Description

QAD (FYE in Jan makes years confusing so have adjusted to CY in some verbiage)

QAD was written up by Conway968 in 2015. We encourage readers to check out the writeup for an overview of the industry and company before going through this. We won’t cover the basics of the business that Conway discussed and will instead focus our writeup on our points of differentiation, current setup, product advancements, and what has changed. We would comment that since Conway’s writeup, market adoption and acceptance for the cloud has certainly accelerated and the company has performed better than expected on its cloud initiatives.

We see +50% as the easy money over the next 6-12 months and a path to 2x - 3x over 3 years with minimal downside at these levels.

Punchline – opportunity to own an underfollowed, high quality software company at <3x recurring revenue where growth should accelerate in the years to come with great r/r skew.

Investment Thesis

1. Large market supports long runway for growth
2. Shift to SaaS obscuring GAAP growth and profitability
3. Subscription and recurring revenue growth likely to accelerate meaningfully from here
4. Large discount to private market value supports downside

Financial Overview

• Subscription revenue has grown from $38M in CY15 to $92M in CY18 and is projected to grow 20%+ this year accelerating to 30% in the 2nd half
• Maintenance revenue has declined from $133M in CY 15 to $123M in CY18 due to conversion to subscription.
• Total recurring revenue has grown at an 8% CAGR in the last 3 years and is accelerating due to the transition
• Converting maint revenue to subscription tends to drive a 3x uplift and thus there is an incremental $350M of subscription revenue to be mined from simply the existing customer base
• Current enterprise value is $650M

Detailed Investment Thesis

We think that #1 and #2 above are fairly self-explanatory – manufacturing software is a $50BN market, ERP is likely 10%-15% of that spend and cloud penetration is very low today relative to other sectors due to the complexity of ERP in general and then in particular due to the slow pace of tech adoption within manufacturing (QAD’s core market). The SaaS delivery method of write-once and deliver the same code out of the box has not been as conducive to ERP as simpler industries like HCM. However, we believe that after years of investment by the industry as a whole, the technology is now where many other industries were a few years ago and at a tipping point. We will focus most of the writeup on our points of differentiation vs the market that drive our view of points 3 and 4.

Thesis Point 3 - Subscription and recurring revenue growth will accelerate

A) Industry hitting growth part of the S-curve

At a high level, we think that cloud ERP industry as a whole is in the sweet spot within the s-curve.  The below graph from Sequoia shows, growth phase typically happens at ~15% penetration.

Cloud penetration for QAD below (based on seats disclosure and our estimates) lines up nicely with the above S-curve

Other comments from other players in the ecosystem (Infor, SAP, Kinaxis, System integrators) have corroborated this dynamic and the number of enterprises actively looking to refresh their ERP have never been higher. This trend has been accelerated by 1) broad industry adoption for cloud in other industries 2) SAP’s decision to sunset support for its non HANA business by 2025 and 3) the fact that the underlying technology has improved to a point where a cloud delivery model makes more sense then the more customizable though expensive on-prem model. One interesting stat is that win rates for QAD are currently only 25% today. However, this is because 50%+ of RFPs end up in no decision as companies defer these decisions. As enterprises increasingly adopt cloud ERP, win rates / incremental revenue growth increases no-decisions go to 0. Beyond the broader industry, there are also a number of QAD–specific factors that will start to become tailwinds for the company.

