QRS is trading at an EV/EBITDA multiple of 3, EV/EBIT of 8, EV/Revenue of 0.40 . The stock price declined substantially this quarter after Fidelity sold over 1 million shares in the first three months of 2004.
For the past 15 years, QRS has been providing software solutions for over 10,000 customers in the retail trading community, mostly from the General Merchandise and Apparel(GMA) industry in which QRS has a dominant market share. Their business has three segments: Software Applications (including enterprise software), Global Services, and Trading Community Management (EDI). Aside from the typical license and service business model, QRS has two businesses that are atypical of other software companies. First, they have a recurring, volume-based electronic data interchange (EDI) business, which they call the Trading Community Management. The EDI business allows retailers, vendors, and trading partners to save on paper and manual input costs by transmitting electronic documents such as invoices, purchase orders, and advance ship notices. Second, they have a business intelligence business, where they manually collect pricing information at retail stores and package the collected information as a competitive business intelligence product.
A former high-flier, QRS is also a victim of the acquisition binge that happened during the heydays of the B2B boom. From 1999 to 2001, it acquired 4 companies (including Tradeweave which was initally an investment), costing QRS over $180 million, most of which QRS paid for in stock. In the third quarter of 2001, a new CEO was brought in. In the same year, as part of a restructuring move, QRS integrated its Tradeweave operations into QRS, discontinued other product lines, and took restructuring charges of $16MM and impairment losses of $120MM.
The business environment for applications software companies has been very difficult over the last three years. The Software Applications group is the worst performing group in the S&P 500 in the last five years. Companies like Ariba, I2, are either trading as penny stocks or have disappeared into oblivion. Consolidation among retailers, economic conditions, lack of corporate spending, competition and continued pricing pressure in the EDI business caused QRS’ revenues to decline. In 2002 and 2003, QRS took additional restructuring expenses of $9.7MM and $11.3MM. In 2002, QRS discontinued several unprofitable software product lines, which accounted for the 7% drop in their software applications revenues for 2003. Revenues for the first half of 2004 will probably show zero if not slightly negative growth.
Despite the negative recent history, there are redeeming tidbits to the QRS story. Unlike Ariba, I2, or the others, QRS has been in business for 15 years. It did survive one of the harsher environments of the last three years. It generates free cash flow. Eighty percent of QRS’ revenues are still recurring and not dependent on product cycles. Switching costs are high. The software requires installation on both the vendors’ and retailer’s systems. There are network effects. Switching to another provider would be very disruptive. They have the largest footprint of GMA retailers. Their catalog is the industry standard with over 100 million items versus the 2nd biggest catalog which has 65 million items. They hardly lose their customers. They have built a dominant market share in the challenging, high turnover fashion industry. All in all, they seem to have built substantial barriers to entry. Competitors have either perished or have been acquired. (QRS’s current two primary competitors are Sterling Commerce and GXS. Sterling Commerce was bought by SBC in 2000. GXS was acquired by a private equity group from General Electric in 2002.) Their competitive advantage seems intact. One very satisfied customer I interviewed told me that they cut their EDI budget by 30% after they switched from Sterling to QRS. Furthermore, now in its fourth year since they started to restructure, QRS is nearing the end of the first phase of their three pronged strategy. Except for the expected decline in TCM segment (the TCM segment includes a business segment totaling 2 million which resells leased line. This should go down to zero eventually), revenues in their software and services segment should improve and EDI pricing seems to have stabilized (In the first quarter of 2004, pricing showed an uptick although management was quick not to claim any sort of victory on this end). Its profitable first quarter surprised the analysts in the conference call. Gross margins are maintained at the 50% level.
The improving economy and some mandates issued by the large retailers are providing some reasons for vendors and other retailers to upgrade their software. One of the initiatives frequently mentioned in the trade magazines is the UCCNet. The UCCnet is a global online registry of product information. By asking its vendors to synchronize their data with the UCCNet, Target, Walmart and other retailers are making their vendors clean up their product database so that when they collaborate with the retailers’ system, the product descriptions and attributes match. The goal of this is when Target orders 200 cases of a product for its thousands of stores, the vendor’s information systems know exactly what Target wants. It is understood that data synchronization will have to come first before RFID can be adopted.
QRS has two new products for 2004. The first one is “QRS Impact”, which was launched in the first quarter of 2004. This product is designed to help vendors and retailers meet the objectives of the UCCNet. It will allow vendors to clean up and sync their product data behind a secure firewall. Unlike the competitors’ products, QRS’s product offers the same software platform between migrations, and it also offers data cleansing which is not available in all of the competitor’s solutions. It has a lower entry price point, and should the customer outgrow it, the customer can easily migrate to a more mature product because the products share the same software platform. Another advantage of QRS is its larger catalog size of 100 million data items. The second product, which is yet unnamed, is a transaction management product. It will allow complete visibility of the whole transaction management cycle. This is the first time in a long while that QRSI has announced new separate products. Prior to these two new product announcements, QRS’ previous announcements were simply modified versions of existing products.
Management is not offering any revenue or profitability guidance. I am estimating a zero growth in total revenues for 2004 and 2005 as the gains in the software applications + global services will be offset by losses in the leased line segment of the TCM business (as discussed above). However I think margins will go up by 1 percentage point. This business has minimal annual capex needs (about 3 million). It generates EBIT/(Total Invested Assets) of about 20 percent. For 1st quarter of 2004, operating margins were 4.25%. For 2005, I estimate operating margins to be about 6.5%. This is not overreaching, considering that adjusted operating margins averaged 5.4 percent last year. The discontinuation of unprofitable product lines and restructuring charges in 2003 should improve operating margins this year. Annual depreciation and amortization should be about $7.5 MM. Using 8 times FCF (EBITDA less maintenance capex), I come up with a value of $8.75 per share by the first half of 2005, an annualized gain of a little over 65%. It’s not that exciting, but given the recurring revenue stream and 15 year history of QRS, it is not a risky estimate. Any little surprise on the upside would be icing on the cake.