Description

Introduction

We are recommending a long position in Spok Holdings (SPOK). Spok is a relatively unknown small cap technology company trading at a low valuation. The obvious reason for the low valuation is the business has been experiencing negative revenue growth for many years. Further, management has been very low key (almost silent) about communicating its strategy, trading illiquidity (daily $ vol is $1MM) and lack of sell-side research coverage as well as good trading comps. We think the time has come where the company’s top-line will began growing again and recommend value investors take a look.

A little history on the company will help provide some perspective. The company is the successor to USA Mobility (USMO), which was created in 2004 from a merger of the two largest paging companies at the time, Arch Wireless and Metrocall. Since then, management has “melted” the paging business for cash flow. In 2011, in an attempt to prolong the life of the paging business, the company acquired Amcom software, a consolidator of the hospital operator console industry. Management saw the overlap of the companies target markets and saw the acquisition as a natural transition to long-term growth.

Since being a public company, the business has generated over $905MM in free cash flow and management has returned most of it to shareholders via dividends. Today, the company is debt-free, sits on a $113MM in cash (proforma Q4 2014) and deferred tax assets of $143MM.

Investment Thesis

We see 2015 as the year where the growth in the software business will overcome the decline in the wireless segment, resulting in growing top-line revenue. The software segment is gaining traction in international markets, experiencing momentum in new verticals and an expanded product offering should result in robust growth for 2015. In addition, in the latest quarter the company posted modest year over year top-line revenue growth and guided to a healthy 4^th quarter. Further, management announced plans to return $26MM in capital back to shareholders in 2015.

The stock trades at 5.5x EV/2014 EBITDA and 12.3x cash EPS. We think the stock is underfollowed because it doesn’t screen well since revenues aren’t growing and looks expensive based on reported earnings per share. What the screens are missing is the cash earnings are much higher than reporting earnings because of the large NOLs and the company is on the cusp of showing consecutive revenue growth.

Company Description

Spok is a critical communications company that creates and delivers smart, reliable communication solutions to help protect the health, well-being and safety of people around the globe. The company has two primary operating segments, wireless and software. Spok has 125,000 customers, 600 employees in 4 offices in the United States, London, Dubai and Perth Australia. In 2015, the company will be expanding into Canada and Latin America.

The primary vertical market is domestic Healthcare, representing more than 70% of revenues. Spok has a solid customer profile consisting of 50% market share in the US Large hospitals (>600 beds), 36% in mid-market hospitals (200-600 beds) and single digit market share of small hospitals (

“Every year, U.S. News & World Report conducts an annual best hospital survey. This year, they surveyed 4,743 adult hospitals and 183 children's hospitals. This year, 17 adult hospitals and 10 children's hospitals qualified for what they called an honor roll. All 27 of these hospitals are Spok customers.”

Size of HCIT market

According to Gartner, global healthcare IT spending is roughly $170B and hospitals make up almost half of the market. Of the $85B of hospital IT spending, Software and Telecom make up 36% of the spending or $28B, leaving a large sellable market for Spok. With HiTECH and the Affordable Care Act, Healthcare providers need to get more efficient and Spok is in a good position to capitalize. The remainder of the business is made up of Government, Hospitality, Large Enterprise and education verticals.

Business Segments

• Wireless (the cash flow) 67% of Revenue

The wireless segment provides paging services to hospitals, government agencies and public service verticals. Spok is the largest wide-area paging solution in the United States. Currently there are 1.2 million subscribers paying roughly $8 per month. In recent years, doctors have only SLOWLY moved to the latest technology like smartphones and tablets. This is due to the reliability of pagers, especially in times of crisis, still making them difficult to replace. The good thing is the churn continues to slow and believe it or not, the company activates a healthy number of new pager subscriptions each quarter. Spok also owns the essential IP for the technology that supports those solutions.

http://www.myfoxtampabay.com/story/26655617/fire-rescue-departments-continue-to-count-on-pagers

• Software (the growth) 33% of Revenue

The software segments offers a focused suite of communications solutions including call center operations, clinical alerting and notifications, mobile communications and public safety solutions. The company currently has a dominate market share position in the healthcare industry, mainly through large hospitals, but also serves to a lesser extent the government, public service and large enterprise areas.

Spok’s software suite is a critical part of an institution’s daily functions. For example, a large majority of all the calls going into healthcare institutions in the United States today go through Spok’s operator console. Further, Spok’s software platform sits in the middle of the organization and communicates with the ERP system. Once these types of systems are up and running, they are difficult to replace, resulting in a very high 99% renewal rate.

The company’s bread and butter solution is contact solutions, contact center solutions and operator console. These modules represent 70% of software customers but the platform offers 30 different products and solutions in total. Further, the software communicates with the healthcare facility’s electronic medical records (EMR) allowing doctors and physicians to send secure messages containing important patient information.

Subscribers buy a one-time perpetual license to get the software, have it installed and training. In addition, there is a maintenance fee, usually 20% of the one-time fee in perpetuity for code releases and upgrades. Growth in revenues comes from adding accounts but also from selling more modules and user seats to existing subscribers. So it is normal for a new account to make an initial purchase for one division or unit with the intention to expend the relationship to into additional division with more user seats as well as modules.

