|Shares Out. (in M):||95||P/E||0||0|
|Market Cap (in $M):||309||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
|TEV (in $M):||251||TEV/EBIT||0||0|
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ServiceSource International (the “Company,” ticker “SREV”) is a B-to-B renewal sales outsourcing company that sells a sticky, high-roi (to its clients), recurring revenue product with limited competition, a strong lead in a minimally penetrated market, attractive cash flow characteristics, and net cash on the balance sheet. The Company was founded in 1999, IPO’d in 2011, is headquartered in Denver (formerly San Francisco), and employed about 3,100 people as of December 2016.
Elevated churn (more on this later) in Q117 combined with a slower-than-expected ramping of revenue from new bookings caused the Company to release Q117 and full-year 2017 revenue guidance well below expectations when it reported Q416 results. SREV then further reduced 2017 guidance when it reported Q117 earnings. With management’s credibility temporarily impaired, the stock has traded from $6.05/share prior to the Q416 release to under $3.20 and closed today at $3.24, leaving it at 7.4x medium-term EBITDA-Less-Maintenance-Capex (referred to hereafter as “EBITDAX”), when it should be more like 12x, which would imply a share price of $4.88 or ~51% upside. In addition, there is potential longer term upside of being a multibagger in the mid-teens.
ServiceSource essentially “created the category” for renewal outsourcing and is the only significant outsourcer of this function. A renewal sale can refer to the renewal either of a support/maintenance package that comes along with an initial purchase of a server package for example, or to the ongoing renewal of a subscription such as to a cloud security software product.
The pain point that the Company addresses is as follows: The sales process for an initial sale is much different from that of a renewal sale and requires a different skillset for effective handling. Simply put, outside sales forces are “hunters,” looking to find prospects, convince them of the value of whatever they’re selling, and close the deal. By contrast, an effective renewal sale requires largely administrative competency such as staying on top of all renewal dates for all of a customer’s products and being familiar with all of the key terms to the contracts that customers have signed. (Note that in this writeup I’ll refer to SREV’s customers as “clients” and to SREV’s clients’ customers as “customers”). Hunters are frequently neither interested in nor effective at managing these administrative functions, and so in many situations the renewal of recurring revenue becomes an orphaned process and renewal rates are lower than they should be. The client is thus left to either have their hunters do a mediocre job, or create an internal group focused on renewals.
SREV however offers a third solution, which is to outsource the renewal sale to a group of experts specializing in renewals. To be clear, most clients are not likely to be outsourcing their most important handful of enterprise customers. These high-touch relationships are managed in-house. However, SREV can provide several benefits to its clients in the management of the rest of the renewal sales:
(i) Benchmarking and client data analysis - SREV has been doing this for 18 years and has closed millions of renewal transactions. Thus the Company has built a significant data asset around (a) reasonable renewal expectations for different types of products, companies, and industries, and (b) best practices for analyzing client data in order to maximize the renewal opportunity. Thus it is easy for them to tell a client “your renewals are X, and based on our analysis of your business and the other companies in your industry that we’re working with your renewal rate should be Y, so we can help you get there.” Although I’ve seen less of this in their documentation recently, they used to advertise that they provided on average a 15 percentage point increase in clients’ renewal rates. This significant head start in leveraging client data to maximize the renewal opportunity provides a major competitive advantage relative to would-be competitors,
(ii) Simplicity - SREV allows its clients to offload an entire function (like outsourcing customer service, for example), resulting in a client that can focus much more on its core operations,
(iii) Increased sales productivity - with renewals off of their plate, hunters can focus 100% of their time on closing new business, and
(iv) a high ROI - SREV is usually paid a commission on renewals closed, meaning they only get paid when their clients get paid. In addition, SREV believes that it provides its renewal services at a lower overall cost (with higher effectiveness) than inhouse solutions. SREV “white-labels” its services, i.e. clients’ customers believe they are speaking with a sales representative from the client. It is worth noting that renewal revenue can be very high margin for clients given the lack of associated implementation costs, hunter commissions, travel and entertainment, etc., meaning that there is a significant return to increases in renewal rates. Conversations with SREV clients over the course of the last few years have confirmed that SREV’s services are indeed highly desired and appreciated for removing this orphan process from clients’ plates, and that it does actually provide an attractive ROI.
