Description

Last week, Roddy Boyd of SIRF put out a terrific piece on SNCR detailing undisclosed related-party dealings as it pertains to SNCR’s sale of its AT&T Activation business to a company named Sequential Technology International (STI).  It’s great work and I highly recommend that readers who haven’t seen it take a look [http://sirf-online.org/2017/02/24/synchronoss-the-friends-and-family-plan/]. Boyd accurately details personal relationships between the founder Stephen Waldis and the owners of STI.  His reporting may have forced SNCR to disclose in its latest 10-K released Monday that STI is really just another name for Omniglobe International, LLC.  

We’ve been following this one for a while and wanted to delve into some of the confusing and potentially misleading statements management has made, and explain why this related-party asset sale SIRF highlighted has the potential to be very negative for the stock.  

Business Overview

Prior to December 6, 2016, SNCR had two main businesses – Activation and Cloud.  The Activation business served telecom carriers around the world by orchestrating back office workflows involved whenever a new customer signs up.  Activation revenue was dominated by AT&T.  

The Cloud business helped carriers provide value-added services (such as cloud-based backup of data from mobile devices) to their customers, thereby enhancing their feature set and presumably helping lower churn.  Cloud revenue was dominated by VZ.  SNCR had begun trying to extend Cloud into the enterprise segment, via JVs with VZ and Goldman Sachs, though early results were inconclusive.

On December 6, 2016, SNCR announced that it was acquiring the public company Intralinks (IL) for ~$900 million in cash.  It also announced that it would be selling the AT&T Activation business to STI for $146 million.  This, the Company said, would create “Synchronoss 3.0,” which would be far less reliant on AT&T/VZ, would be primarily a software business focused on the Enterprise market, and would have 30+% operating margins.  The founder/CEO Stephen Waldis would become Chairman and step down as CEO, turning the combined company’s reins over to IL CEO Ron Hovsepian.  The IL acquisition would allow the combined company to cross-sell SNCR Cloud to IL’s enterprise customers and IL’s Dropbox/Box-like storage to SNCR’s carrier customers.

Further, and perhaps most important, the transaction would allow SNCR to get rid of its slow/no growth Activation business and focus instead on its purportedly high-growth Cloud business – and be valued on a cloud-like revenue multiple rather than on a stodgy P/E or EV/EBITDA multiple.  

Our view: IL may be a decent acquisition – it seems Hovsepian, the new CEO of the combined company, is well regarded; moreover, there may be a reasonable amount of low-hanging fruit on the expense side to cut.  But our focus today will be on the AT&T Activation sale and the statements made around it.  

AT&T Activation Sale

1. TERMS: We’ll start with the purchase price.

“After considering carefully a number of strategic options at the table, we have reached the definitive agreement to sell a portion of our activation business to Sequential Technology for $146 million. As part of that transaction, Sequential Technology will own 70% of this piece of our activation business and our intention will be to sell the remaining 30% of our ownership in this asset over the course of the next 12 to 18 months to another strategic or financial buyer.” – Stephen Waldis (12/6/16 conference call announcing the deal)

To us, this sounded like SNCR was getting $146 million for the 70%.  However, this was not the case as disclosed in a later 8-K filed 12/22/16 (https://www.sec.gov/Archives/edgar/data/1131554/000113155416000063/exhibit991_122216.htm).  The $146 million was actually the total purchase price and SNCR would only get 70% (~$102 million).  In fact, SNCR would only get $17.1 million in cash and $83.0 million in a sellers note.  The remaining 30% SNCR still owned would be valued at $45.9 million on the balance sheet.  The numbers don’t fully add up, a recurring theme for SNCR.

As SIRF pointed out, the multiple that was paid seems low (STI paid somewhere between 2.8x and 5x EBITDA, depending on how costs are allocated).  But with 100% customer concentration risk and AT&T likely needing to approve the buyer, we’ll accept this for now despite the confusion around how much the acquisition price was and what the terms were.  

2. WHO: SIRF covered who STI is (and was).  Again, a must read and great work.

3. WHAT: We’d like to examine the $32 million transition services agreement between SNCR and STI.  There was no mention of this during the 12/6/16 conference call announcing the deal.  The first time that this was mentioned was in a footnote in the 12/22/16 8-K regarding costs allocated to the AT&T Activation business that will remain at SNCR: “Reflects the inclusion of cost of services which were historically allocated to the BPO Business and will remain with the Company's continuing operations. Certain of these costs will be recovered prospectively as part of our support services agreements with STI.”

