Description

Overview

On the surface, Salary.com (SLRY) appears to be an excessively dilutive, money losing broken IPO.  But a deeper look reveals a low cost subscription based business with 90+% renewal rates trading at a fraction of the value of their peers.  The subscription based model will allow them to be cash flow positive beginning this year, while non-gaap EPS profitability isn't expected until FY ending 3/31/2012.  In addition, there are catalysts over the next few months that should help unlock some value.

Compensation Industry

Salary.com's main product is called Comp Analyst, and it competes in the compensation business, specifically compensation benchmarking.  Companies want to know how much a position is worth to ensure they are not under/over paying employees, how much to offer for a new position being created, etc. This business has traditionally been dominated by large consulting firms such as Mercer, Watson Wyatt, Towers Perrin (which recently agreed to merge with Watson Wyatt), or Hewitt that prepare a general survey at the request of a client. This survey would take a few weeks and cost approximately $500-$1000 per position surveyed. There are also specialized companies that own a specific niche of the job market, such as McLagen in financial services.  For example, Goldman Sachs is going to use McLagen for all their specialized employees, but the janitors, receptionists, etc would be priced through a more general source.

These surveys are generally sold in one of two methods.  Mercer and Watson Wyatt will sell their data to anyone willing to pay for it.  Towers Perrin, Hewitt, and McLagen won't sell the data unless potential customer first participates in their survey.  Surveys are conducted by interviewing HR members, not employees, and the data is aggregated by industry, geography, and company size.   Therefore, a receptionist in NYC at a 50 person firm is not compared to a receptionist in Indianapolis at a 5000 person firm.

The Salary.com Method

Salary.com created an application (now called Comp Analyst) that aggregates all the different compensation surveys.  They buy the data from the different companies that will provide it to them, and then analyze it (through an algorithm for which they have a patent), and then sell "an opinion" on what a specific function is worth.  This is an important distinguishing element, as they buy data from many sources and they don't mention where they get the data from (their competitors don't want to be named for obvious reasons).  And because they have multiple sources, it's often more accurate than any specific survey done by one consulting company. 

Companies realize that the big consulting company's data is missing a lot of information (often as much as 80% of the positions don't have enough data points to be accurate).  So they will often hire more than one company to price the jobs and then average them.  Salary.com's advantage is being able to take the different sources of data, along with their algorithm, and price any job. If during the sales cycle a customer questions how accurate the data is, Salary.com suggest using Comp Analyst to price some of the jobs that were recently priced with consultants, and the results are almost always very close.  The goal is not to be precise, but to be accurate, as the companies often adjust the pricing anyway to match other jobs at the same level within the company. 

Salary.com has more recently started pricing their own jobs in addition to buying data from the consultants.  They acquired ICR, which had the iPass Global Technology Survey.  This survey is very highly regarded in the Tech Industry (much like McLagen in Financial Services), and it is the single source of data for global technology jobs.  It was unique in that it was the same survey for all users across all tech sub industries, so the data is more relevant.  iPass only sold this data to the companies which participated in it, and charged $5k per company, which Salary.com increased to market rates after they acquired it.  Radford, another respected company with a competing tech survey, is focused on the US, not globally.  ICR also does a survey focused on the Retail industry.  Salary.com now includes the ICR data in their Comp Analyst module, and it gives them an advantage over the other participant only surveys. 

Traditionally, companies would take the data from the surveys they bought, and keep track of different jobs by hand in Excel.  Comp Analyst provides a better way of doing this.  It is available to multiple HR employees, can be access anywhere on the network, etc.  This module is the key to the Salary.com story.  It's better and cheaper.  And if a customer does not want to pay for the data, they can buy just the platform and Salary.com will enter the data the customer bought from other sources (for example, Financial Services firms that only want to access the expensive McLagen survey).  One customer who uses salary.com as a secondary source for the generic jobs said her favorite part was being able to price a "hybrid job" easily (something that was 60% job X, 30% job Y, and 10% job Z), and get a range for the market price.

Advertising Revenue

In addition to selling the data to companies on a subscription basis, Salary.com also provides access to individuals.  Anyone can go to www.salary.com to see the market price for their position, free of charge.  This is supported by advertising revenue ($800k per quarter recently).  In addition, small businesses that don't want to pay for an annual subscription can also price specific jobs for as little as $50 each on the website.

Business Expansion

With a great business in the compensation industry, Salary.com embarked on their "Total HR Vision" to provide all software needed to complete the HR functions.  This cycle starts with resume collection/applicant tracking (to compete with the Taleo's and Kenexa's of the world), goes on to talent management (to compete with SuccessFactors), then comes pay and benefits (Comp Analyst), which then goes into payroll (Paychex/ADP), and finally the data goes back into the surveys.  It's an end to end suite.

