Description

iPass is a low-tech technology company that trades at less than the cash on its balance sheet. iPass provides internet connectivity services for corporations. In practice, that means that the typical IT department that contracts for iPass' services gets:

• Enterprise mobility - This is iPass' main business and most valuable asset. iPass plays the role of aggregator, having forged deals with 550 internet access providers across the world. As a client, you connect to the iPass service, and you can automatically connect anytime there's an available wi-fi, 3G, dial, or wired broadband connection from one of the providers that iPass has contracted with. This worldwide aggregation is extremely tough to replicate (iPass has only one private competitor - Fiberlink) and is absolutely essential for the traveling businesspeople who use it. It's also the reason why iPass has an attrition rate that's close to 1%.
• iPass software - the software that gets installed on the computers of iPass users allows the corporate IT department to easily push out software updates to all its users, monitor corporate internet use on company-owned laptops, and configure and enforce network access policies due to security concerns.

It also helps that when an IT department signs a contract with iPass, it doesn't have to worry about its users logging on to insecure internet connections in random places with the company laptop. Also, the individual user doesn't have to shell out from his own pocket when he needs an internet connection, and all the billing is centralized so the company gets only one bill for its traveling employees' connectivity needs. (iPass also has another business, which is barely, if at all, profitable in which it aggregates, for example, several retail stores for a chain into one network and takes care of security, managed VPNs, etc. iPass shelled out $80M for this business several years ago and wrote it down to 0 in the most recent quarter.)

iPass' History

If all that sounds way too good to be true for a company that presently trades at around the value of cash on its balance sheet and significantly less than liquidation value, that's because it is. 5 years ago, iPass only offered dial service and that was a phenomenal business. Dial ISPs were dying so they gave iPass great deals if iPass would steer some traffic to their networks. The company had 75% gross margins (70% margins on the dial revenue and nearly 100% gross margins on the software and services that they provided clients in conjunction with the core connectivity product) and with no one else coming even close to replicating their aggregated network, they were able to generate a fat 20% operating margin.

Alas, nobody really uses dial anymore. iPass was forced to do the same aggregation with broadband that they did with dial. And they did, except that it's nowhere near as profitable. Companies with wi-fi hotspot networks, and more recently 3G operators, didn't give iPass the same deals iPass got in the dial space. The reason is obvious - iPass doesn't have the same type of leverage working with Verizon today as it does with Earthlink, which is starving to get any possible dollar for traffic crossing its dial network. The transition from dial to broadband has devastated the company's margin structure. To make matters worse, iPass' dial revenue has not had the same trajectory as, say, Earthlink. Dial revenue fell off a cliff due to the fact that iPass' corporate clientele had no use for dial connectivity and switched their plans to iPass' broadband connectivity product. Here are the data so you can see for yourself:

With iPass facing a shift from 70% gross margin revenues to 35% gross margin revenues, the company figured it had to do something. Unfortunately, the first thing they did was go out and use their $150M cash hoard to make a stupid acquisition. I'm not 100% sure what the rationale was in spending$80M onGoRemote in 2006. GoRemote's main business was "aggregating" wired broadband connectivity to companies that had several locations so that they would only have to deal withGoRemote instead of the several companies that provide broadband in various locations throughout the country. While in theory this business was somewhat connected to whatiPass was doing, GoRemote operated in the world of wired broadband connections, which doesn't have very much to do with the "traveling salesman" client thatiPass has historically courted, and it didn't add much value given that things like wired internet connections are usually dealt with by the localcorpoarte back-office rather than IT headquarters. As of the latest quarter, the GoRemote acquisition was written down to 0, and the $30M in annual revenue that it generates is at around breakeven (~30% gross margin).

With half its cash gone and nothing to show for it, the company decided to change the way they charge their clients in order to jack up margins. The new contract structure is being labeled byiPass as Enterprise Flat Rate and it's set up as follows: iPass charges a small monthly fee for the iPass software to be installed on a pre-set number of users' computers. In addition to this software fee, iPass charges the customer a larger monthly per-person usage fee based on the subset of users that accessed the core iPass connectivity service (not all users that had the software installed on their box needed the connectivity piece every month). In this way,iPass managed to separate its product into two components:

• The software, which is meant to make network management much easier on the IT administrator.
• The connectivity, which is meant to make sure that there's always a connection available for the traveling salesman.

