lack of near term license revenue growth at the companies. License revenue has suffered due to the low level of overall capital expenditures at corporations. Currently, capital spending by U.S. companies is extremely depressed compared to their depreciation levels and gross cash flow. Interestingly, technology has grown to become over 50% of total capital spending in the U.S.

To understand why the economics of enterprise software is so attractive one should think about a company deciding to buy software for a department or for their entire company. What is the “cost” of that software? One might reasonably assume that the cost is the license fee to hook up all the users to that software plus the ongoing maintenance fee that they will pay each year to get service and upgrades. However, in the case ECM (as well as a number of other areas of software), the license and maintenance fees are really small parts of the overall cost of the software. The ‘true cost’ is the cost of building various business processes around that particular software as well as training employees to use it. In other words, it is the cost of committing to that vendor’s software. This switching cost – or “stickiness” - creates an enormous barrier to entry. Once you have built your various business processes around one type of software, it costs a tremendous amount of money and man-hours to rip it out, take the required downtime, and implement a new vendor’s product. You then need to train employees all over again to get them up to speed on the new software. As one IT executive said to me, “I’d rather go through ten root canals”. If ripping out a corporation’s current software is the equivalent to multiple root canals then you can be pretty sure that if another vendor comes to them with a lower price (or even a slightly better technology) that customers are unlikely to switch.

The high switching costs result in valuable maintenance streams for the software companies. Maintenance costs average approximately 20% per year of the original license cost. In other words, for every $100 in license fees a company typically pays $20 in maintenance fees every year to their software vendors. The payment is made up front for the following year – a very attractive situation for the software vendors. Because the switching costs are so high, the software companies have an extremely reliable and steady cash-flow stream coming from these maintenance contracts.

Interestingly, the funds pressuring software stock prices don’t seem to be making the distinction between the vendors who supply product with high switching costs from the ones who don’t. This enables value investors to be able to buy high quality software companies at very attractive prices. Hummingbird is one of the best examples of this – with approximately 95% maintenance renewal rates. In addition it has a pristine balance sheet with large amounts of cash and no debt. The company and the industry are extremely over-capitalized in my opinion. This cash is basically cash that’s been building up over time due to this maintenance stream that we’re talking about.

I expect that we will get paid for this investment in a couple of ways. The first has to do with the eventual pick up in capital spending by corporations. This may be imminent. Some of our recent research indicates that companies are getting the approval by their CFO’s to spend again but are unable to implement many projects due to a shortage of IT staff. In addition, the IT people that the corporations do have are spending their time on Sarbanes-Oxley. Freedman, Billings, Ramsey & Co. did a survey of value-added-resellers regarding corporate spending plans and commented that “every respondent emphatically agreed that a lack of personnel at IT shops around the country is a key constraint on customers’ ability to move as rapidly as they would like with regard to new IT projects.” (May 12, 2005 - Data Storage Reseller and Integrator Survey). This implies that there may be pent-up demand and that license revenues could pick up as companies begin rebuilding their IT staff.

I also believe that there will be a significant amount of consolidation in the industry and that Hummingbird is a very attractive acquisition candidate. There is a tremendous amount of redundant R&D and SG&A among companies and, given the extreme valuations at present, many deals would be long-term accretive. Think about it this way: let’s say that you are a CEO of an ECM company that sells software to the financial services industry. As mentioned, ECM is extremely “sticky” using our definition above and the companies who sell this kind of software consistently have maintenance renewal rates of almost 95% - meaning that almost every customer renews their existing contracts each year. Let’s say that you decide that you want to start selling your ECM software into the legal industry. Unfortunately Hummingbird is already there. You have 2 choices if you want to enter: (1) embark on an extremely costly strategy of trying to get law firms to start ripping out Hummingbird’s ECM software in order to switch to yours. It’s unclear how you would get them to do this given the headaches the law firms would have to go through. The cost to you to get them to switch would likely be so high that you would not earn a return of any kind. Or, (2) buy your competitor and enter the new vertical that way. Given that the company is sitting on a mountain of cash and has a reliable maintenance cash-flow stream you’d be able to buy the company at a level that generates high single-digit free cash flow returns to you before any synergies. So the deal would be accretive immediately. Additionally, the synergies should be significant. There will probably be a lot of redundant R&D given the similarities of the two companies’ products. Also, there should be a decent amount of SG&A overlap. As a result, you may be able to cut out 20-40% of the operating expenses of the company. This option is extremely attractive to a buyer and is the reason we will likely see a major consolidation over the next several years. Oracle executives, for example, have been particularly vocal about their desire to buy other software companies and have pointed out the market’s mis-pricing of a lot of them compared to their maintenance streams.

Finally, I expect that we’ll see private equity firms continue to buy up software companies and Hummingbird, with it’s large predictable cash flow stream and high maintenance renewal rates would fit the profile of what they typically look for. In fact even the connectivity business would likely be attractive to them. Golden Gate Capital purchased Attachmate recently for a bit over 6X EBITDA. Attachmate is one of Hummingbird’s main competitors in connectivity. They also recently announced the purchase of Geac Computer Corp. – a software company whose sales are predominantly flat to declining maintenance stream type products as well.


Valuation

Hummingbird currently has a market cap of $385 million and has cash on their balance sheet of $85 million (about $4.85 / share) and no debt – or an enterprise value of $300million. They are generating free cash flow of about $32-33 million annually. So you get a company with all the above characteristics at over 2X the average company’s free cash flow yield. I believe that the cash flow should grow at least 5% per year over the next 3 years from top-line growth and margin expansion. The company recently announced that they will buy back 1.5 million shares – or 8.6% of their shares outstanding. If I assume that they pay an average of $25 / share then the cost will be about $37.5 million. The large free-cash-flow, meanwhile, will continue to accumulate on their balance sheet and I estimate that the company will have an additional $62 million on hand even after the buyback (assuming no further buybacks or acquisitions). The $62 million added to today’s $85million is $147million by that time on 15.95mill shares (which is 17.45 mill less the 1.5 mill shares repurchased) or $9.22/share. If I assume that the company sells at a free cash flow yield on enterprise value of 8% by that time (which is very conservative in my opinion) then the EV will be $475million (which assumes around $38million in free cash flow that year). Adding back the cash of $147 you get a market cap of a bit over $620 million – or about $39 / share.

Alternatively you can look at this on a sum of the parts basis. Connectivity has an EBITDA of about $21.85 million by my estimates. Assuming 6.5X EBITDA for that business (similar to recent acquisitions - Attachmate was purchased for over 6X and GEAC is being purchased for over 8X) values it at a bit over $140 million or $8.00/ share. I would value the ECM business at at least 1.7X revenue (a bit of a discount to FILE and a bit of a premium to OTEX who has a number of company specific problems). Revenue of ECM is a bit above $200mill – so at 1.7X we would value it at $343 million – or $19.7 / share. Adding back the cash of $4.85/ share gets you to $32.70 / share. Of course – you can make your own assumptions on what multiples to put on the 2 businesses – this is my way of looking at it. At a price of $21.50 currently the upside is anywhere from 50-80% by my estimates.

Catalyst

Large share buybacks at very attractive free cash flow yields
Potential acquisition candidate for another software company
Potential acquisition candidate for a private equity firm