Curiously, this 8-K was amended on 1/5/17, but the amount paid by STI to SNCR for these costs was not included.  The amount was included in another 8-K filed on the same day detailing the pro forma financials for the IL acquisition: “As part of the divestiture, Synchronoss has entered into a three-year transition services agreement (“TSA”) with STI to support various indirect activities. As part of the TSA Synchronoss will receive an annual payment of approximately $32 million.”

On the 4Q16 conference call on 2/8/17, many analysts were very confused by what this was.  The Company did not help clear up any misunderstanding, in our opinion.  The Raymond James analyst asked about revenues coming from STI to SNCR.  CFO Karen Rosenberger (who had just announced she was leaving the company to explore other pursuits) explained:

“I think as we went through the transaction we had talked about the fact that we were going to provide ongoing services for a three-year term to Sequential Technologies. Obviously contractual, around $30 million in revenue per year over the next three years associated with those services. As far as margins, et cetera, we don't give those details, but it's clearly consistent with our mix of business.” – Karen Rosenberger (2/8/17 conference call)

Yet, the 1/5/17 IL PF 8-K shows the $32 million as a 100% EBITDA margin addback to PF EBITDA, contradicting the CFO’s margin comments.   

When pressed by the Stifel analyst to expand, management said it would be a part of continuing operations (we’ll explain the importance of this later) and that it had to do with analytics software.  So, is it to reimburse for costs or to pay for the analytics software?

Actually, based on the 10-K that came out Monday, it’s definitely a reimbursement of costs.  And the revenue STI is paying SNCR for analytics APIs?  It’s a one-time license payment they already booked in 4Q16.  

Implications for Continuing Operations

Bulls ask “Why does this all matter if it deals with a business that the Company is divesting?”  Well, there are clear implications for what rate the remaining business is growing at.  The aforementioned Stifel analyst has actually done very good work here trying to parse through all the misleading statements to determine what this means for the continuing operations.  He deduced, correctly as the 10-K confirmed, that the Company was reclassifying some non-AT&T Activation revenue into Cloud.

Below, we attempt to take his analysis a bit further.

Organic Cloud Growth Analysis

Footnotes:

1. The continuing operations have stripped out AT&T Activation revenue, so that balance goes to 0 in 2017.  

2. The Company also did exactly what the Stifel analyst guessed, they reclassified some historical Activation revenue that was analytics related into Cloud (this likely was revenue from Razorsight, an August 2015 acquisition, so the growth in the reclassified revenue from $5 million to $25 million is not all organic, but it’s probably growing).  

3. The Openwave acquisition contributed $42.5 million of revenues beginning in March 2016.  Note that the Company specifically said that Openwave would contribute “negligible revenue” for 2016 when they discussed the deal on the 1Q16 call on 5/5/16.  Another misleading statement.

4. In the 10-K, SNCR discloses for the first time they received a license payment for $9.2 million in 4Q16 for analytics APIs. This was not mentioned at all on the 4Q16 earnings announcement or when analysts asked them about revenue from STI during the earnings call.

Backing out all the one-time items to derive true organic growth, we see that Cloud revenue grew less than 1% in 2016.  And based on their guidance of at least $520 million of Cloud revenue in 2017, that number will have to accelerate to 14.5%.  

Guidance

The last topic we’ll try to address is guidance, because most sell-side analysts are taking management at their word on 2018 goals of ultimately reaching $1b of sales and a 30% operating profit margin.  

In our opinion, their 4Q16 guidance and 2017 full year guidance have been made with many misleading assumptions.  

4Q16 Guidance

On their 11/8/16 3Q16 conference call, the Company guided 4Q16 to:

• $194-201 million of total revenue, comprised of:

• $122-125 million of Cloud revenue, “or a growth of 36% at the midpoint of our range as we have a visible, stronger pipeline heading into the fourth quarter in 2017 on the heels of a number of cloud deployments with new and existing customers.” –Karen Rosenberger, outgoing CFO

• $72-76 million of Activation revenue

When the Company announced the IL acquisition and AT&T Activation divestiture, they lowered the Activation revenue for 4Q by roughly $50 million despite ultimately closing the divestiture on 12/16/16.   