While Comp Analyst still accounts for between 60% and 75% of sales, Salary.com created a Talent Management module a few years ago.  It grew at a rate of over 50% in FQ409 (ending 3/31/09), partly due to a recent award received for their Succession Planning module.  Their sales force has started leading with this product, instead of Comp Analyst, in some deals.  While it is not as strong as their competitors' offering (SuccessFactors for example), it is improving and priced at a discount (30%). 

In addition, in December, Salary.com acquired Genesys Software Systems, a provider of HRMS (Human Resources Management System) and payroll services, which provides the last set of offerings they needed to complete the full suite. They admit their offerings are weaker than competitors in Applicant Tracking as well as Training, so they want to improve these modules, which they expect to do through partnerships.  The challenge is now to integrate all of the modules.  Salary.com still thinks they are 2+ years away from having all their modules fully integrated. 

The problem with this model is each segment is dominated by a different company.  Customers that I've talked to say that when a company branches out of their "dominant" area, the products are not as good as their competitors and definitely not as good as the original product.

Renewal Rates

Because of the subscription based model, renewal rates are quite high.  Salary.com has enjoyed renewal rates over 90% historically, and I do not see why that would not continue.  Once an HR employee is trained on Salary.com's platform, it doesn't make a lot of sense to switch to a competitor, or to go back to the old Excel file method.

In early 2009, the company saw pressure on the renewal rates as some smaller companies chose to skip buying the data in 2009.  So as far as renewal rates on customers go, those buying data fell below 90%, but when looked at in terms of dollar volume, they remained over 90% as the larger customers has compensation surveys as part of their budget.  The company doesn't expect customers to skip buying the data for 2 years in a row as it is not static data, it fluctuates, and if companies want to retain talent, they need to know how much to pay.  High inflation could be very good for Salary.com as salaries could change so rapidly that companies would be forced to stay current with the data.  And Salary.com is much more cost effective on a subscription basis than paying a consultant each time you want to reprice a job.

2008's Misstep / 2009's Correction

Salary.com is a SAAS (Software-As-A-Service) company.  They sell their solution on subscription basis, with payment generally made up front for a year of service.  They have had 32 straight quarters of sequential revenue growth. The upfront payments allowed them to be operating cash flow positive beginning in 2004.  However, in early 2008 they made the decision to increase their sales force to accelerate growth.  They added more than 100 sales people, and intentionally went operating cash flow negative.  The economy proceeded to deteriorate, the expanded sales force didn't deliver the results they had hoped, and they ultimately made the decision in early 2009 that it was better to be cash flow positive and have slightly slower growth than to grow unprofitably.   

As a result, they laid off over 100 employees across all levels of the company (including a member of the executive committee who had been with the company for 8 years).  They expect to be cash flow positive in the first half of FY2010 (ending 03/31/2010), meaning positive OCF in Q2 will more than offset any negative OCF in Q1.  Once they turn positive, they expect to remain so.  I believe this will be the case as they were cash flow positive for four years prior to the decision to increase the sales force.

Valuation

Salary.com has a very good balance sheet (although it has recently deteriorated after burning cash over the past 4 quarters and acquiring Genesys).  They have about $13m in net cash, or $0.80 per share.  The company has a target Non-GAAP operating model of 80+% Gross Margins and 20+% operating margins.  Genesys has lower margins than their other products, but they still expect to be able to hit this model in the long run (5+ years).  The Comp Analyst module is currently profitable and at the target margins.

The common way to value SAAS firms by sell side analysts is an Enterprise Value to Sales multiple.  Citigroup recently initiated coverage of Concur (CNQR), a company that does expense reports, and came to a target price based on a 4.8x multiple of EV/S.  At 4.8x EV/Sales, SLRY would be worth $13.50 per share.  Concur is a very good company (transaction based model (paid per expense report) with a partnership with American Express - Amex sells Concur's product to their travel customers). So I think 4.8x is likely too high for SLRY.com as a whole. But at the $30m in bookings that the 20% OM Comp Analyst product did in FY09, this product alone would be worth $9.50 per share, and there are free options on any of the other modules making money.   Less bullish analysts on the sector use an EV/S multiple of 2x for target prices (SuccessFactors Initiation at Hold by Kaufman in January).  Applying this to SLRY's revenue gives a share price just under $6.

Alternatively, if in 5 years they can double revenue to $85m (which would still be below the current revenue rate of most of their peers), achieve the targeted 20% operating margins, and trade at only 10x this number, the stock would be worth $8.50, before giving credit for any cash on the balance sheet, and assuming 4% annual dilution.