Where is Spok today?

We have been following this story for a few years now. After a few fits and stops, management’s investments in R&D and sales and marketing are showing positive signs. Software bookings have shown several quarters of sequential growth pushing backlog to company records while the churn in the wireless segment continues to make multi-year lows. In July, management introduced a new company name coupled with a rebranding exercise followed by an Analyst Day to facilitate the official kickoff of a formal, well-articulated growth plan for the company.

Software Revenue Growth

YTD 2014 the software business has shown a lot of traction. Bookings have been growing nicely but recognized revenue has lagged do to conservative revenue recognition methodology. The book-to-bill ratio has decreased from .95 in 2013 to .83 in the 3^rd quarter.

We think it is important to know how the company recognizes software revenue. Getting a signed contract back from a new client is only step one. A signed contract only contributes to bookings, not revenue. Then to recognize those contracts as revenue, the company needs to get the software installed and up and running in the client’s environment. In 2013, the company was required to change the way it recognized software revenue and had to restate several quarter’s results. The company was recognizing revenue as certain milestones were achieved, including the maintenance revenue. Then the SEC said revenue can only be recognized after the entire software implementation was complete, slowing down recognized revenue. What’s important is the change only impacted recognized revenue and not cash flow. Now, the company has millions of dollars to still hit the income statement, which will increase revenue growth. This revenue growth will tilt the company into growing revenue on an annual basis in 2015. Going forward, revenue will be recognized ratably over the implementation period, resulting in a book-to bill closer to one. We think it’s also worth mentioning that roughly 50% of software revenue is maintenance and reoccurring in nature with a cancel rate less than 1%.

“Second, our internal control remediation process which was completed in 2013 require that we differ a certain software revenue recognition until the completion of the professional service period relating to software arrangements, which effectively satisfied all the terms of our contract. The process also provided us with the ability to reliably estimate the service periods, which allows us to recognize revenue from those accounts on a ratable basis. The net effects was to delay our ability to recognize certain software revenue into 2014. Going forward however, we expect the remediation process will not impact software operations revenue in the third or fourth quarters.” - Shawn Endsley – Spok Holdings CFO 2^nd quarter conference call 2014

Wireless Churn continues to slow

Wireless churn continues to fall. In the latest quarter, the net disconnects (gross adds less gross disconnects) reached the lowest rate in over 10 years. This is important because as doctors move on to newer technology, the company is still selling a healthy 40-50k new pagers subscriptions per quarter. Unfortunately, the gross additions do not make up for the gross disconnections, resulting in the business losing 20,000- 30,000 pagers a quarter. At these current rates, the paging business has a life of 48 years. Management has a done a great job reducing costs as revenue shrinks to maintain margins.

Increased company communication

Management is beginning to get out and tell the story, which makes us think they have visibility into the business. For example, the company hosted an Analyst Day in NYC in November. This is a big step considering historically, the company did not take investor calls and would only answer questions on earnings conference calls, which only yielded 2-3 questions at most.

During the Analyst Day, investors got a chance to hear from the newly built team of experienced industry veterans lay out a pretty simple strategy to create shareholder value. The plan consists of four steps:

• Grow our software revenue and bookings

• Retain our profitable wireless subscribers

• Conservatively return capital to our shareholders

• Acquisitions that are accretive on a per share basis, drive revenue growth and utilize deferred tax assets

Spok has expanded the management team with well-experienced industry/market division heads to facilitate the growth story.

Growth Plan

Management has laid out a multiyear growth plan. Even though it is early, there are several “green shoots” which should drive long-term revenue growth.

Traction in international markets

2014 was a year of establishing presence in several international markets. The company announced several large wins of Australian healthcare companies. These large wins give the company a solid customer list to use as reference accounts to win more business. The international traffic on Spok’s website has increased 38% and leads are up 145% compared to 2013. In addition, the company has hired several new mid-level managers to head these international markets which should help Spok get established in these markets.

“We've already seen some progress. We've opened up offices, as Vince said, in London in U.K, in the United Arab Emirates in Dubai. And we have offices in Perth, Australia. We're seeing wins, and we're already getting some reference accounts. I can think of 3 large wins in Australia, for example, both East and West Coasts, that are referenceable today. And you also think of a win in the National Health Service in the U.K. There was a win last year that is now referenceable today.” .”- Colin Balmforth - Spok Holdings, Inc. - President Of Company Operating Company 2014 Analyst Day

Momentum in New Verticals (Public Safety)

Recently, Spok has been gaining traction in the public safety vertical, making it the fastest growing segment. There is a big push to get communication systems updated to next-generation 911. This means technology that can handle text messages containing location information, picture and videos. This is positive for 2 reasons. First, the average price for public has been coming in at $150,000 per account versus $111,000 for healthcare accounts. Second, it means the software platform has a larger total sellable market than originally thought. There are 36,000 municipalities in the US, presenting $5.4B TAM assuming a $150K initial sale. There is also room for additional modules and additional sales.