B) Channel Islands Launch Accelerate QAD’s growth

Channel Islands is effectively QAD’s new cloud product launch. The company has been investing a significant amount into the product over the last 5 years and this just went GA last September. There are a number of companies piloting the product and QAD will use its explore conference in May as a tool for a more aggressive marketing push. There are three significant benefits to this product

• First are UI upgrades that make it possible to generate insights from the ERP on any device with built-in charts and analytics. Real time insights are a big deal in manufacturing as it allows for companies to react to shocks in the system like long lead times or trade wars - better faster decision-making adds significant value and is not simply a normal course UI face lift. Incremental to this, deal sizes increase as seats can be sold to more users as more folks can readily access the data in a easily digestible form – a study by Mint Jutras estimates that SaaS ERP sells ~25% more users than on-prem
• Secondly, Channel Islands is built modularly which allows for portions of the enterprise to upgrade to the cloud before others. E.g., can just shift the financial department first vs shifting the entire org. This change will help to accelerate cloud adoption and drive wholesale “no-decisions” down.
• Thirdly, as mentioned previously, one of the biggest knocks against single instance multi-tenant software in ERP is that it is too complex to be built in this model. Channel islands solves this issue by having a single code base underlying the core but allowing for individual enterprises to write applications and workflows on top. This architecture should also accelerate cloud adoption. 

C) Accelerating Investment Post Channel Island Launch

One detractor of the business historically has been that it has been run as a lifestyle business. We believe that the appointment of new CEO Anton Chilton + a newly announced plan to hire an incremental 100 headcount in sales is a positive sign that mgmt. sees the inflection point on the horizon for the space and are attacking the market in a way the organization has not done previously.

D) Historical Investment in S&M / Customer Success

QAD has arguably over-spent on customer engagement and satisfaction historically. As cloud penetration inflects, they should be able to harvest some return on this investment in an accelerated fashion. These are long sales cycles and QAD have been having conversations with each of their customers for the last 5 years. Once the organization is ready to make the switch, QAD will be in a prime position to capture higher share than orgs who have put in less investment.

E) Progress / OpenEdge

QAD is unique in that they are written on Progress / OpenEdge. DB-Engines provides a good overview landscape and popularity of various databases. We would not read much into the quantitative numbers given their data collection methodology but rather the takeaway here is the relative market share. The bottom line on the chart below (the y-axis is logarhythmic so makes the scale look a bit off) is Progress. From a ranking perspective, Progress is the 75th in terms of popularity, down from 70 last year.

The implication here is two fold. First, it was an incremental pain point for enterprises to buy QAD on-prem depending on their existing tech stack, since companies who did not already have a Progress stack in house and the engineers to support it would have viewed this as a negative. The move to the cloud gets rid of this pain point. QAD has somewhat proved out this thesis point in the early days of cloud, having already added ~25M of subscription revenue from net new logos over the past 3 years. Secondly, existing on-prem customers now have an incremental reason to move to the cloud as they can rationalize their in-house Progress footprint. Even without employee rationalizations, QAD can save their customers money and time by getting rid of HW costs. Including employee rationalizations, the payback and ROI is much more significant.  See below case study for example.

F) Temporary issues driving revenue deceleration

One issue that cropped up on the past earnings call and sent the stock down 8% was a sales execution issue in EMEA. As quoted on the call:

“North America, our most mature market, had a strong finish to the year both in the cloud and on-premise businesses. Asia Pacific and Latin America experienced the fastest growth in the cloud, and this could signal an acceleration of cloud adoption in both those regions. EMEA, however, had a disappointing year, suffering from various execution issues. We've already implemented a number of management changes designed to get our EMEA business back on track over the next couple of quarters.”

Reading this alone, it is easy to interpret as a market or macro issue that has implications for long term growth. With some more context, we realize the issues are much more fixable and transitory.

By way of background, Karl Lopker, the old CEO, tragically passed away the middle of last year. Anton Chilton (old global sales & services) was promoted to CEO and Ed Boclair (old Head of NA sales) was promoted to Global head of sales in December of 2018. The company has confirmed that execution issues in EMEA was a result of unexpected churn out of the salesforce the end of last year (some not by choice) and as a result, deals in the sales pipeline of these individuals did not close as a result of the departures. However, upon reviewing LinkedIn data, we noticed that the head of EMEA sales, JC Walravens, recently left the company. Our checks have suggested and the slide below illustrates those three as the successors to the Lopkers. As the head of EMEA sales, JC’s departure likely drove a big chunk of the miss in Q4 bookings. Q4 is a large quarter for any software company and as a result, this will impact the first half of FY2020. While employee turnover is always a negative (particularly a strong executive as JC), this is a very fixable issue and we expect growth to rebound.