In theory, if executed properly, the introduction of EFR would be used to generate a lot of software & service revenue for iPass at no marginal cost. After all, they were developing the software anyway; what did they care if it got installed on a few hundred extra computers per company? And the IT administrator, for a low monthly fee per computer, got a nice piece of network administration software he could install on any computer that could conceivably need to access a broadband connection while traveling. Having iPass installed on these computers would make sure that the users were not taking actions that could damage network security or doing things on company laptops that were not approved.

The software also gave iPass a nice piece of computer real estate situated at the crossroads of the corporate IT department, the internet, and the end-user (over 1M end-users at this point). This could be monetized (again, in theory) by developing new useful services that made sense to deliver via this piece of real estate or by partnering with someone who would develop these services and taking a cut of the revenue.

iPass at Present

Of course, anyone familiar with the iPass story will easily be able to tell you that  the execution of the changeover to EFR has left something to be desired. In fact, iPass' new CEO, in surveying IT departments and end-users to get the customer's perspective on the product, found that only 30-40% of the end users on whose computer the iPass software had been installed even knew about it. Interestingly, that same proportion of users use the core connectivity product. Thus, the plan to sell software into computers that may not necessarily be using the connectivity product hasn't been working so well (iPass, of course, cannot charge its customer - the IT department - if the users aren't using the software).

The only way to interpret that failure, I think, is that the iPass software is simply not so important to the IT department unless it's being used by a connectivity user. And that makes intuitive sense: why should the IT department need another  piece of software to take care of network security and other network administration issues when they're probably buying those products from software companies (like Symantec or HP or IBM) that specialize in them? On the other hand, if you have salespeople that are out in the field, as an IT administrator, you want to be able to monitor their internet use, make sure there are no security breaches, etc. At present, the iPass software has no value except with regard to those out-in-the-field users.

Where does iPass Go From Here?

The way I see it, there are three different paths iPass could take in the next 2 years or so, each leading to a different valuation:

1. Successful restructuring
2. Stagnation
3. "Resource conversion."

Successful Implementation of Strategic Restructuring

Given the MBA-ish-sounding quality of those words, you can probably imagine that I view this as the least probable scenario. A new CEO has recently been brought on atiPass (Evan Kaplan), and for a change, at least he knows what's wrong. His restructuring plan is focused on:

• Convincing IT managers that the iPass software is useful to everyone and not just the connectivity users. In Kaplan's words: "We are making substantial improvements to our existing client [software] and we are also enhancing our service with value-adds around freewi-fi." What that actually means in practice is beyond me because the company is not really detailing how they intend to improve the software so that IT managers consider it worth their time and money to make sure everyone - not just the road warriors - uses it.
• Focus sales and marketing on 3G, mostly ignoring the fixed broadband product. The margins on 3G are much higher than the fixed broadband margins orwi-fi margins (3G margins are +40%) and 3G is also more ubiquitous than both. It's also growing much faster, from a laptop usage standpoint, than eitherwi-fi or fixed broadband. If iPass is able to grow its 3G customer base faster, a few things happen to improve the bottom line:
  • Any incremental gross profit drops straight to the bottom line as there is no incremental OpEx involved here - the OpEx base at present is more than enough.
  • As iPass brings more traffic to the 3G providers, it gets more leverage negotiating better deals with them. For example, iPass is presently Verizon's #1 or #2 3G customer in any particular quarter. There's a lot of negotiating leverage that comes with that. 
  • MUCH MORE IMPORTANTLY, and this might generate some good discussion, I think the walled gardens of the telcos (and probably cable companies as well) are slowly becoming more commoditized due to competition. Over the next few years, in any given geography, a typical consumer will have wireless connectivity available from multiple 3G providers, multiple 4G providers, andwi-fi networks, in addition to an increasing number of options in the fixed broadband space. The increasing competition plays perfectly intoiPass' hands as the company will be exponentially increasing its leverage with its broadband suppliers.
• Take advantage of the real estate occupied by iPass' software. For those end-users that are using iPass software, they're passing through iPass real estate every time they connect to the internet. This is a valuable asset as iPass can add either its own services - maybe allowing it to charge for a la carte services, for example - or other companies' services, allowing iPass to be the portal through which software companies can easily target the highly specialized population of "traveling salesmen." Admittedly, some ofiPass' aspirations in this arena seem like a long shot, but I still think that they could do more to monetize the position they occupy on the end user's computer.

