Description

We believe Software AG is one of the stickiest and cheapest enterprise software companies in the world.  It has been subject to 2 VIC write-ups in the last 3 years and burned a whose who of value investors. At 2.3x FY23 recurring revenue, 7.3x LTM EBITDA (ex-Streamsets losses), with a mid-90s gross customer retention, this situation usually doesn’t exist in the public markets, and when it does, it usually doesn’t last long. Software AG fits into a classic software no-man’s-land — the business isn’t growing fast enough to attract growth investors, and it’s burned most value-oriented software investors by consistently over-promising, under-delivering, and reducing margins in the pursuit of elusive growth. The final straw for most investors occurred in January 2023 when the company guided to EBITA margins of 16-18% for FY23, after promising 25-30% EBITA margins only 7 months prior. The stock has fallen over 25% since these results, the CFO was replaced again (for the second time in 3 years), and Software AG ruined what little credibility it had left. While the company hasn’t executed well, we believe the issues are fixable and governance is such that they will be fixed. We also believe investors are overlooking several key positives:

1. Positive changes in governance: The company, which for years was “controlled” by a charitable trust set up by Software AG’s founder, who refused to sell the company, is now “controlled” by the PE firm Silver Lake, who holds 2 of the 6 company board seats, removing a historical impediment to acquisition by private equity or a strategic acquirer.  Further we believe that while Sanjay and his team have made mistakes, they are mostly mistakes of overly aggressive guidance. Under the stewardess of its new PE partners, we expect more realistic and beatable guidance and better communication. 

2. Complex accounting / impending business inflection: The company is in the midst of a license to subscription / SaaS transition, which by its nature temporarily reduces margins and FCF. The accounting of these transitions are complex and management credibility is paramount to guiding investors through the inevitable short-term negative financial impacts - but because the company has lost credibility, investors are discounting an impending inflection in cash flow generation that we believe further analysis can prove out.

3. Profitability as a choice: Most of the decline in EBITA margins at the company from 31.5% in 2018 to 16-18% in 2023 is easily reversible if the company were to divest certain money losing businesses (for a premium to the current valuation, we believe), and prioritize profitability over uneconomic growth investments.  We believe the company is trading closer to 5x ebitda adjusted for these easily reversible discretionary growth investments. 

4. Private market value: Software AG trades below any comparable transaction we’ve been able to locate since 2016 for similarly sticky, “indestructible” software businesses. We see 80%+ upside if the company were to be acquired for the lowest comparable transaction executed since 2016. 

5. Sum of Parts Value: Although software AG has performed poorly in aggregate (namely in its Webmethods and Cumulocity segments), it has performed very well in others (Adabas & Natural, Streamsets, Aris). The company is aware of its valuation disconnect, and has signaled an intention to divest certain money losing assets to highlight the value of its portfolio and focus on where it can win (Cumulocity and trend miner). We think these money losing assets are growing 30%/yr and are worth double the multiple the company currently trades at in a transaction.  

Overall, we see less than 20% downside at these levels compared to upside of over 70% as the company rebuilds credibility by continuing to execute on its subscription transition, setting and beating more realistic guidance, and divesting certain high value non-core assets. We also think there is a decent chance that, if the current valuation persists, the company is sold at a meaningful premium to the current price. 

Basic Business Description:

Software AG has multiple software businesses housed within two segments - its Adabas & Natural segment, which includes its legacy, low-growth, super-sticky, highly-profitable database software solution, and its DBP segment, which includes a hodgepodge of different software assets with varying levels of growth and profitability. We briefly outline each segment below:

Adabas & Natural (31% of software revs, 82% of software EBITA)

Adabas & Natural composes Software AG’s original software franchise. Adabas is short for adaptable database system and is a high-performance transactional database management software used in conjunction with mainframes (but increasingly also in the cloud). Natural is an accompanying development environment and programming language which is used to build applications that interact with database management systems such as Adabas. This technology works best with mission critical high transaction volume based businesses such as financial institutions, state governments, airlines and freight services. Because the software runs such mission critical systems, and because most firms have moved off mainframe long ago for the easiest applications to migrate or have migrated their instances of Adabas to the cloud, what remains here is highly sticky with what we estimate to be 99% gross customer retention. 

