Description

Introduction

PROS Holdings provides software to large companies that help them offer automated, customized product configurations and prices. In a world where the “Amazon effect” is rapidly improving price discovery, placing greater emphasis on omnichannel sales, and dramatically increasing customer experience expectations, the intelligence and tools provided by PROS to offer what they refer to as “frictionless commerce” are becoming increasingly essential.

PROS Holdings is an extremely high-quality (+95% gross revenue retention) software company with favorable secular trends and near dominant (+2.5x the size of its largest competitor) market position trading at a deep discount to its intrinsic value. At $26 share, PROS is valued at roughly 3.6x 2018 recurring revenue, pro forma for the conversion of existing maintenance revenue to cloud subscription revenue.  With a multi-year runway of +20% recurring revenue growth (not including the maintenance conversion), I believe PROS should currently trade at 5-6x recurring revenue, implying 40-70% upside. I expect that there is significant potential for long-term appreciation beyond simply re-rating to peers over the next year. We plan to own PROS for a very long time.

At the company’s Analyst Day in November 2016 they updated the timing on their goal of $500MM in revenue and 18-22% free cash flow margins to sometime in 2021 or 2022 (they had previously set a 2020 goal when they announced their Cloud First strategy in June 2015). Following their Q3 2017 earnings release, management noted that they are tracking ahead of their prior expectations. Should PROS achieve their goal, I anticipate that the company would warrant a value of 6x recurring revenue and +25x free cash flow (in-line with mature, likely slower growing peers). This would result in a share price of nearly $80, driving a multi-year IRR of 25-30%.

Framing the Opportunity

Although PROS share price has gained 22% year-to-date, it has underperformed the software index (IGV) by almost 20%. Despite showing revenue acceleration throughout the year, PROS has sold off almost 15% from its intra-year highs. The selloff is a result of an increase in 2017 cash burn versus initial guidance, poorly received color regarding 2018 revenue expectations that was given on the Q3 earnings call and a convertible debt offering in June that drove increased short interest (13% of float currently short). I will unpack the details later in this write-up, but to jump to the conclusion here, the additional spending is related to an acquisition and acceleration of cloud spending (i.e. does not reflect cash earnings power) and the 2018 confusion centers around ASC606 accounting rules, the timing of maintenance to license conversions and a healthy amount of conservatism.

On the heels of a period in which the stock price underperformed while the business materially exceeded expectations (subscription revenue will grow 48% organically versus a 40% guide), we are also entering a time during which PROS will post rapidly accelerating revenue growth. The “cloud transition” is one of our favorite software themes when we look for good investment opportunities. When a company pivots from earning the bulk of its profits from one-time license sales to multi-year subscription contracts, both revenue and margins take a nosedive at a time when the business is actually becoming much more valuable (PROS estimates that the lifetime value of a subscription customer is 40% higher than a license customer; also, recurring revenue is much easier for investors to model and therefore receives a higher multiple). If a business has even the slightest misstep during this transition, the offending company’s stock frequently takes a hefty tumble (e.g. TYL in 2010 and ADSK in 2014) That’s exactly what happened to PROS. Coming out of the gate in the two quarters following their Cloud First announcement, PROS struggled with their “packaging” (pricing, term, services offered etc.) and they experienced a notable sales air pocket. Following their Q4 2015 report, PROS stock declined 60% from its price when Cloud First was announced. While we are well above 2016 lows, I think the stock would be much higher today had the early days of the transition gone more smoothly. With the PROS’ share price still +40% below 2014 highs (despite growing significantly and market multiples for software expanding meaningfully), we are still paying for errors which are well in the rearview mirror.

If you were to start researching PROS by simply looking at their reported financials without the cloud conversion as context there is pretty much zero chance that you’d think “this is a quality, growing business.” In the quarters following the pivot to cloud-only sales to new customers, revenue growth collapsed from +33% in 2014 to -11% in 2015 and -15% in 2016. Revenue inflected positively in Q1 of 2017 and has been on an upward trajectory since. The declines in profitability were even more severe. After growing 34% in 2014, gross profit declined almost 18% in 2015 and another 18% in 2016. This outsized decline in margins (+1000 basis point decline in gross margin from peak to trough) is driven by an extended period in which the infrastructure needed to support the cloud business far exceeds the size of the cloud subscription business.

