Description
OTGS is a small cap software company with (1) proprietary technology
targeting an interesting and long term important area of IT; (2) net cash
equal to more than half of its market capitalization; (3) a history of operating
profitably, and a business model unburdened by many fixed costs; (4)
positive operating and net earnings in 2000 and positive net earnings projections for 2001 (so far); (5) heavy insider ownership; (6) an attractive valuation; and (7) some significant challenges. I think the reward far outweighs the risk.
What It Does: Storage software. OTG's base technology falls into the realm
of storage software known as HSM: Hierarchical storage management. The
concept is that data that users access frequently should be stored in
primary devices that are easiest to access, but data that users access less
frequently should be stored in secondary devices where easy access is less
important. The use of secondary storage devices promotes the efficient
management of data and prevents the unnecessary and expensive backup of data
on primary devices if that data has not changed or been looked at in a
while. For the admirably uninitiated, industry analysts project digital
technologies will lead to the production of more data creation in the next 3 years than in the
prior 2000. Data has value, and as a result enterprise spending on storage
technology will grow fast. Enterprise storage system companies (like EMC,
Hitachi, CPQ & SUNW) place an increasing amount of importance on software as
a means of differentiating their product offerings to enterprises.
OTG got its start in the early 90s helping MSFT solve some tricky technical
issues involving the interaction of early NT code with storage devices. By
getting an early look at the NT source code, OTG was able to develop HSM functionality aimed at applications running on NT. OTG's core
DiskXTender product now has roughly 1/3 of the NT based HSM market, and OTG
has ported DiskXtender to Unix & Linux environments. OTG has extended its
product offering by aiming its core HSM technology at data intensive
applications like email and rich media. The Email product (EmailXTender) is
probably the most interesting extension. It enables the migration of less
frequently accessed email data to secondary devices, but maintains the
ability for users to regain access to migrated data from their desktops (or
other clients) within minutes. No more IT admin messages telling you to
empty your deleted files, and no more calls to admin to recall tape to get
old data, a process that can take days. OTG does face competition, most
notably from storage software industry leader Veritas, but its HSM
technologies are unique in their ability quickly to access migrated data (an
important differentiator for enterprise users) and their support of any kind
of secondary storage device (tape, optical, CD, DVD). Its email product
supports both Exchange & Lotus (VRTS is Exchange only), migrates message
texts and attachments (VRTS does attachments only), and enables far speedier
access. I could recite more of the product literature or due diligence
checks, but the point is that OTG has proprietary technology that addresses
important enterprise IT demands.
Early Public History: OTG went public in March 2000 at $19 and traded to the
mid 40s in the summer 2000 Nasdaq bounce on solid Q200 & Q300 quarterly
reports. In September, OTG did a secondary offering of insider and newly
issued shares in the high 20s. This would concern me more if the stock were higher
than $6.
Trouble: (1) As for other categories of IT spending, 2000 saw enterprises buy
storage hardware systems well in excess of need. Despite the speed of data
growth, enterprise utilization of storage hardware is likely 30-50% in H101.
Underutilization of hardware capacity makes HSM technology more
nice-to-have than need-to-have, as primary storage devices are often not
full. Plus, initial enterprise storage demand is centered around the basic
need to backup data as it is being created, and restore data on system failures. HSM
is a smaller and less immediately necessary part of the storage software
market than backup & restore software. In an environment of constrained IT
spending, nice-to-have technologies get left behind, especially when they
are being offered by secondary, smaller vendors like OTG. (2) Like most
software companies, OTG's quarters are quite back end loaded (roughly 65% of
the deals close in the last 3 weeks of the quarter). OTG, as a smaller
vendor who came public at the very end of the bull market, lacks a strong
direct channel of product distribution. Its revenues are roughly 20%
direct, 20% OEM (including IBM & Maxtor), and 60% VAR. In an
environment of slower IT spending OTG saw demand start to fade in
December 2000 and did something dumb. They stuffed long payment
date deals through the VAR channel to make the income statement meet their
guidance. DSOs rose from 103 to 124, and the market unsurprisingly treated
OTG like it had badly missed. The stock traded to 10, rallied briefly in
January 2001 with the Nasdaq, sold off in the downdraft in February & March,
and has not recovered. (3) In March 2001, OTG saw an opportunity to acquire
a competitor (Smart Storage, privately held) with rich media technology &
international distribution & development assets that OTG had planned to
build over the course of the year. The competitor lacked financing,
and liked the fit with OTG. The $25mm valuation for the
deal was 2x revenues, and cost synergies alone made the deal
accretive to both eps and returns within 6 months. So OTG went ahead and
did it. With stock. Despite the $100mm of cash on its balance sheet.
And despite the following valuation facts about OTG.
Valuation: 31mm shares out (pro forma for Smart Storage), $103mm net cash, 2000 results included 43mm in revenue, 2mm in operating income and 3mm in net income (interest income on the cash offsets taxes), Q300 was 12mm revenue & 17% operating margin, Q4 (though disappointing) was 14mm revenue & 9% operating margin. Q101 was 14mm revenue & negative 1.4mm EBIT on costs incurred in the pooling with unprofitable SmartStorage, but OTG still broke even on the bottom line, and expects to get back to operating profitability in Q301. 2001 guidance is for 70mm revenue, break even EBIT for the full year but exiting in Q4 at 13% margin, and 2.6mm net income. Non cash depreciation is about 0.2mm per quarter, and capex is 1.0mm. OTG targets bringing its DSOs down to 100 by year end through the buildout of the OEM channel, better traction with its direct salesforce, and tighter payment terms in the channel. Q101 DSOs were down from 124 to 120. In the absence of a dramatic revenue shortfall, the cash usage is minimal, if positive at all.
The bottom line is an enterprise valuation of less than 100mm for an entity that (1) did 43mm in revenue last year; (2) is targeting 70mm this year; (3) has had positive operating income in every year since 1997 (during which its revenue has grown by a 50% CAGR); (4) owns proprietary technology addressing one of the fastest growing IT markets; and (5) has well incentived management.
Management: OTG is controlled (43% stake) by a CEO who founded the company and financed it out of its operating cash flow with very little leverage and relatively little venture capital. No question, a number of the decisions the management team has made display questionable judgment. But this is a guy who has built up a net worth that is (still) around $100mm from close to nothing by running a growing technology company in a financially responsible manner. The $100mm of cash on the balance sheet protects his downside, and mine, and is something that he will not tap into on a pipedream of product development.
The strategy: OTG's plan at this point is to keep plugging away, integrate the deal, try to put up the numbers, and wait for people to care again. The market cap keeps most institutions away. Sell side coverage is limited. The companies size is an obstacle to solid marketing and gaining large account credibility, but OTG does have a significant number of Fortune 500 customers. Especially in light of this, competition is a clear risk, but OTG's technical lead is not insignificant. And a number of the best capitalized enterprise hardware companies in the world are looking for software technologies to differentiate their storage products.
Catalyst
(1) Better IT spending environment; (2) Continued growth of enterprise spending on storage; (3) Share repurchase (which management is considering); (4)M&A