DBP Segment (69% of Software Revs, 18% of Software EBITA)

DBP houses many assets acquired by Software AG since 2016. We estimate this business splits out as follows, and briefly outline each segment.

Web Methods: Web Methods is a middleware software offering that, while low growth, is very sticky (we estimate mid-90s gross customer retention). The core product is the connective tissue between different on-premise, legacy software systems that allow them to share data and interact with each other. The company also has Webmethods.io, which allows for hybrid integration (between on-prem and saas software), but this is a smaller and less competitive product offering. Competitors include Mulesoft, Tibco, and others.

Streamsets - this is a rapidly growing data integration business Software AG bought in early 2022 for 13x 2022 ARR. The company expects it to grow 30% next year after growing 50%+ in 2022. The business is currently losing over 30M of EBITA per year.

Aris & Alfabet: The company lumps these two businesses together with “Business Transformation”, even though they are largely different businesses. We believe the larger, more rapidly growing business is Aris, which includes a business process management and process mining business. In aggregate we believe this business is growing in the teens. The process mining business is growing faster, and comps to businesses like Signavio, which we estimate was acquired for 19x revs by SAP in 2021, and Celonis, which we estimate was valued at 32x revenues in an August 2022 valuation round. Alfabet competes in the Enterprise architecture tools business, which we estimate is growing closer to MSD to HSD.

Cumulocity: When Software AG’s new CEO took over the business in 2019, he highly touted Cumulocity as a rapidly growing IoT software business. The company competes with other IoT platforms like C3.ai and PTC. While the company claims this business is growing 30%+, we believe it is unprofitable and has not met the growth expectations of the company. We believe this unit will potentially be put up for sale sometime this year.

Why the Opportunity Exists

1.  History of overly optimistic guidance assumptions have ruined credibility

Since Sanjay Brahmawar took over as CEO in 2019, the company has consistently missed its operating targets, especially as it relates to margins and cash flow. We believe this chronic disappointment has left investors skeptical of management’s ability to improve margins, while we view this disappointment largely as a function of poor capital allocation focused on driving (marginal) growth at the expense of profits.

When Software AG launched its Helix strategy, the company noted it would be taking EBITA margins down from a best in class 31.5%, to the high / mid 20s, eventually reaching 30%+ margins again by 2023. Instead, the company took margins much lower, and they still haven’t recovered.

What was supposed to be margins returning to 30% in 2023 and reaching a trough of 26-28% in 2020 (green lines) instead morphed into lower and lower margins, now promised to bottom at 16-18% in 2023E (red lines).

2. Complex accounting around license to subscription transition masks FCF generation ability of the business in a steady state

Software AG will generate little to no cash flow both in 2022 and 2023. Prior to these years, the company was a prolific generator of free cash flow. While some potential investors may believe this disconnect between IFRS profitability and cash flow is nefarious, we believe this is simply a function of the transition from license to subscription revenue and the resulting cash impacts. This confusion is understandable - the company has done a poor job communicating the impact to cash flow from its transition. The company originally gave guidance of operating cashflow CAGR of 5-10% from 2018 to 2023. Instead, this is how operating cash flow has trended:

We will elaborate more on this dynamic in a subsequent section.

3. Perception that the company cannot be sold has investors overly discounting the possibility of an eventual sale and relevant acquisition comparables

Software AG has historically been roughly 30% owned by the Software AG foundation, which was established by Software AG’s founder Dr. Peter Schnell. Based on conversations with industry participants and former employees, we believe Dr. Schnell refused to sell the company and used his large holding, combined with a friendly board, to block any potential acquisition interest. We believe this stance changed in late 2018, as Dr. Schnell reached his 81st birthday. The foundation had nearly 60% of its assets in Software AG stock.  We believe Dr. Schnell and the board supported the hiring of Sanjay in the hope that he could accelerate revenue growth leading to a better share price and higher sale value for the Software AG foundation. Based on public rumors and subsequent activity, we believe the company put itself up for sale in late 2021, which resulted not in a take private but instead in a €350M investment in convertible preferred by PE firm Silver Lake with a strike price €46.54 a share. We think investors wrongly view this fact pattern as a sign the company will never be sold.