“Beyond hospitality, public safety has seen tremendous growth and continues to be our fastest growing market. Our public safety customers rely on our products to support the emergency call handling at their 911 dispatch centers.

Because of our solutions dependability, which has been verified by extensive testing to acquire Joint Interoperability Test Command, or JITC, certification, the government sector and US military locations remain an important part of this growth. Combined with municipals sales, we had 28 public safety software deals this quarter. That's compared to 19 in Q2, and 8 in the first quarter.”- Colin Balmforth - Spok Holdings, Inc. - President Of Company Operating Company 3^rd quarter conference call 2014

Expanded product offerings

Management has emphasized its commitment to innovation and creating new product offerings. For example, to break into the smaller hospitals that lack a robust capex budget and dedicated IT staff, Spok is introducing a cloud offering. Since Spok currently has a dominant market share position in the large and mid-market hospitals and only less than 10% of smaller hospitals (

“So we've started already, and we've already launched some of our first SaaS solutions. And we have more products coming down in our road map for 2015 in the area of our console products for SaaS” .”- Colin Balmforth - Spok Holdings, Inc. - President Of Company Operating 2014 Analyst Day

Further, in order to reduce risk of creating software in a vacuum, the company has created a user group consisting of 350 memberships as well as formed a Physician Advisory Board consisting of C-level representation members. This is an effective way to get street-level feedback and learn what issues customers are facing in order to develop solutions that customers need.

M&A

Management has also been very active to find “bolt-on” acquisitions in order to use enhance the product offering and also take advantage of the sizeable deferred tax assets. On numerous occasions, Vincent Kelly (CEO) has reiterated the company is going to be prudent and only make compelling, accretive acquisitions. To him, valuation is very important. The Amcom acquisition has been criticized in the past because management paid a high multiple for the business (16x EBITDA). In management’s defense, management needed to act to stem the migration away from pagers and “preserve” the life of the wireless business. Management has expressed its discipline and it’s not going to overpay again. For example, management has mentioned it has passed on various deals due to valuations being too high.

We will remain very disciplined with respect to our acquisition plan. I know some shareholders have asked, "Are you're going to pay up a big multiple buying another software company?" No, we're not. We're going to be very disciplined. And we're going to continue to returning meaningful capital to our shareholders, both in the form of our recurring dividend, share repurchases. And if needed, as I discussed earlier, a special dividend at the end of next year. .”- Vince Kelly - Spok Holdings, Inc. - Chief Executive Officer, President and Director 2014 Analyst Day

Return of Capital Plan

In addition to a well thought out growth plan, management said it intends to return $26MM back to shareholders in the form of the regular quarterly $.125 per share dividend as well as through share repurchases or special dividend, if needed.

Valuation

The company is not as cheap it was when the company reported 3^rd quarter results, but it’s still undervalued trading at 5.5x 2014 EBITDA and 14.7% free cash flow yield. We are modeling a modest revenue growth of 3.6% in 2015 and improvement in margins from 23.6% to 25.2%, resulting in 2015 EBITDA of $53MM up from $48MM in 2014. 2015 Free cash flow of $44MM up from $39MM in 2014. We aren’t modeling huge expectations for 2015 but if the software business can continue to perform from the management’s plans and the wireless churn continues to slow, the company can attract new investors, which will rerate the stock with a higher “growth” multiple.

At the Analyst Day, management reiterated 2014’s financial guidance and mentioned it should come in at the high end of the range. Guidance implies the fourth quarter revenue should come in around $52MM, 4.4% sequential quarter over quarter growth. (We have modeled a slight beat to guidance). 2014 guidance doesn’t equate to year over year annual growth but we are looking for positive 2015 guidance with 4^th quarter results.

“As of the third quarter this year, we had done just under $150 million in revenue. Our estimates this year that we've given the market in terms of guidance are for revenue to be between $183 million and $201 million. We're very confident right now that we're going to come in at the high end of the range for revenue and the high end of what would be the implied range for operating cash flow, because we give guidance on expenses and CapEx so you can do the math.” –Vince Kelly Chief Executive Officer, Analyst Day 2014

Income Statement

Sum of the Parts (SOTP) and Scenario Analysis

Using a SOTP analysis, we get to $22.24 a share, roughly 28% more than where the stock is currently trading. In our analysis, we used an industry comp EV/2014 Revenue of 3x for the software business. For the wireless segment, we ran the business off as a melting ice cube with a decreasing churn, ARPU and EBITDA margin. We also gave the company value for the NOLs, valuing them by assuming the company will use them over a 7 year period and using a 10% discount rate.

Using various multiples, and assuming the $ 1.20 per share from the regular and special dividends, we think the stock can provide a total return of 35-45% return (SOTP/ 7x multiple).

**West Corp (WSTC) paid 2.8x revenue for SchoolMessenger in April 2014

Wireless DCF

Catalyst

New increased 2015 financial guidance

Continued growth in Software bookings/revenue

Accretive M&A