Description

Kofax is a small-cap software company whose shares have been beaten down due to two consecutive quarters of missing estimates, its delisting from the London Stock Exchange and year-end tax-loss selling.  Management has obviously lost some credibility with investors, but we believe the sell-off is overdone and current valuation offers compelling risk/reward trade-off.  Insiders own over 30% of shares outstanding and have been buying shares over the past seven months at prices ranging from $6.50 to $8.60.  Additionally, a recent bidding war by two rivals over a smaller competitor in this software category highlights strategic interest.  Driven by faster growth of new products and salesforce productivity ramp-up, we expect Kofax to beat lowered expectations.  If the company were to miss again, we believe the largest holders (who are also on the Board) would terminate the CEO and put Kofax up for sale. The stock is currently trading at 1.6x ttm total revenue and 3.6x maintenance revenue.   Our target price is $10-11/share (70-90% upside).

Company background

Based in Irvine, CA, Kofax provides software that enables document image capture, process management, and data analytics.  The company was acquired by UK-based Dicom Group in 1999 and is listed on LSE.  Dicom changed its name to Kofax in 2008 and sold its hardware distribution business in 2011.  In December 2013, Kofax became listed on NASDAQ and recently announced plan to delist from LSE.  Kofax has over 20,000 customers in banking, insurance, government, healthcare, and business process outsourcing markets.  Kofax’s competitors include EMC, IBM, Lexmark, ReadSoft (just acquired by Lexmark), Hyland and Open Text.  CEO Reynolds Bish joined in 2007 and was previously the CEO of a Kofax competitor, Capitva, which he sold to EMC in 2005.

Why the opportunity exists: two consecutive misses, delisting from LSE, tax-loss selling

Kofax missed fiscal Q4 (Jun 2014) citing delays in closing 7-figure license deals.  This week, the company missed fiscal Q1 (Sep 2014), citing delays in closing not only 7-figure deals but also some 6-figure deals in legacy capture software.  Kofax reduced its FY15 guidance, taking 7-figure deals out of its new outlook.  Management lost its credibility with investors after two consecutive misses as the stock suffered a 25% one-day decline.  We believe the stock is further pressured by the company’s plan to delist from LSE, prompting UK-based investors to dump their holdings.  Finally, we believe year-end tax-loss selling is the final straw that caused investors to give up on the stock.

Are the problems temporary?

Though it may be hard for investors to believe, we do not think Kofax’s issues are permanent.  First, license-based software companies tend do have quarters where they miss estimates but then bounce back later.  This is the nature of signing large license deals at the end of quarters.  In fact, Kofax has a prior history of two consecutive bad quarters followed by a string of strong quarters.  Second, we do not believe competition from SaaS companies is impacting Kofax.   We have not yet seen SaaS companies having material traction in document capture and process management as they have in salesforce automation and human capital management.  Third, Kofax’s miss came from legacy capture, but license sales of new products grew at 80% in fiscal Q1 (Sep 2014) and contributed 35% of total license revenue. 

How will the company grow?

As referenced above, one challenge facing Kofax is that its legacy capture software is mature and slow growing (low single digits).  Over the past few years, Kofax has invested in new products beyond legacy capture, either organically or via acquisitions.  These new products include mobile capture, business process automation platform (Kofax TotalAgility), accounts payable automation, mortgage automation, business intelligence, data integration and e-signature.  License revenue from these new products is growing at 30%+ annually, but was only 26% of total license sales in FY14.  As revenue contribution from new products becomes more significant, we expect Kofax’s total revenue growth rate to accelerate.

A second challenge facing Kofax is salesforce productivity.  In FY14, Kofax increased its quota-carrying reps from 100 to 135 (+35%).  A new sales rep typically takes 6-9 months to begin generating sales and another 6-9 months to become fully productive.  Kofax has begun to see new sales reps bringing in deals, and we expect meaningful contribution from these new sales reps in FY15.

ReadSoft bidding war

We believe there is sufficient interest in Kofax from strategic buyers.  The recent bidding war over ReadSoft, a smaller rival to Kofax, highlights the push for consolidation in the industry.  ReadSoft is a European-based competitor that had about $110m in revenue (vs. $300m at Kofax).  Unlike Kofax, ReadSoft is more dependent on lower-margin professional services (26% of total revenue at ReadSoft vs. 13% at Kofax).

Lexmark initially agreed to acquire ReadSoft for SEK 40/share on May 5, only to be trumped by Hyland’s hostile bid of SEK 42.86/share on June 18.  The bidding went back and forth between Lexmark and Hyland until Lexmark’s final bid of SEK 57/share (total enterprise value of $250m) secured the deal on August 20. 

We believe the market for document capture and process management is ripe for consolidation.  Even though Hyland lost out on ReadSoft, we believe it would be interested in a combination with Kofax.  Other potential strategic buyers include large ERP vendors (Oracle, SAP) or multi-function printer vendors (Xerox, Canon, Ricoh).  Lexmark’s aggressive/acquisitive software strategy puts pressure on other printer vendors to diversify from commodity hardware business.

Insider ownership and recent purchases

We believe management and shareholder interests are aligned at Kofax.  Insiders own more than 30% of the company, with the Comfort family and its affiliates owning around 29%.  CEO Bish owns 1m shares (just over 1%).  Importantly, several board members have been buying stock on the open market since March 2014 at prices ranging from $6.50-8.60/share.  Notably, one director affiliated with the Comfort family acquired 1m shares in September at $7.97/share – after the company had already missed its fiscal Q4.  (Because Kofax is still listed on LSE, these transactions are filed under Form 6-K in EDGAR instead of Form 4.)  Clearly, insiders think current prices materially undervalue the company.  We expect insiders to be active on the open market again, unless the company is considering a sale.

Valuation

For software companies, downside valuation is supported by high-margin recurring revenue (maintenance).  Companies that have growing maintenance revenue do not typically trade below 5x maintenance.  Even distressed software companies do not trade below 3x maintenance.  At $5.86/share, Kofax is trading at 3.6x ttm maintenance even though its maintenance revenue is growing at high single digits.  On an EV/EBITDA basis, Kofax is trading at 10x FY15 EBITDA, even though EBITDA margin is depressed by heavy investment in sales and marketing.

We believe the upside scenario is at least $10-11/share.  We believe there’s more operating leverage in Kofax than it is currently generating.  The company is guiding to 14% EBITDA margin for FY15 due to investments in growth initiatives (new products and quota reps).  With 80% gross margin, there is no reason Kofax cannot generate 25-30% EBITDA margin.  For example, Progress Software (PRGS), a similarly-sized enterprise software company, produces 90% gross margin and 35-40% EBITDA margin.  If Kofax can return license growth above 10% and show operating leverage in FY16, we believe a $10 price target is realistic at slightly expanded multiples of 12-13x FY16 EBITDA. 

Ultimately we believe the company will be sold.  The CEO has indicated this much: Kofax will not be an independent company in 3 years.  He sold his prior company to EMC.  There are strategic interests in this category as evidenced by ReadSoft’s bidding war.  Software acquisitions are highly accretive because gross margins on software are 80-90% while most of operating expenses can be cut.  This is why the ReadSoft deal was completed at a final price that is 42% higher than the initial bid.  Lexmark paid 3.2x ReadSoft’s ttm software revenue (license and maintenance, excluding professional services and others) and 6.3x ttm maintenance revenue.  Applying similar multiples to Kofax’s FY15 revenues would yield $10-11/share.

Risks

Legacy capture continues to stagnate or decline

Faster than expected shift to SaaS

Catalyst