In addition to this, PS revenues were also guided to decline 10% due to the lapping of a large implementation project – this drove a big chunk of revenue miss vs street which is immaterial to the LT value of the company.

Lastly, there may be an element of the new CEO setting the bar lower for beat and raise. The company has already closed more cloud business in the first quarter and the entire quarter of the previous year. Furthermore, QAD does not usually put out press releases except for significant deals and they have already put out two in the last few weeks.

Thesis Point 4 - Trades at significant discount to private market value due to Lopker control and relative illiquidity

One thing that gives us comfort in the downside protection here is simply the sheer value discount to the private market value of the company. To be clear, this is not an actionable take-out candidate or activist name given the Lopker’s class B shares but the magnitude of the discount is worth highlighting. As the company continues to execute on cloud growth, we believe this discount to fair value will diminish. Importantly, you don’t need the discount to go away for the investment to work out given the growth of the cloud, just an incremental free option on top.

The chart below summarizes our view of what a PE or strategic could do to improve margins without having an impact to growth rates. These are fairly uncontroversial changes that we think are conservative and help illustrate the opportunity here.

It is clear that any reasonable EBIT multiple on a growing high retention software business would lead to meaningful upside relative to the current $650M enterprise value.

• Professional services margin – virtually every other software company looks to make 15%-30% gross margin on services revenue. QAD simply looks to break even on the spend. Just charging 20% gross margins would add 17M of EBITDA.
• Efficiency of opex – as outlined by Conway’s original writeup and confirmed through our research calls, review of org chart, and comps to similar vertical software companies with high retention, it is very clear there is improvement potential in expense management. A strategic could very easily plug QAD into their existing salesforce and cut the majority of S&M and G&A expense. PE could likely capture ½ of these savings without impacting growth.
• Latent Pricing Power in core – our checks have suggested that comparable SAP products are priced at 3x – 10x QAD for modules that are in-line from a feature perspective. We just put 20% as a placeholder. 

Lastly, part of reason the discount exists is that there are no obvious comps for the company as nearly all other industries have made the switch to SaaS already and manufacturing ERP is a fairly niche space. One thing could help bring attention to the value here are potential IPOs of Infor and/or Plex. Infor is a larger $3bn revenue company also making the transition to cloud ERP from on-prem. Plex is a pure-play SaaS company – they were reportedly seeking a $1bn valuation as of 2017 on $100M of total revenue (likely same mix SaaS vs PS revs as QAD implying 12-13x multiple on the SaaS revs) and growing at similar rates.

The last point we would make on downside protection is simply the reaction of the stock after the last print. When a company guides for decelerating subscription revenues to have only a modest impact on the share price. However, we think QAD has found real valuation support at these levels and any sign of acceleration sends the stock up meaningfully. 

Why does the opportunity exist?

• Underfollowed company with low float
• Lack of stock price recovery after December sell-off due to lack of fundamental buyers
• Temporary EMEA issues driving weaker than expected FY2020 revenue growth

Model and Return Math

Below are some base case estimates. Basically with cloud continuing to grow, others shrinking, modest margin expansion. To be conservative, we are using a reasonable recurring revenue multiple on accelerating recurring revenue. EBITDA multiples could be higher here as well due to the latent margin expansion opportunity at CY22 (Vista could take margins to 40%). You don’t need to believe high multiples here to see a good return.

Catalyst

• Beating and raising sub growth next quarter (have been some good press releases and bookings for first month already larger than Q1 of last year

• Subscription revenue acceleration back half of the yearCommentary from Explore conference

• IPOs of direct competitors

• More attention on underfollowed company

• Rotation from software names that have worked