Lawson Software 2.5% Sr. Cvt. LWSN
December 15, 2008 - 3:09pm EST by
2008 2009
Price: 72.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 240 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Lawson's 2.5% Senior Convertible Notes due 2012 are currently trading at 72 cents, implying a yield to maturity of 13.2%.  We believe these notes present a very compelling risk-reward profile.  As of the company's first quarter ended 8/31/08, the company had $113 million of net cash.  There is $240 million of converts, $8.4 million of miscellaneous other debt and $361 million of cash, the vast majority of which is domiciled in the U.S.  The company generates significant amounts of free cash flow and the majority of its EBITDA comes from very sticky maintenance contracts.  Interest coverage is ample with an EBITDA/Interest Expense ratio of 15x. Therefore, it is very difficult to think of a scenario where these notes are not money-good.  Additionally, there’s a reasonable chance that these bonds will be trading well above par at the time of maturity. Lawson is a good business in a growing market, offering a compelling, lower-cost alternative to Oracle and SAP. These bonds offer the chance to earn at least a 13% yield with huge margins of safety.  

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Lawson Software is an enterprise resource planning (ERP) software vendor that focuses on the mid-market (customers with $250 mm - $1,000 mm in revenue).  Lawson is the 3rd largest ERP vendor next to Oracle and SAP, focusing on six key verticals:  healthcare, public services, food and beverage, fashion, distribution and equipment rentals.  The company's provides products within the areas of finance, manufacturing, distribution, maintenance and supply chain, complemented by solutions for human capital management, customer relationship management and business intelligence.  In 2006, Lawson merged with a Swedish ERP vendor, Intentia, which effectively doubled the size of the business.  Since the merger, CEO Harry Debes has done a good job of integrating the businesses, rationalizing expenses, and instilling greater discipline and accountability with the salesforce.  The company has improved operating margins from 7% at the time of acquisition to 10% for fiscal 2008.  The company's long-term margin targets are 17-19%. The bridge from 10% to 17-19% is as follows: (i) 2-3% from growth in license and maintenance revenues; (ii) 2% from improved consulting services margins; and (iii) 3-4% from operating expense efficiencies. For the fiscal year ended May 2008, the company generated revenues of $854 million, EBITDA of $99 million and cash earnings of $60 million.   

The most attractive attribute of Lawson's revenue model is that 40% of total revenue comes from annual maintenance contracts.  Maintenance revenue is high margin, recurring revenue that should perform very well, even in the current downturn.  Annual maintenance contracts are typically priced at 15-20% of the initial license sale and they enable customers to get continued support from Lawson (in the form of troubleshooting and access to future upgrades/improvements).  Renewal rates for the legacy Lawson side has been in the mid 90%'s and in the high 80%'s for the Intentia side.  Maintenance revenue has a highly scalable cost structure; since the vast majority of Lawson's installed base elect to purchase maintenance contracts, maintenance gross margins run in the low 80% range.  Maintenance revenue accounts for 40% of total revenue and 60% of total gross profit. 

The other 40% of gross profit comes from new license sales and consulting revenue, both of which should be more vulnerable in an economic downturn. In preparation for the anticipated softness, the company recently announced significant cost reduction measures whereby its global workforce will be reduced by between 8-10%. Annualized cost savings from the restructuring is estimated to be in the range of $40-$50 million, representing ~50% of trailing EBITDA. The company has not given any specific guidance for their fiscal year ending May 2009, but they did indicate that consulting revenues should be down in the high single digits, due to the economic softness as well as proactive efforts to eliminate less-profitable work. My best guess for license is that too could be down high single digit %, or maybe even more. Maintenance revenue will continue to grow, as the addition of new maintenance contracts from new licenses plus annual price increases of 5% more than offset the modest attrition that occurs every year. The combination of the growing maintenance stream with the significant cost savings leads me to believe that earnings in 2009 will not fluctuate dramatically from 2008 and that the company will generate significant FCF. This is further corroborated by the fact that management intends to improve operating margins in 2009, even with the prevailing economic headwinds.     

Management is very conservative with their capital structure and they insist on running their business with around a $100 mm net cash position at all times. Therefore, I see the chances of them incurring debt ahead of the converts as extremely low. The company was active in buying back their stock in fiscal 2008, but they have stopped buying back stock in light of the current environment. The biggest risk I see with this investment is that they utilize their cash balance to do a foolish acquisition. I definitely think the company will seek to gain greater scale at some point, so I think they will certainly do acquisitions in the future. However, their conservative stance on always running a net cash balance of at least $100 mm mitigates this risk in the near-term.

The notes are convertible into 83.2 shares per $1,000 bond, implying a conversion price of $12.01. At 72 cents on the dollar, your conversion price is reduced to $8.65. Above $8.65, we would participate dollar for dollar in share-price appreciation. I’m not placing a huge probability on this outcome, but it is certainly within reason for the stock to trade above $8.65 in 2012. For example, at $10, Lawson would be trading at an EV/Maint Revenue (trailing) multiple of 4.6x. Acquisitions of comparable software vendors have been done at maintenance revenue multiples of between 5-7x. Looking at it another way, a medium-term target for the company has been to get to $1,000 mm of revenue. Giving them credit for a 15% margin yields $150 mm of EBITA; at $10.00 per share (and ignoring all of the interim FCF generation), that would imply an EV/EBITA multiple of 10x. At any rate, this is just upside and merely getting repaid at maturity will earn us a 13% yield. 


Collection of coupon payments
Potential acquisition of company (there is a change of control provision)
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