Moving into 2018, PROS revenue growth will accelerate materially as the gains in subscription revenue outpace the declines in license and maintenance revenues. First by a small amount, and then quite significantly. In 2018 subscription revenue growth should exceed 50%, but total revenue is guided to a much smaller 12%. This delta is a result of the fact that subscription revenue is less than 40% of the total and the other components (license and maintenance) are declining. By the end of 2018, subscription revenue will eclipse 50% of total revenue. In 2019 subscription revenue growth will continue to accelerate as existing perpetual license customers convert to the cloud. To-date, cloud conversions have driven minimal subscription revenues (subscription growth has been split evenly between new customers and existing customers expanding their use of PROS). From 2019 through 2022, annualized total revenue growth should clock in at north of 30%. I expect that valuation multiple will expand materially in conjunction with accelerated revenue gains.

Margin expansion will follow revenue improvements due to the fact that the cloud business will remain in investment mode. In 2017, PROS will burn around $32MM. Cash flow will turn positive in 2018 as PROS laps acquisition and cloud investment expenses and layers on more than $30MM in additional subscription billings. From 2018 through 2022, free cash flow margins will increase by as much as 2000 basis points (going from break even to ~20% FCF margins). We think the successive catalysts of revenue growth acceleration followed by dramatic margin expansion make PROS a very good multi-year investment.

By combining our strong appreciation for the economics that drive customer ROI, the favorable competitive environment within pricing software and our broader industry research of ways in which software is “eating the world”, I think our investment in PROS is one where we can sufficiently establish where our edge lies. This isn’t to say that we can’t lose money investing in PROS. Rather, it means that we will be unusually disappointed if we do, and that will likely know precisely where our thesis was wrong (nothing like being able to pinpoint an exit wound!).

The Business

PROS is a software company that takes complex pricing practices out of the hands of manual spreadsheets and human “intuition” and applies statistical analysis and machine learning to identify significant variables that drive pricing recommendations. After employing its data science to identify pricing trends and recommended pricing levels, PROS produces data visualization and change management tools that customers use to achieve optimized pricing and margin outcomes. Over the past few years the company has augmented its suite of products to include software used to build quotes (called configure price quote, or CPQ), tools that recommend specific product sales based on shared customer buying habits and deep integration with Microsoft and SalesForce CRM platforms. Of note, PROS is heavily integrated with Microsoft. They have received multiple Partner of the Year awards from Microsoft. Here is a link to the keynote speech from this year’s PROS user conference which featured the head of global sales for Microsoft Dynamics (their ERP and CRM platform) –  https://www.youtube.com/watch?v=DR9ivkv6CT8.

PROS was founded in 1985 by Ron and Mariette Woestemeyer, who still sit hold board seats and 13% of the company. Prior to starting PROS, Ron spent 14 years in the airline industry. Initially, PROS was solely focused on offering dynamic pricing solutions for airlines. Southwest Airlines was their first customer; three decades later, they are still a customer (at a much expanded revenue base).

Today, airlines represent about 40% of PROS revenue. The airline business is grouped under the RevenuePRO product family. Of the top 50 airlines, 47 are PROS customers (Delta, American Airlines and United have in-house pricing solutions). PROS technology is used to price over 60% of all airline tickets sold globally. Since the majority of airlines that are not PROS customers have developed in-house solutions, third-party competition is essentially non-existent. Despite the fact that the airline industry is quite mature when it comes to adopting pricing software, PROS’ revenue from airline customers has grown at a double digit rate for the last ten years and is currently growing in the mid-teens range. The growth is driven by product enhancements (such as a recently deployed group ticket pricing module) and industry expansion (PROS ties its contracts to revenue and/or usage levels). PROS’ recent acquisition of a travel technology company called Vayant (which I will discuss more later) should accelerate growth in the airline vertical at the expense of legacy global distribution systems (GDS) like Sabre and Amadeus.