In terms of other quick overview information, SREV generated $253mm of revenue in 2016 with reported Adjusted EBITDA of $13mm (including an $11mm stock-based comp addback). Approximately 25% of its revenue was generated in EMEA and 10% in Asia-Pacific. The Company delivers its services from nine “Revenue Delivery Centers” in eight countries through which its ~3,000 “revenue experts” speaking 35 languages call into customers in 170 countries. SREV has approximately 65 clients across a number of industries including hardware, software, medical devices and industrial IoT equipment. See pages 15 and 16 of their “Q1 2017 Update” investor presentation for a more detailed list of subsectors and clients.
The Market Opportunity
Before I continue I should note the following: when you go through the Company’s investor presentation you will be bombarded by exciting ancillary opportunities such as outsourced inside sales, outsourced customer success, etc. It’s important to keep in mind that while these all make sense and might be significant value drivers in future years, nearly all of SREV’s current revenue comes from renewal sales, and the Company says as much in its Form 10’s. This is important because it limits the size of the Company’s TAM to ~$10 billion and reduces the degree to which it is worthwhile for potential competitors to invest significant resources in this space. In very rough numbers that TAM equates to a ~2.7% commission on $375B of renewable revenue (the Company’s most recent results imply a ~2.6% commission rate, which SREV has confirmed as ballpark). My own research (nothing particularly fancy, just scraping around for data on the sizes of various industry segments) implies $300B to $500B of potential renewable revenue that they can attack. Impossible to get precise on this, but for sure it’s big enough for the Company to multiply in size several times (SREV currently manages approximately $10 billion of client recurring revenue streams). In addition SREV states that it has identified 1,000 target potential clients vs. its current base of 65 clients.
Although SREV’s direct, comparable competition is quite limited, it makes sense to give a brief overview of who/what they’re selling against. Their “competition” can be divided into a couple of categories: (i) customized versions of CRM or ERP tools such as Oracle/SAP/salesforce.com/NetSuite, etc. that are often customized by (ii) consulting firms such Accenture, (iii) recurring revenue software products such as Aria Systems or Zuora, or (iv) fully insourced renewal sales teams (page 19 of the Company’s investor presentation gives an amusing though probably self-indulgent look at the many different functions that a client may need to cobble together to create an effective renewal sales operation). The common thread among all of these competitive solutions is that they generate costs for the client without offering any guarantee of success, thus leaving the onus of actually generating renewal sales on the client. By contrast, SREV provides a turnkey, pay-for-performance solution whereby SREV takes all of the responsibility and risk for clients’ renewal sales. Regardless of the resources that the Company dedicates to a client under such arrangements, if renewal sales aren’t generated, SREV doesn’t get paid. Thus the above-mentioned high ROI that SREV offers is also a strong selling point because it is easy to measure and compare, and clients often have some idea of how much they currently have to spend in order to generate X dollars of renewal revenue.
So What Happened? Chapter 1 - IPO through Q316 Earnings Release
Basically this company didn’t transition soon enough away from their visionary entrepreneurial business-builder management team under Mike Smerklo, who helmed the Company from 2003 until 2014. Just as renewals are essentially a boring business, by the time SREV exceeded $250mm of revenue, what it needed was a boring management team focused on blocking and tackling to keep client satisfaction high, to push penetration of additional recurring revenue mandates within existing clients, to sign new logos, and to control expenses. Instead what it had was a CEO trying to turn it into a software product company. The kernel of the idea wasn’t terrible - sell SREV’s internal technology platform to clients so that they could replicate SREV’s expertise inhouse. However the idea ignores the simplifying value provided by SREV’s fully outsourced solution, causes confusion about whether the SREV is just a CRM product company, and most importantly, execution was very very poor. Significant resources were pulled from the outsourcing side of the house in order to develop and sell the software platform (called Renew OnDemand) at a time when resources were already strained due to extremely fast growth. The SREV salesforce was highly incentivized to make sure that any deal they were selling to clients included a software component of some sort. This is problematic because selling software and selling outsourcing are two very different things. When you’re selling outsourcing, you’re usually selling an “outcome,” and you have responsibility/control over creating that outcome. If you’re selling someone a piece of software and promising them a certain outcome, that is an excellent recipe for an unhappy client if the client is unable to wring the promised outcome from the software they’ve purchased. So the combination of constrained resources and poorly structured statements of work (i.e. promising results and instead just delivering software, and then spending significant amounts on external resources in order to try to deliver the promised results, leading to negative cash flow) resulted in service levels going from good to unacceptable, as confirmed to me by employees and former employees of the Company. This inevitably resulting in elevated churn while the confused go-to-market strategy performed poorly in winning new business. As a result, revenue growth went from 40% in 2010 (prior to March 2011 IPO), to 35% in 2011, to 20% in 2012, to flat in 2014.