Relative Valuation           

Below is a table comparing Salary.com to their competitors, including SAAS companies such as Concur and Salesforce.com, as well as Watson Wyatt, ADP, and Paychex, traditional companies who also compete with at least one of Salary.com's modules:

Source: Bloomberg

Salary.com is much cheaper on an EV/Sales basis, and compares favorably on Gross Margins.  Operating margin is not as favorable, which shows how much cost could come out of the business if it was to be acquired.  However, even a larger company, such as SuccessFactors, with a negative operating margin similar to SLRY, is awarded an EV/S ratio of 4.3, which would value SLRY at $12.15 per share.

Catalysts

Cannell Capital, owners of 6.8% of the company, filed a 13-D in March asking the board of directors to put the company up for sale.  I agree that it makes sense for a larger competitor with a strong product to purchase smaller companies who have a strong offering in other areas.  If this were to happen, Salary.com would be an ideal target, as they are the only one with the compensation data module.  A competitor could pay $10 per share just for the Comp Analyst module and eliminate the other products and be getting a fair deal (this is still less than the IPO price 2 years ago!).  Note that according to Forbes, SuccessFactors has apparently turned down an offer to be acquired by Oracle[1], so there is definite interest in the industry.

One potential hurdle preventing SLRY from being acquired is the Founder and CEO, Kent Plunkett. He appears to be concerned with empire building more than shareholder value, which is surprising considering he owns over 20% of the company.  He has a vision to get to $1 billion in annual revenue, which is only 2.5% of what the company claims is a $40 billion addressable market.  The $40 billion is based on $200 per employee per year at the firms that they currently count as customers (so you can back into the fact they're getting less than a quarter per employee per year currently, the cross selling opportunities are almost endless).  I've also heard anecdotally that he may be a "control freak" and lack the ability to move Salary.com into the next stage of growth.  And that is where the activists come in...

In addition to Cannell's 6.8% stake, Raging Capital, owner of 8.7% of the company, filed a 13-D in March asking the board to replace existing members with new ones who actually own the stock.  And Kinderhook Partners, owners of 9.6% of the stock, filed a 13-D in April saying they were in agreement with Raging Capital.  This represents almost 25% of Salary.com's owners who are not happy with the current direction of the company.  To help placate these investors, William Martin, Head of Raging Capital, was added to the board in the past month.  The next annual shareholder meeting is expected to be only a few months away in September.  The company is going to have to respond to Cannell when they file their proxy material, however as of yet they have not hired anyone to explore a sale (if they do announce that they've hired someone and the stock pops, I will likely reduce my exposure as I do not believe they are actually serious about selling the company).

But what they are serious about is buying back stock.  The board authorized $2.5m in share repurchases in December in response to Cannell's first letter to the board opposing the Genesys acquisition; they recently increased the authorization to $7.5m, or almost 20% of the outstanding stock at the current price.  The company has been active, already repurchasing 878,000 shares at an average of $1.61 ($1.4m total).

And finally, the CEO and CFO have authorized Rule 10b5-1 trading plans to buy stock.  While they have only bought a total of 8000 shares, it is a change from the constant selling that took place over $4 by the CEO throughout 2008.

Risks

No investment is without risks, and Salary.com definitely has some worth noting.  Dilution is a major risk.  I'm assuming 4% per year over the next 5 years, which hopefully will turn out to be low.  Diluted shares outstanding has increased from 13.3m shares to 15.9m, or over 9% per year, in the 2 years since being a public company.  Some of this is from acquisitions, but after talking with the CFO, it is evident he realizes that shareholders are not happy with this level of dilution.  The non-employee members of the Board of Directors own very little shares; most of their ownership is through options they were granted which may explain why the do not appear to be overly concerned with the share count.  I believe the larger shareholders have made this point clear to management and with a representative on the Board of Directors, 4% going forward should turn out to be high.

Salary.com is the smallest public company in the HR software space, and they are looking to grow the applications outside of Comp Analyst.  I doubt, however, that the other applications will ever become as successful as Comp Analyst and could use up a lot of resources.

The stock is very thinly traded, so if any of the large holders decided to sell their shares, it could cause an extended amount of pressure on the shares.

Summary

Salary.com has a good business model, with recurring, subscription based revenue with over 90% renewal rates, and the stock is worth at a minimum 100% more than the current level, likely closer to 4x the current price.  Insiders have started to buy (at least token amounts), the company is buying back stock, and shareholders are pushing for either a sale of the company or a board of directors that is more concerned with shareholder value.  The stock represents a compelling value at the current level.

[1] http://www.forbes.com/2009/05/14/saas-software-oracle-technology-enterprise-tech-saas.html

Catalyst

Earnings on 8/6 could potentially be the first cash flow positive quarter, but will at least have guidance for positive cash flow going forward.

Proxy material when filed will have a response to Cannell's request for a sale of the company.

I had been expecting a possible proxy fight at the Annual Meeting in September, however the recent appointment of William Martin to the board makes this not likely.