The non-airline business is predominantly comprised of B2B customers, with a smaller contribution from B2C customers. Their customers are household names. Please refer to Appendix A for an infographic showing several of their customers. You’ll likely note that PROS frequently has a high share within the verticals it serves (eg – Avis and Hertz, McKesson and Cardinal Health). Oftentimes, when one customer adopts PROS solutions its competitors follow suit. We have had multiple conversations with customers who have talked about the arms race that they felt they were in with their competitors while deploying PROS, often implementing within months of each other. While this is purely an anecdotal observation (albeit, one strengthened by their dominant airline market share), I think that this speaks to the efficacy of the product, the power of customer reference-ability and the high likelihood of PROS’ continued success as the company continues to transition its sales teams from geographical divisions to vertical industry expertise (something that was announced at the 2016 Analyst Day).

In general, PROS’ customers have revenue north of $1B and sell more than 10,000 SKUs.  Through a combination of pivoting to a more “land and expand” approach and more companies adopting technology (augmented by extending SKU counts through drop-ship), PROS believes that it can sell to any company that does more than $100MM in sales. PROS has identified the 7,500 largest global companies as potential customers. In total, this results in a $22B total addressable market (TAM) for the B2B market. Over time, PROS could go further down market and add an additional $5B TAM (per JP Morgan initiation in Fall 2016). PROS identifies an additional $1B TAM in the B2C market, comprised largely of travel companies. All this is to say that with less than $200MM in revenue, PROS has an extremely long runway in front of it. If you include competing solutions and in-house products, PROS estimates that the market is 10-15% penetrated. I have no way of getting granular on this claim, but since first investing in PROS during the summer of 2016 I have made it a point to ask every company we meet with whether they use any form of pricing software. I am shocked at how often the answer is “no”.

Rounding out our discussion of the non-airline business, I’ll touch briefly on their product offerings. The products PROS sells are grouped into two families – PricingPRO and SellingPRO. PricingPRO has two modules – Control and Guidance. Control is a centralized hub for managing the pricing process. It allows companies to replace manually updated spreadsheets with a single reference point for price management, pricing strategy and execution. By using Control, a company can instantly identify areas where revenue and margin are “leaking” and then pushes out data visualization and change management tools to achieve desired pricing outcomes.

The Guidance model houses the data-science and machine learning capabilities that create price recommendations. These price recommendations are made at the customer level and help maximize the value for each transaction based on numerous variables such as customer size, geography, historical purchasing activity and real-time factors such as commodity prices or certain industry conditions (ie – tight supply/demand scenarios). Like Control, Guidance also comes with data visualization and change management tools that help put recommendations into practice.

The family of SellingPRO modules focuses more on the sales process by giving sales people tools needed to quickly and effectively quote new business and improving the customer buying experience. PROS brands the SellingPRO experience through there Modern Commerce initiative, which maintains that the B2B experience needs to look more like what we all have become accustomed to on the B2C side. There are four modules within Selling PRO. In a feeble attempt at brevity, I’ll just list the three smaller modules (DealDesk, Opportunity Detection and eCommerce) and give a short background on SmartCPQ, the most significant of the four. SmartCPQ presents salespeople with a toolkit used to prepare customized proposals. The business was acquired in 2013 for $33MM and was previously called Chameleon. Since its acquisition, PROS has added functionality like virtual reality, which they demoed at their 2017 Outperform Conference. The stand-alone CPQ space is quite competitive. There are probably a dozen reasonably-sized competitive offerings from the likes of SalesForce (acquired SteelBrick in 2015 for $360MM) and IBM (BigMachines; acquired in 2013 for $400MM). Current and prospective customers have offered positive feedback on the acquisition and integration.  Most seemed to have liked Chameleon when it was independent, stating that it was competitive with BigMachines and well-suited for situations that required significant configuration (i.e. products with lots of specs). Several note that by combining CPQ with PricingPRO, PROS becomes a complete solution that takes a company from bid to close in a way that no one else can. Commenting on CPQ competition, CEO Andres Reiner says that other solutions “just help you fail faster.”

Competition

As stated previously, at ~$180MM in run-rate revenue, PROS is roughly 2.5x larger than the second largest player in the space. The two largest competitors, both private, are Vendavo (estimate $80MM in revenue, with significant perpetual license/on prem sales) and Zilliant (estimate $40MM in subscription revenue). We have also heard that Price f(x), a European startup, is gaining ground at the SMB level.