If iPass is actually able to successfully execute the very ambitious plan I just outlined, there's a very good chance that core broadband gross margins slowly move toward the 50% range, and overall gross margins continue to increase toward the 65% range as software & services revenue grows as a piece of the overall revenue pie. Meanwhile, growth of OpEx should remain muted because none of the above requires extra OpEx - it just requires better use of the company's present expense base. Assuming dial continues to decline toward ~5% of revenue and that overall revenues are up slightly as broadband and software revenue increase, iPass should be generating ~10% EBIT Margins 2 years out (65% GMs and 55% OpEx). On a revenue base of ~$190-200M, that will equal ~$20M in operating profit. All for a grand total of about negative $4M today.

Stagnation

Fortunately, I view this scenario as unlikely as a really successful turnaround (maybe more-so) . In a worst case scenario, iPass simply stagnates as its turnaround goes nowhere. They keep booking new broadband customers at the rate they have been, they cut costs, they lose dial customers as they have been, and they stay approximately cashflow breakeven. Two years from now, you're still looking at a pile of cash, an all-star customer base, and an unreplicated "virtual" aggregation of the most popular wireless connections available globally. I would say that that's still worth more than just the pile of cash (it's certainly not worth less).

A more likely scenario is that some elements of the restructuring work (it's a virtual certainty that they'll continue to get better terms from their suppliers) and others won't. 2 years from now, you're looking at a slightly profitable business with a slightly larger cash pile and the same set of assets. Again, this is not worth less than the cash in the bank.

The nice thing with iPass is that it's hard to figure out a way that the company destroys value. The most likely path of doing that - a stupid acquisition with the cash pile - is off-limits given the 35% stake in the company currently held by activist investors. While I'm usually not interested in the typical quick-buck mentality of "activists," it's good to know that they'll be protecting the cash pile here. In terms of destroyed business value, there is simply no sign of iPass slowing down in terms of booking new revenue. Their core broadband product continues to grow even through the recession, and the number of customers they sign on to their product is growing even faster (offset, of course, by layoffs within their customer base).

iPass is Acquired

Given the extremely disgruntled activist base of investors, the fact that iPass trades at less than cash, and the very valuable intangible assets that iPass possesses, it's very likely that if the stagnation scenario takes hold, the company will be sold. I see no reason why Symantec, for example, can't take the iPass product and incorporate it into stable of software products it sells to corporate customers. The aggregation work is done for them, and the vast majority of the SG&A base ($110M annually) can be cut, as iPass will now be just another product that the Symantec salesforce offers its customers. Of course, you can make this argument for any corporate-IT-facing company (HP, IBM, etc.) buying iPass. Any one of these companies can easily pay $5/share for iPass (the rumored price of an acquisition that iPass turned down in January of 2008) and still get a phenomenal ROI. Here's the bankers' pitch:

• $5/share equals $320M. Net out the cash, and you're paying $250M. Cut the SG&A base by half, and you're at $55M in annual EBIT (which is understating earnings given virtually no capex requirement). Oh, and you get an $80M NOL thrown in for free courtesy of the stupid GoRemote acquisition. Including the PV of the NOL (which would probably be used up in a year or two by an acquirer), you're paying ~4X EBIT for a company with a great set of intangible assets that are worth more to you anyway, and there's the great macro tailwind of commoditization of broadband pipes.

I'm pretty sure that the above is the train of thought of Shamrock, Foxhill, Ramius, WC, etc. when they constantly yell and scream that iPass should be sold. Two years ago, when crappy companies were being sold at 10x EV/EBITDA, Shamrock was not off-base suggesting that iPass could be sold for $8-10/share, which, under the previous rationale, would have been ~7-10X EBIT for a pretty good company with good assets, etc.

Now, I'm not saying that iPass will be acquire for $5. It may only be acquired for $3. But the stock trades at $1.05 these days. It wouldn't be the end of the world if it got acquired at $3.

Summary

To sum up, I think there are three possibilities at iPass - management successfully running the business, stagnation, or acquisition. In the worst case scenario, you don't lose money. In any other scenario, it wouldn't take much to move the stock a couple hundred percent (imagine a mediocre 5% operating margin on $200M in revenue - at 7x EV/EBIT, it's a $2.25 stock). So while there might be some uncertainty as to where iPass is headed in the near term, I'm fairly certain that it's not downhill for its shareholders long-term.

Catalyst

Gross margin expansion, software and services traction