Investment Thesis:

1. Governance has materially improved over the last several years. Germany has a supervisory board that functions much like a board of directors in the US. If you have more than 2,000 employees in Germany, which Software AG had for most of the 2010s, you have 12 board members, half of which are employees. Fast forward to today, and now that the company has less than 2,000 employees in Germany, it only has 6 board members, 4 of which are shareholder representatives and only 2 of which are employees. Furthermore, 3 of 4 of the shareholder board members have turned over in the last year - 2 are Silver Lake appointed and the other 2 are independent. The chairman holds a tie breaking vote. So we have transitioned from a board composed mostly of people opposed to a potential sale (employees and long standing board members aligned with the foundation, to being one vote away from a potential sale. While we don’t claim to have insight into exactly what Silver Lake is thinking, based on our conversations with the company, we believe Silver Lake either has an incentive to make a bid for the company at a depressed valuation or improve its performance. More importantly, unlike the prior board, they have an incentive to maximize shareholder value vs protect the interests of the foundation and the company’s founder.

2. Valuation - Software AG has never traded at this valuation of total or recurring revenue. We choose revenue, rather than profits, because we believe revenue is a better reflection of profit potential for a sticky software business, whereas current profits are depressed by discretionary growth spending (which can be reversed). We believe challenges in certain business areas (namely Webmethods) are more than reflected in the current valuation, providing an attractive margin of safety with substantial upside if sentiment changes:

At 2.3x forward ARR, Software AG also trades well below any comparable private equity transaction since 2016. A takeout at the lowest multiple of any comparable business would result in upside of 84%. 

Software AG also trades at material discounts to all publicly traded peers with similarly low growth:

3. Complex accounting related to revenue model transition is depressing cashflow & margins. Software AG is in the process of transitioning from an on-prem, perpetual license model to a combination of cloud, SaaS based sales, and on-prem, subscription based sales. While these types of transitions are well understood by US investors (especially license to SaaS transitions), they are less well understood by European investors. Furthermore, Software AG’s transition is particularly complicated, even for more experienced software investors, as it is transitioning mostly from on-prem perpetual to on-prem subscription, a less common transition for which there is a greater disconnect between cash flow and IFRS profits. As a short-cut, investors usually rely on management’s forecasts - unfortunately Software AG hasn’t given clear guidance on cash flow progression, and when it has (as it did in 2019), it’s been wildly off in its forecasts. As such, many investors are uncomfortable with the current lack of cash generation, fearing signs of a bigger problem.

We believe this fear is misguided - all transitions from perpetual license to subscription have a cash drag component. Let's take an example of a 3yr, $1.675M contract. If structured as a perpetual license deal, the customer typically pays $1.225M upfront on deal signing - $1M for the license payment with the first year maintenance prepaid. On an ongoing basis, the recurring payment ($225k) is much smaller. This model generates a lot of revenue and cash upfront, but less on an ongoing basis. As such, this model results in very lumpy cash flows & revenues that rely on new, big contracts to show meaningful growth.  

To make their businesses more predictable and maximize long-term customer value, the software industry has shifted to subscription or SaaS contracts.  The same 3 year, 1.675M software sale sold as SaaS or subscription contract, by comparison, generates $558k of cash in year one, or 55% less than a perpetual model.  The SaaS model is the most common - if software is delivered in the cloud, revenue is recognized ratably over the life of the contract.  But there are still certain products that need to be delivered “on-prem”, or hosted by the customer. In this case, if you sign a similar contract with a recurring payment, there becomes a big disconnect between revenues and cash flow.  Software AG is mostly doing the later transition, which is less common and more confusing.