Finally in 2014 Mike Smerklo resigned and the Company brought in Chris Carrington, a career BPO executive who had overseen a turnaround at Alpine Access, resulting in a sale to Sykes Enterprises. A comment that Chris made early on I thought summed up the situation very well (my paraphrasing) “this isn’t a fancy software company, this is just a nichey BPO company, and we are at the beginning of a large opportunity in revenue-related outsourcing, so if we just execute on the simple stuff, this company should quadruple in size.”
At the time that Carrington joined SREV, the cycle of (i) investment in the Renew OnDemand platform causing (ii) unhappy outsourcing clients causing (iii) general sales weakness causing (iv) further spending to try to prop up the core business drove gross margins from the mid 40s to the mid 20s and EBITDA to negative $20mm. Carrington cut expenses very quickly and worked to offshore some operations, driving gross margins back above 40% and generating $5mm of Adjusted EBITDA in Q416. In addition, he brought in a number of new executives and refocused the company on client satisfaction, raising retention rates back up near historical norms and restoring the solid platform from which the Company could grow, resulting in revenue growth going from negative at the end of 2014 to +5% in the second half of 2016. During this time the stock price rose from under $3 per share to the mid $5s and as high as $6/share.
So What Happened? Chapter 2 - Q416 Earnings Release to Today
When SREV reported Q416 earnings, the Company’s revenue guidance implied a 5% decline for Q117 and flat for 2017, which was a significant departure from the path toward double-digit revenue growth that SREV had been on. This sudden increase in churn mid-first-quarter was caused by (i) Cisco (a major client) discontinuing a number of products for which SREV managed renewals, as part of its transition to become more focused on software and subscription products and (ii) the bankruptcy of Avaya, a top five client of SREV’s. In addition, Carrington stated that the larger, global deals that they had been signing were taking longer to ramp revenue than they had projected (this is the process of analyzing and integrating client data into their own operations and getting set up to call on clients’ customers). As a result the stock traded from over $6 per share to the mid/high $3’s.
When SREV then reported Q117 earnings, management stated that as of the prior earnings release the situation had been “fluid” and “dynamic” and they had since done a deeper dive on their calculation of ACV (Annual Contract Value - a measure of the amount of revenue the Company expects to generate from the contracts that they’ve signed with clients. Note that the amount of time required to ramp revenue on a new contract can cause revenue for a specific period to trail starting ACV for that period) and were further reducing guidance to an 8% Yoy revenue decline for Q217 and a 5% decline for 2017. Importantly, this was not due to additional losses of business, but rather due to a more detailed (and, I assume conservative) look at the ramp of new business wins. SREV also announced that it was undertaking $20mm of annualized cost reductions and that it expected to be “sustainably free cash flow positive” by the fourth quarter of 2017. Following this earnings report the stock price fell below $3.25/share and then floated around in the $3.50 to $4.00/share range.
The Company’s Q217 earnings were a bit anticlimactic relative to the prior two quarters, with a revenue decline of 6% (meeting high end of guidance) and reported Adjusted EBITDA of $4.7mm (exceeding guidance) while maintaining full-year 2017 guidance. Two things to note on the quarter: (a) guidance implies a sequential decline in Q317 revenue followed by a meaningful sequential increase in Q417. The Company attributes this to normal seasonality (driven by the amount that SREV is able to sell to customers within the context of its existing contracts during summer months, rather than by the winning/losing of contracts themselves), which is reasonable if you look at Q3 and Q4 sequential revenue changes over past years (though not in 2016) and (b) the Company has decided to reduce the amount of guidance and financial detail they give out on a quarterly basis in order to be more like “other publicly traded tech-enabled service companies,” so from here on out it’s annual revenue, gross margins, operating expenses, and profitability with quarterly affirmations (vs. much more detailed quarterly guidance historically). Also, because business lines like inside sales don’t really fit into an ACV/churn framework, SREV will no longer give out ACV or churn figures. I don’t have anything particularly insightful to say about this, but obviously more information is better than less and I don’t love it when companies reduce the amount of info they give out. Perhaps as a result (and, I imagine, investor fatigue), the stock price has drifted from ~$3.75/share prior to earnings to $3.24/share as of today’s close.