Vendavo’s business is most similar to PROS. Most of the consultants we spoke with said they only worked with Vendavo or PROS at the enterprise level. Like PROS, they offer several data visualization and change management tools used to monitor and implement pricing tools. It is comparably priced and has several large customers such as Dell and Dow. Historically, many of Vendavo’s customers were acquired through their partnership with SAP. Until about two years ago, SAP salespeople were paid a 40% commission when they sold Vendavo products. Despite this partnership, several people that we spoke with commented that PROS integrated much better with SAP. For instance, PROS integrated with SAP Hana a year before Vendavo.

Based on feedback from a former data scientist at Vendavo and a former Deloitte consultant who specialized in pricing, Vendavo’s pricing science is much weaker than PROS. In certain scenarios, Deloitte would elect to deploy an in-house pricing algorithm instead of Vendavo. PROS employs over 50 data scientists. I do not know how many data scientists Vendavo employs, but I think it is only a fraction. Given that Vendavo is owned by private equity (Francisco Partners), I suspect that it is unlikely they will accelerate their investment in data science. As a former PROS CMO told us, “the gap between PROS and Vendavo is wide, and getting wider.”

Unlike Vendavo, Zilliant is generally thought of as having strong data science, but lacks in its analytics and change management tools and struggles to scale across a large corporation. Zilliant skews to more of a mid-market customer base and is perceived as being low cost, but we have also heard of scenarios where pricing for larger-scale deployments is similar between PROS and Zilliant. In addition to having strong data science, Zilliant has also done a good job developing some additional ways to deploy their algorithms outside of strictly pricing. They are branding these extensions as an “IQ Platform.” Sale IQ is the module that came up the most in our conversations. It identifies customer retention and growth opportunities by making product recommendations (i.e. finding products that are bought by similar customers). PROS rolled out their competitive response, Opportunity Detection, in September 2017. Although the extension of their applications will likely result in certain customers selecting Zilliant over PROS, we think that PROS will continue to copy their more successful products and that any advantage that Zilliant holds will be short-lived.

Our research has taught us that customer reference-ability is critical because most people don’t really understand the science behind the recommendations. We think this creates a material incumbent advantage. As a result, we believe that the current industry structure, in which PROS and Vendavo are leaders and Zilliant is somewhat of a visionary (to use Gartner terminology), is likely to persist. All three are likely to grow, and new competitors like Price f(x) will certainly crop up from time to time. At some point, there will likely be an acquisition spree by the likes of SalesForce, Microsoft and the ERP players. While an acquisition of one of PROS’ competitors is a headline risk, we think the business impact would be minimal. Should SalesForce strike first, perhaps by acquiring Zilliant or Price f(x), we would expect that Microsoft would acquire PROS.

Acquisitions

PROS has completed three acquisitions in the past three years. All have been technology purchases. The first was SignalDemand in December 2013 for $13.5MM. The acquired company had developed algorithms that focused on product mix and commodity price inputs. While I don’t know what specific revenue is related to SignalDemand, in the periods following the acquisition analysts attributed most of their then $7MM subscription revenue to SignalDemand, implying a very modest revenue multiple. Four years later, the technology is fully integrated and PROS has many customers who rely heavily on their mix and commodity price capabilities. The second acquisition was the aforementioned CPQ provider, Chameleon, for $30MM. While again I don’t have specific numbers attributable to the acquisition, nearly every conversation we have had credits the integration of Chameleon into PROS as the key reason why PROS is now viewed as the market-leading, end-to-end solution. It must have worked reasonably well, because just this summer Vendavo acquired their own CPQ solution (in the words of Oscar Wilde, “Imitation is the sincerest form of flattery that mediocrity can pay to greatness.”)

PROS acquired Vayant this Fall for $35MM with some of the proceeds they received from a convertible note they issued in June (allaying our concerns that the convert was a signal they didn’t think they could internally generate the cash needed to pay off their 2019 convertible maturity). Vayant is a SaaS provider of shopping, pricing and merchandising technology for the travel industry. They are based in Bulgaria and do about $7.5MM in revenue.This video helped me visualize what Vayant does - https://www.youtube.com/watch?v=jRDMi8UU0JQ. PROS has stated that Vayant should grow in the mid-20% range. I think they are sandbagging big time here.