We’ve tried to illustrate the difference between this contracts below:

Ultimately, the value to the customer of a subscription contract is a lower upfront payment, which creates a cash drag as firms’ transition between revenue models. At the end of year 3, this transition becomes accretive to cash flow, but in the early years (especially year 1) cash inflow is less than half the amount that would typically have been earned in a perpetual contract as well as lower than the recorded revenue amount. This dynamic we believe is creating a temporary cash flow drag and disconnect between reported EBITA and cash flow. We believe this disconnect is explainable, misunderstood, and should converge in the next couple years.

4. Software AG is consciously depressing profits to invest in growth within its DBP segment. Value investors typically pay a multiple of earnings based on what a company earns today, not what it is capable of earning. While it can be very difficult to figure out what an unprofitable business with a new business model is capable of earning, it’s relatively easy for a sticky software business like Software AG. Since Helix was announced in 2018, Software AG has seen DBP segment EBIT decline over $100M despite revenues growing $100M over the same timeframe. Segment margins have declined from 31.6% in 2018 to just 6.9% in 2022. 

We believe this investment in growth has had a questionable return, and that new management or private equity could return this business to mid 20% operating margins if they were willing to sacrifice some growth and/or sell Streamsets. Excluding the losses from Streamsets and valuing this business at a 66% discount to what Software AG paid for it a year ago, we believe you are creating the legacy Software AG business today for 5.3x EBITDA. We believe this EBITDA is a more accurate reflection of the true earnings power of the business and could easily be realized with a management team more focused on balancing profits and growth. 

5. Sum-of-Parts Value

Software AG is cheap on multiple measures. We highlight a few of our preferred methodologies below:

1. EV / ARR - Ultimately we believe this method is the best reflection of how a growth private equity firm or strategic would value Software AG.

2. EV / PF EBITDA - In this scenario, we assume Streamsets is sold for varying discounts of its 2022 purchase price, DBP margin improves as the company is run for cash, and the stock trades at a resultant multiple of EBITDA PF for those changes. We believe this is consistent with how a value focused PE firm would value the business or public markets investors if this transition occurred in the public markets.

3. EV / Revs - This is a simplistic analysis showing what the company could trade at on EV / Revs based on where it has traded historically over the last 10 years, if nothing changes and the market continues to value this as a value trap in fits and starts. 

4. Sum of Parts - In this method, we look at the value more on a sum of parts basis for different aspects of the businesses, using a different valuation methodology for each software product. In this scenario, we ascribe zero value to the consulting business which does $20M of EBIT.

We see upside of between 77% to 119% in our base and bull cases, and limited downside at these levels given poor sentiment and valuation levels at the bottom of the company’s historical valuation range and well below private market values.  If the stock re-rates further to 1.5x LTM revs and 6.2x LTM EBITDA ex streamsets, we see 18% downside.

Key Risks / Issues:

• The biggest risk is that nothing changes and the stock continues to trade like a value trap. The board with Silver Lake at the health renewed Sanjay’s contract through 2026 in October 2022, oversaw the value destructive acquisition of Streamsets, and didn’t properly reset expectations on margins at its capital markets day in 2022. Silver Lake’s convertible is very out of the money at this point, and it’s unclear what incentive they have at this point. 

• Software AG has not executed well in our view, especially in their Cumulocity and Webmethods businesses where we believe they are losing share. In general without change it is possible the business slowly leaks value over time. 

• It’s possible the company is still not for sale at a reasonable price. Despite the foundation’s stated openness to selling and despite running a sale process in late 2021, the company remains public. With higher interest rates and a lower share price, it’s unclear if the foundation or the board would be receptive to an offer below the Silver Lake convertible strike price. While the foundation no longer sits on the board, their 30% shareholding makes a deal without them difficult. 

Disclaimer:

As of the publication date of this report, the author has long positions in Software AG and stands to realize gains in the event the stock price increases. Following publication of the report, the author may transact in securities of Software AG. All content in this report represents the opinions of the author who has obtained all information within this report from sources they believe to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind – whether express or implied.

Catalyst

**Beat and raises throughout 2023

**Cash flow inflection

**Divestiture of Cumolicity

**May Capital Markets Day

**Acquisition interest if stock remains depressed