More importantly, though, the Company reported “GAAP Cloud Services revenue from continuing operations accounted for $121.7 million in the fourth quarter” on 2/8/17.  The amount was all of the GAAP revenue for the quarter.  However, the 10-K revealed that there continues to be non-AT&T Activation revenue in 2016, even after reclassifying some to the new Cloud definition.

So, the $121.7 million of “Cloud Services revenue” includes 1) a $9.2 million license payment from STI to SNCR that the Company could NOT have known about or baked into guidance on the 3Q16 call, given that they announced on that call that they had just begun looking at strategic alternatives for the Activation business – the STI deal was not announced until 12/6/16; and 2) some non-AT&T Activation revenue that hasn’t been reclassified as Cloud, which we conservatively estimate at a quarter’s worth of the $86.8 million full year number, so $21.7mm.  Thus, our conclusion is that the true apples-to-apples Cloud revenue in 4Q16 the Company could have possibly known about when they gave guidance on 11/8/16 was only $90.8mm, which was flat from $90.9 million in 4Q15.  

2017 Guidance

On the 3Q16 conference call, the Company guided to at least $520 million of Cloud revenues for 2017.  

When asked on the 4Q16 call whether this $520 million included the $32 million TSA payment, the Company confirmed that it did.  However, the same troubling fact pattern exists with this guidance – when it was given on 11/8/2016, management had only just announced the exploration of strategic alternatives for the AT&T Activation business so it could NOT have known about the TSA.

Conclusion

Coupled with the SIRF report detailing the related-party issues around the AT&T Activation divestiture to STI, it is reasonable to conclude that management had already figured out its Cloud business was slowing down and it needed to structure some financial engineering to make it look like growth was going to stay strong.  

If the bulls respond that Stephen Waldis and Karen Rosenberger are no longer in their roles now and they were the ones who gave guidance, we only wonder what the new CEO and CFO will do at their upcoming analyst day after they’ve fully recognized the problems here.  

The shares have definitely taken another leg down post the 10-K as people digest the new disclosures.  However, we still see downside in the shares because:

• The Company now has $1b of debt post the IL acquisition vs a clean balance sheet before

• Margins from Cloud are likely to decline due to overreliance on VZ (we see what happened with the Activation business and its reliance on AT&T, as well as other historical examples of vendors with large carrier concentration) and the high degree of substitute products, many of which are free to users

• Revenue growth and margins reset as the new management team does not come up with 1x tricks to meet aggressive guidance

• Besides the $9.2 million of license revenue in 4Q16, 3Q16 included a $25 million VZ JV license deal, and 4Q15 included a $20.3 million JV license deal

• New CEO and CFO should be incentivized to do the “kitchen sink” at the Analyst Day in March

How do you value a business where the numbers are in question?  We will give them the benefit of the doubt that IL is worth the $900 million they paid for it.  The proxy shows that Waldis seemed to be in a hurry to do some type of deal, so perhaps they paid up for the CEO.  

The continuing operations did $477 million of revenue in 2016, which consists of:

• $86.8 million of reclassified non-AT&T Activation revenue, which includes $50 million the Company is “sunsetting” and will go away – let’s value the remaining $36.8 million at 1x revenue;

• $42.5 million of acquired Openwave revenue, which the Company told the street was negligible yet used it to show growth during the year – we apply a 0.5x multiple on annualized revenue given our belief this is steadily declining;

• $347.4 million of Cloud revenue excluding Openwave, which grew from $315.8 million in 2015 (10% nominal growth, however, less than 10% organic growth given the Razorsight acquisition in mid-year 2015) – we grow it at 10% for 2017 (generous) and apply a 2x multiple given the low growth, heavy VZ exposure, and questionable quality of earnings.

Key Risks

• The Company has been promising $100 million of bookings from Japan, which may materialize more quickly than street expects

• IL revenue synergies are real, despite limited strategic overlap

• VZ revenue reaccelerates

Catalyst

Upcoming analyst day, earnings that don't hit 2017 guidance