Final note - the Company announced today that Steve Cakebread is resigning from its board at the end of the year for personal reasons and not due to any disagreements with the Company, likely causing further investor fatigue and resulting in another 5% decline in the stock price. He’s been on the board since January 2010, so he may have just felt that it was time to move on, but I haven’t spoken with the Company about this yet.
Where We Are Now and Current Misunderstanding
What we are left with now is a high quality, nichey outsourcing company with a large (but not too large) TAM, high ROI to clients, limited existing competition, and a significant head start on potential future competition that is trading at 7.4x normalized EV/EBITDAX (see Valuation section below).
There are several risks that the market is weighting too heavily by valuing SREV as a particularly low-quality outsourcing company:
1 - “SREV’s effective TAM is much lower than the Company states, and the poor 2017 revenue guidance is a symptom of this lack of opportunity.” It is difficult to add up the recurring revenue opportunities in on-premise and cloud software, and hardware (ignoring SREV’s other verticals of med devices and IoT), as reported by sources such as Gartner, IDC, and Bloomberg Industries without getting a figure in the hundreds of billions. The figure for these verticals from SREV’s investor presentation results in an opportunity of about $300 billion in recurring revenue. Even assuming a 25% decline in SREV’s commission rate from ~2.5% to 2% (which seems unlikely given the limited competition and high client ROI that a commission structure provides), SREV’s current revenue run-rate would represent penetration of about 4%, leaving a tremendous amount of headroom. SREV’S credibility in penetrating this opportunity is further supported by its global footprint and the fact that it has already achieved critical mass in generating global revenue (~$90mm of international revenue in 2016 representing 35% of total revenue) and continues to sign new global deals.
2 - “Renewals were a feature of the old on-premise software and hardware purchase world and have no place in the new cloud/subscription world.” In fact, (i) tight renewal execution is even more important in the XAAS/subscription world than in the purchase/on-premise world because switching costs are much lower in the absence of expensive initial purchase transactions that customers are stuck with for several years and (ii) renewal sales in the on-prem and hardware sectors correspond only to clients’ maintenance revenue streams (some portion of total revenue), while renewal sales for a XAAS/subscription client correspond to the client’s entire revenue base, meaning that these renewals are more important to today’s subscription clients. It is worth noting here that with XAAS/subscription clients, SREV’s renewal process overlaps a bit with customer success work in terms of engaging with customers well before the renewal date to ensure that the client’s product is working for them and they are happy enough with it to renew. The logical extension to this semi-customer-success approach is to offer fully outsourced customer success services (assisting with onboarding, continually working with customers to ensure that they’re getting the maximum value out of clients’ products, etc.). As I’ve noted above, SREV is working to create a meaningful customer success business. They may certainly succeed at this, but such success is not necessary due to the large renewal-based TAM already in front of the Company.