Without knowing it, we crossed paths with Vayant a few years ago when we were researching the global distribution systems (GDS) space. The GDS is essentially a middleman between airlines and travel agents. The airlines communicate their seat and ancillary availability to the GDS’ and the GDS’ consolidate and deliver the content to travel agents. It is a pretty antiquated set up and ripe for disintermediation. There is nothing modern about selling products with static prices over a blue screen.

One of the most concerning cracks in the relationship between the airlines and GDS’ came about in 2015 when Lufthansa started adding a €16 per ticket fee to seats booked through a GDS channel. Here is a link to the announcement -

https://www.brusselsairlines.com/it-it/corporate/press-room/detail.aspx?PRID=tcm:313-35931-16. Basically, Lufthansa was tired of paying a “three-digit million euro amount” to GDS’ for a service that “cannot adequately display the individual offers, with their variety of product components.” Sounds like a problem, and one that’s not at all unique to Lufthansa.

Lufthansa was able to break ranks with the industry because of the capabilities that Vayant brought. The airline became Vayant’s largest customer in 2013 and invested in the technology startup in 2014. At the time, many speculated that Lufthansa would eventually fold in Vayant. This belief likely stymied their ability to win business from competing airlines. Now that Vayant is in the hands of PROS (a service provider airlines already do a lot of business with), I think it is quite reasonable to expect a much accelerated growth rate. Although we can’t quantify how big the Vayant business will become, I think the opportunity is material relative to PROS’ current $180MM revenue base.

Cash Flow and 2018 Guidance

As noted previously, while PROS share price has risen in 2017, it has materially lagged its software peers and has underperformed relative to its strong financial performance. I believe that PROS’ underachieving stock price is mostly attributable to increased 2017 cash burn relative to initial guidance and 2018 commentary that, at first glance, suggests the business is slowing. I’ll spend a few moments dissecting these numbers and, hopefully, demonstrate why they set up for a strong lineup of 2018 news flow.

Below is a comparison of the initial 2017 guidance and current guidance (all numbers taken at midpoint; current revenue, ARR and subscription revenue guidance backs out Vayant contributions).

As you can see, PROS has come in better on the key revenue numbers (ARR and subscription) but they are consuming loads more cash than expected (as a quick aside, meeting guidance is no small feat; if the market priced in PROS’ guidance then the stock would be materially higher). So why if they hit their revenue numbers did cash flow come in so much worse? Is there a cash earnings problem? No (sorry, rhetorical questions really are the worst).

Below is a breakdown of the $11.5MM cash consumption delta. These numbers are my estimates.

Azure Prepayment: On the second quarter call, CFO Stefan Schulz commented “we restructured our primary cloud provider agreement for another three years, which will provide us with additional economies as we continue to grow our cloud business in the future. This new agreement required a significant cash payment in the third quarter, which will negatively impact free cash flow in the third quarter.” I believe the prepayment was around $5MM and that they will get a 200bps (or around $4MM) uplift in 2018 margins as a result of the restructuring.

Vayant Loss and Integration: Also on the Q2 call, CFO Schulz stated that Vayant would “slightly increase our loss and free cash flow burn in the first 12 months.” The cash flow loss was called out as $1.5-2MM for 2017. As discussed in the prior section, I think that Vayant will be a much larger, more profitable business inside of PROS.

Unforeseen Parallel Computing Costs: This is one area that reflects negatively on the company’s 2017 cash situation; but the impact will be short-lived. As PROS moves more workloads to the cloud there is a period where you have duplicative on-prem costs. The transitions took longer than expected and more legacy costs were incurred. Even still, this issue will not recur in 2018.

Client Billing Timing: Based on a post-road show download conversation with Needham analyst Scott Berg (who is great and has PROS as his top 2018 pick), there are a few chunky customer cash collections that are expected to hit in early 2018 versus 2017. Unless this becomes a trend, I don’t find this concerning.

Additional Interest Expense: At the beginning of the year, PROS was not planning to issue a convertible note mid-year. The 2% coupon on $106MM shakes out to a little over $1MM in additional interest expense.