3 - “The client revenue streams that SREV services are heavily weighted toward dying products like servers and networking equipment so these large churn events will continue to occur.” While 35% of SREV’s revenue is hardware based, it is important to note that (i) the Company has stated that it is growing with seven of its ten largest clients and (ii) hardware as a whole is not going away. There are still many business processes that customers need to handle with inhouse hardware and SREV in fact noted on its Q416 conference call that it is growing business with some clients in the same sectors as those that caused the Q117 churn event. More importantly than the resilience of some amount of the Company’s hardware business, 57% of the Company’s revenue comes from software, SAAS, and cloud product categories such as virtualization, security, and application software. SREV stated on the same Q4 call that the “vast majority” of their nine new client wins were in the cloud subscription space. While certain technologies will come and go, SREV should be able to continually develop new revenue streams from whatever technologies are emerging and gaining critical mass whether that’s driven by additional business from existing clients who develop new products or deals with new clients. This concept also segues into the next misunderstood risk:
4 - “The business model will always suffer from having the immediate impact of churn outweigh the delayed impact of slower-ramping new revenue.” I would first point out that this is a potential issue with any company that sells a sticky product that is deeply integrated into clients’ processes and thus takes time to fully implement (e.g. many high quality SAAS companies). With respect to SREV this is certainly a potential issue today as demonstrated over the last two quarters. However, rather than a structural issue, it is a temporary symptom of the current management’s efforts over 2015 and early 2016 to fix client satisfaction and further penetrate its existing client base (Carrington commented on the Q316 conference call that their penetration of existing clients is 10-11%, providing in their estimate at least an opportunity to double the Company’s size just by expanding with these clients). SREV is just starting to catch up on signing new clients (the third leg of the “control churn, expand with existings, and sign new clients” stool). A look at their comments on conference calls about the deals they’ve signed over the last couple of years shows that they signed ten new clients in the last two quarters, compared to eight total in the eight quarters before that. Carrington has stated that (i) they are targeting an eventual 50/50 mix of deals with new and existing clients, and (ii) the current pipeline is up 30% over last year. In addition, while churn has obviously been elevated in recent years due to the previous client satisfaction issues, the Company has historically had a ~90% revenue retention rate.
5 - “Sure the market opportunity is fine but this company will never be able to execute, and the Q1 churn is an example of that.” It is important to differentiate between business lost due to poor performance on SREV’s part, and business lost because clients are discontinuing certain products as part of strategic decisions that have nothing to do with renewal rates or SREV’s performance. SREV continues to execute well for its clients and calls with SREV’s clients following Q416 earnings are quite positive regarding the usefulness of SREV’s services, intentions to increase spend, and overall client satisfaction. Carrington echoed this dynamic on the conference call in saying “I do want to emphasize that we continued to perform well for these clients and our relationship and client satisfaction remained strong. Based on discussions with these clients we believe that with time we will be able to grow these particular relationships again.” In fact, the Company has inked two additional deals with Cisco subsequent to the churn issues. In addition it is worth noting that the Company’s 2017 ACV forecast given on the Q117 conference call reflected 0-3% growth, supporting the idea that even in light of the recent churn, the business is expected to expand, and the decline in revenue is, in fact, a function of the timing difference between signing deals and generating the associated revenue. I note also that if a slower revenue ramp is the ticket toward a population of larger, stickier, and more strategic client deals, that is a good tradeoff for SREV to be making.
6 - “SREV is going to have its lunch eaten by all the flashy new customer success startups out there.” Although as stated above, customer success represents a potential(ly large) opportunity for SREV, the Company’s current revenue is overwhelmingly provided by the renewal business, which can by itself support a multi-fold increase in the Company’s size. Further, it is worth differentiating between a customer success product that needs to be run by inhouse client staff, and a turnkey customer success outsourcing solution. The vast majority of venture capital attention has been given to the former, while SREV provides the latter. In fact, a partnership that SREV announced with Gainsight was partially driven according to the Company by clients who loved Gainsight’s products but just didn’t have the bodies to run and manage them, which is exactly what SREV provides.
7 - “Even if SREV continues to grow its revenue and margins, the capex for this business is dismayingly high.” SREV’s capex is currently elevated due to 2016 investments in its physical footprint (new facilities in Bulgaria and Singapore) and a “digital transformation” to integrate five internal platforms into one (expected to be completed in 2018), resulting in $26mm of capex in 2016 of which half was additions to capitalized internal use software. Although I don’t have a definitive picture because the Company has been cagey when I’ve tried to drill down on this, I have a hard time believing that a company with $37mm of PP&E needs more than ~$5mm of maintenance asset capex (approximate amount recognized in 2013, 2014, and 2015) plus a minimal amount of additions to capitalized internal use software ($3 million recognized in 2014 and none in 2013) in a normal environment.
8 - “This company represents ‘dead money’ for the foreseeable future. Who knows when they’ll actually offset the timing issue to get revenue growth back on track?” Admittedly I was a bit surprised that Carrington, who has made a lot of impressive operational moves during his time at SREV, allowed the Q1 churn to represent bad news on both the Q416 and Q117 calls. However, I would be even more surprised if the revised guidance didn’t represent a new level of conservatism resulting in meeting if not beating throughout the rest of the year. Obviously this is impossible to know and SREV is attractive on a long-term basis regardless of what happens this year.
9 - “This company has a scary maturity coming up in 2018.” Perhaps I’ve spent too much time looking at really challenged companies, but I don’t consider this much of an issue. However I bring it up because there have been questions about it on the last two earnings calls. The $150mm convert matures on August 1, 2018. SREV has ~$33mm of domestic cash and ~$140mm of short-term investments (i.e. domestic net cash of ~$22mm). LTM cash from operations is basically flat, and as stated above capex “needs” should be minimal. Although SREV has stated that they’d like to have $50mm of cash onhand to run the business, historical working capital swings have been under $10mm in almost every quarter in the last several years.
1 - Client concentration - SREV has approximately 65 clients, of which the top ten represented 66% of 2016 revenue. As seen very obviously this year, this level of concentration means that reductions in business from top clients can have a meaningful impact on results. The potential harm caused by this risk is mitigated somewhat by SREV’s high level of client satisfaction and average client tenure of 5.1 years (even given that 13 client relationships are less than a year old).
2 - Lack of control over client strategic shifts - The other risk convincingly demonstrated in recent quarters is that in certain cases SREV can provide great performance and yet still lose business if a client decides to discontinue a product. As stated above, with continued new client wins, SREV should be able to continue to weight its book of business toward long-lived opportunities.
3 - AI/automation risk - SREV currently focuses mainly on clients’ “middle market” customers (revenue to client of $1,000 to $1mm annually) and believes that renewal work for smaller ticket sizes than that is usually best handled through automated channels such as email notifications. As “the machines get smarter,” it is possible that larger customer segments will be handled capably through automated processes.
4 - Very significant acceleration of shift away from hardware purchases - although SREV has done well thus far in building business on the favorable side of the technology curve, it still earns 35% of its revenue from hardware products that are in many cases being replaced by cloud services. A sudden acceleration in this replacement would exacerbate the Company’s current timing mismatch between churn and new revenue ramp.
5 - Benchmark liquidation - I don’t have a line into Benchmark so I don’t know what they’re thinking, but Benchmark Capital Partners V, L.P. owned just over 6.5% of the Company as of 12/31/16 and the fund was formed in mid-2004, making it thirteen years old. It’s possible that Benchmark will either liquidate its position soon or distribute shares to LPs, who will then liquidate it themselves. This is of course only a temporary risk to the stock price and more of a buying opportunity than anything else but it is worth mentioning. Bruce Dunlevie, Benchmark’s board rep, is SREV’s lead independent director and has been on the board since December 2004.
My model and valuation is pretty simple for this company. In the short term I have no reason to project differently than management’s guidance.
However, I believe that the Company’s intermediate-term target operating model as shown in the investor presentation (page 8) understates SREV’s earnings power by implying almost no operating leverage on opex despite a 33% increase in revenue from the 2017 guidance. The target model as shown contemplates a 10% revenue CAGR from 2017 to 2020 (note that SREV has stated this doesn’t represent official 2020 guidance), resulting in revenue of $321mm, and an expansion in Non-GAAP (i.e. excluding stock-based comp) gross margins from 37.5% to 45% - this is highly reasonable to me given that SREV has already generated gross margins in the low 40s at much lower revenue run-rates. The model then shows Adjusted EBITDA (again excluding SBC) increasing from the guidance midpoint of $16.5mm for 2017 to $45mm+ in 2020. If you back out the implied Non-GAAP opex (i.e. Sales and Marketing, Research and Development, and General and Administrative expense, all excluding stock-based comp) and assume a flat amount of asset depreciation (I assume flat depreciation because I use a flat maintenance capex number in my Base Case below, however the implied opex growth is even greater if you grow depreciation with revenue), you find that the guidance implies that Non-GAAP opex grows nearly as fast as revenue and twice as fast as COGS during this period. This doesn’t make sense given that the Company already has a solid operational base. In fairness to the Company, their slide does specify “$45mm+” of Adjusted EBITDA. My point here is that the “+” is likely meaningful. See discussion of my Base Case further below and I’ve pasted immediately below a table laying out the above figures:
My Base Case assumes that SREV achieves no operating leverage on Sales and Marketing and that Research and Development and General and Administrative expenses grow at half the rate of revenue between 2017 and 2020. These assumptions still allow for a ~$19 million increase in Non-GAAP opex from $82 million in 2017 to $101 million in 2020 (and still show opex growing faster than COGS, meaning that these projections may still be too conservative) but result in 2020 Adjusted EBITDA of $52.1 million vs. the Company’s $45 million figure (16% margin vs. 14% margin). After reducing Reported Adjusted EBITDA by $5 million for maintenance capex and another $13 million for stock-based compensation (average SBC for 2015-2017E), I reach a base case EBITDAX figure of $34.1 million. SREV’s current enterprise value is $251.4 million based on $150 million of debt outstanding, $172.1 million of domestic cash and investments, $35 million of NOL value (based on a $233mm federal NOL and $378mm state NOL), and 95.2 million diluted shares (89.2mm basic shares, 6mm RSUs expected to vest, 3.6mm exercisable options struck at average of $4.57 so not currently dilutive and cause minimal dilution in Base Case) trading at $3.24 per share. This implies a current multiple of 7.4x 2020 EV/EBITDAX. This is far too low for a high quality, sticky outsourcing business with significant growth ahead of it. I value SREV in my base case at 12x 2020 EV/EBITDAX given its client value proposition, normalized margin profile, and large addressable market, which results in a share price of $4.88 or 51% upside from current levels. The table below lays out these calculations.