So now that we have a handle on why PROS burned more cash in 2017 than expected, what should we be thinking about for their 2018 cash flow target of break-even? On the Q3 earnings call, Schulz gave an initial look into 2018 that, frankly, wasn’t communicated very well given how many moving pieces there are.  He commented that that 2018 revenue would grow 10-12%, or $18MM, subscription revenue would grow around 50% (or $28MM) and that cash flow would improve by “at least” $30MM. So how does that work? Well, when dealing with software businesses, changes in billings (i.e. cash in the door) are a better measure of changes in cash flow than revenue (i.e. how GAAP says you should recognize cash coming in the door). In other words, reported revenue is a lagging indicator for the cash generation of the business.

In round numbers, at year end 2017 the ARR (which is a measure of how much annual recurring contracts the company has at that point in time and is a good base for predicting next twelve months revenue) will be a little bit higher than $157MM. This is about $35MM more than the ARR at the end of 2016. Assuming cash collections on new ARR booked and collected throughout the year roughly net out the hit from declining license and maintenance cash collections, cash receipts should improve by around $35MM which, from an adjusted prior year cash burn of around $20MM, paints a picture for how cash generation will move into positive territory by year end.

But it wasn’t just the cash flow guidance that required some unpacking. The top line 2018 revenue number was below consensus and the subscription growth rate implied about a 1000 basis point (60% stepping down to 50%) deceleration from the Q3 2017 growth rate. As for the top line, I think the difference is attributable to consensus not factoring in enough of a headwind from license declines (+50% year over year decline in 2018), maintenance declines as a result of conversions to subscriptions (likely to decline high-single digits in 2018) and a relative decline in the amount of professional services required to stand-up new customers (expected to be flat year-over-year despite revenue growth). In any case, these revenue sources have little to do with the long-term value of PROS. It’s all about the subscription revenue growth. So how do you reconcile the optical growth rate deceleration? Again, here is a snapshot of adjustments to subscription revenues.

Backing out contributions from Vayant and a 500 basis point impact from ASC 606 (which is a 2018 GAAP change that modifies how companies book services revenue) and we can find that the CFO was really just trying to say that the business would continue to grow at its current rate. I think that he intended to set this as a floor and didn’t put a whole lot of thought into how people would receive, what looked like, a deceleration. As maintenance to subscription conversions pick up throughout the year, quoted revenue growth rates will only improve.

As highlighted in the Q3 earnings call, on the next quarterly call the company will provide formal guidance for 2018 and offer additional metrics that should shed light on the cloud conversion. I don’t think the market is banking on any additional metrics and, as we have seen elsewhere in the software space (i.e. ServiceNOW), multiples tend to improve materially when management gives more color into the specific vectors of growth. Bottom line, I think that company communication will turn from a headwind to a tailwind in 2018.

Financial Forecasting

On the heels of a year in which cash flow burn ended up being 50% more than initially expected, and yet I maintain that the value of the business is completely intact, I think it is important to recognize that we are still in the fairly early innings of the cloud conversion and that financial metrics are going to remain in flux for the next 12 to 18 months. During this window, I am most interested in seeing subscription revenue and ARR growth accelerate as the pipeline grows (deal volume was up +30% first nine months of 2017), maintenance revenues convert to the cloud and the effects of the land-and-expand strategy start to bear fruit. While we will certainly monitor gross margin expansion and sales and marketing efficiency, billings growth is the focus. Margin expansion will be a story for 2020 and beyond. At the risk of presenting numbers that I am 100% certain will not be correct, below is our rough estimate for how the business should evolve over the next five years. I think the key to this analysis is to demonstrate the inflection in revenue growth, and the corresponding rapid decline in the recurring revenue multiple that you are paying when you buy PROS today.

Primary Risks

Strategic acquisition of a competitor

New entrants

More desire to keep pricing in-house

Appendix A

Disclosures / Disclaimers

This is not an offer to buy or sell a security. The ideas expressed in this posting are the views and opinions of the author of this posting (Author).  Author has no obligation to update any of the information contained herein and has no obligation to update the posting to reflect any changes in the Author’s opinion on any of the companies or topics contained herein. Do not rely upon the information contained in this posting for making investment decisions; prepare your own analysis or contact your financial advisor. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  Past performance is not necessarily indicative of future results, and there can be no assurance that targeted or projected returns will be achieved.

Catalyst

full 2018 guidance

additional reported metrics

revenue growth acceleration

margin expansion

free cash flow generation

potential acquisition target