Given SREV’s net cash balance and stated commitment to control costs and be sustainably cash flow positive by the end of 2017 as well as its recurring revenue stream, I see limited downside from the current price, which represents an EV/Revenue multiple of 1.0x (or 1.6x non-hardware-related revenue). I think of 1x EV/Revenue for a business like this as the area where it becomes attractive for a financial buyer to come in and run the company for cash. If we assume that hardware-related revenue disappears completely, 1.0x EV/Non-Hardware-Related Revenue results in a stock price of $2.24/share or downside of 31%. A simple runoff scenario assuming 30% annual declines in hardware-related revenue and 5% declines in all other revenue (which may be overly conservative) with 40% gross margins and operating expenses cut to $20 million/year (and declining with revenue) generates a value per share of $2.22, again reflecting 31% downside.
There is also significant upside far beyond my Base Case estimate. With penetration of its TAM so low, $321mm of revenue likely represents only a stepping stone on the way to a much larger revenue number that is likely to bring with it further operating leverage and higher margins and cash flow. In addition to continuing to grow into its renewals opportunity, the Company estimates that by adding outsourced customer success and outsourced inside sales to its product portfolio, it has quadrupled the size of its TAM to over $40 billion. Given that SREV has not yet proven the ability to generate significant revenue in these areas, I don’t value them in my Base Case, however if SREV gains traction with these products, it could easily grow revenue into the multiple billions and still represent only a small fraction of the total opportunity. While there is certainly greater potential for competition with a TAM of this size, the Company believes that it has the potential to be an early mover in the outsourcing of these revenue-related functions and thus recreate the competitive advantages it has in optimizing renewal transactions. In terms of putting a quick value on potential upside cases, I’ll assume flat EBITDAX margin vs. 2020, which is too conservative, but it doesn’t make sense to spend a lot of time looking at very specific upside cases. At $700mm of revenue (1.8% penetration of $40b TAM) and 12x EV/EBITDAX it’s $9.77 or a 3-bagger. At $1.2b of revenue (3% of $40b TAM) it’s $16.21/share or a 5-bagger. In addition there is potential further value in the context of a strategic buyer (likely to be larger consultancies such as Accenture, Convergys, Capgemini, etc.) who would be able to significantly reduce costs by integrating SREV’s sales and administrative functions with its own, allowing it to pay a higher multiple.
1 - SREV reports Q317 earnings in November. To the extent they make progress towards improving revenue trends and cash flow, it is possible that the market will respond positively, but the market will likely want to see a couple of quarters of progress, so the next few quarterly earnings reports may all be potential catalysts.
2 - Achieving sustainable cash generation at the end of 2017 will likely make the stock “buyable” to a new crop of investors.
3 - Evidence that SREV’s ancillary products (customer success, inside sales) are gaining traction with clients will de-risk somewhat a very large opportunity that I’m not currently valuing.
4 - Potential negative catalyst in the event that SREV’s small amount (I estimate ~3% of revenue) of Renew OnDemand software sales go away. Insignificant relative to the opportunity in front of the Company, but would represent another temporary setback.
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