Description
Intro:
Over the last year, Segue has undergone a series of major changes in its core operations: restructuring (operating expenses cut by 50%) new strategic partners (signed IBM to 3 year exclusive deal), new products (SilkTest, SilkRadar, SilkVision), expanded distribution (25+ new silk elite partners + up to 2,000 IBM global consultants), High margin business (GM 80%) on brink of profits (shooting for this qtr)+ (extremely low PSR ev/sls .40x), left for dead by both buy/sell side, and insider buying. Segue’s story is for those who believe in second chances. Past financial history is flat out ugly, but with recent operating trends and management’s focus on profitability I believe now is the inflection point (equity price vs. operations). While this is clearly an aggressive investment, it should more than adequately reward investors (downside $1.75 –17% and upside P/sales 1x & 2x $4.60-$8.33(117%-293% from current level) or EV/sales 1x & 2x ($3.90-$7.80 84%-267%). The immediate catalysts to unlock value: 1) expected positive cash flow this qtr (first in 6 qtrs.), 2) strongest qtr/qtr top line growth (in 5 qtrs.), 3) additional tier I partnerships (last cc said the company hopes to announce 3 this qtr), and 4) substantial EPS power (possibly $4mm in operating cash flow next 3 qtrs/$15.20mm EV). Strong board: Ted Kelly, CEO of Liberty Mutual, Robert Powers, Founder of Applied Value consulting, and #1 performing hedge fund manager over the last 13 years, Jim Simons.
Description
Segue’s software tools help ensure accuracy and performance for enterprise software. The company’s tools help improve software quality, reduce development costs, manage application components, and shorten the time required to develop critical applications. Their products keep web sites and software applications functioning with minimal downtime.
This is a one of the most attractive areas of the Internet Infrastructure Software sector. This is an essential service, high ROI for customers, and low average selling price (the company’s that have had trouble in software space very high ASP & high integration costs, this is not the case in this niche. Avg deal size runs $65,000).
Strengths, Weaknesses and Recent history
Segue is weakness in the past is clear: marketing and distribution, for which they have paid a big price. Two years ago, over 60% of Segue’s revenues were from dot.com’s versus less than 1% today. The company has had to evolve into a 100% enterprise sales force. Dot.com;s are gone and the market has shifted to blue chip and enterprise customers for their Internet operations, where Segue does quite well.
The company’s strength is product quality. For Instance, 2 months ago IBM announced an exclusive 3 year deal with Segue (mkt cap $23mm) beating out Mercury (mkt cap $2.9Bn). Second, from a Betasoft user forum, SEGU’s products were rated highest by users over MERQ’s (source: betasoft.com). Segue’s Silkperformer was rated 39.03% vs. Mercury’s Loadrunner 35.38% out of 3669 votes and on new product’s Segue’s SilkTest voted 42.34% vs. Mercury’s 25.36% on 944 votes. In addition, in speaking to a number of third party integrators nearly all said Segue has a far better product, but marketing has been the issue (that is why I think SEGU is on the brink of success by having tier I partners market and integrate). Finally, Segue has a tier I customer base: AOL, Intel, Nortel Networks, IBM, Cisco, Verizon Communications, Sybase, Citibank, Fleetbank, Boeing, Sears, Merill Lynch, JP Morgan, Qwest, AT&T, Sun Microsystems, E-Bay, Wells Fargo, Chase, Nasdaq, Dell, Compaq, American Airlines, Britsh Petro, Federal Reserve Bank of Boston, Fidelity, Visa, United Healthcare, Sprint, GE Medical, EMC. Nearly 40% of revenues are recurring from their installed base.
I believe Segue is on the brink of becoming a viable #2 player in this fast growing industry here’s why: Segue biggest problem was distribution. They had only 40 direct salesmen a year ago and 28 SilkElite partners. Today they now have same head count on sales force + 10 new inside sales, 48 Silk Elite partners (regional integrators), and “going deep with tier I strategic partners” such as IBM (which they just got in March). I believe SEGU is working possibly on additional partnerships with PRSE, RATL, BMC, CPWR, Tivoli, PSFT and SEBL (last conference call said they hope to announce 3 this qtr). Winning any of these deals will open up distribution (without much incremental cost) and greatly help in marketing, further establishing the company as a viable #2 competitor. The IBM deal is a tremendous win for the company. IBM hopes to have up to 2,000 consultants selling software on a global basis over time and 400 by the end of this year. Second, from a brand/marketing perspective Segue has a huge IBM logo on their home page “IBM and Segue team up..” this gives customers confidence to buy Segue’s product. On the last conference call the company said they are getting into Mercury’s strong hold ERP/CRM, with over 20 deals in the pipeline just for that sector of the market. IBM global services have a very strong SEBL consulting practice, which should greatly help SEGU penetrate this market. The IBM deal kills two birds with one stone: marketing and distribution.
Products
SilkTest and Silkperformer make up 94% of sales.
Product: Silktest, Silktest International, Silkperformer V, Silkvision, Silkplan Pro, Silkradar, and Silkpilot.
What products accomplish:
Automated testing: Load testing simulation how many users can hit a site until it breaks down, and where that weakness is which allows system to perform end to end component testing across various interoperable networks.
Localization testing: Estimates are that 66% of internet users by 2003 will be non-english speaking. Web sites are quickly becoming multi-lingual to grow revenues, which are causing strain on Quality Assurance resources. Segue’s has a program that is compliant in nearly every language that can be managed worldwide from one central location.
Test & Readiness management: Is infrastructure for application deployments. This product allows multiple users inside a corporation to see the progress of where an application is in the development process (from CEO to QA).
ERP/CRM: Segue’s products for the ERP/CRM markets ensure performance and accuracy of mission critical applications from PSFT, SAP, ORCL, and SEBL. These solutions improve quality and deployment times which result in faster time to revenue.
E-business: applications test for fluctuating demands of a live e-business environment, which helps eliminate downtime and brand damage by predicting and preventing application failure.
Market Structure
Mercury (MERQ) has approximately 50% market share and the rest of the pie is carved between Segue (SEGU) 14%, Rational (RATL) 12%, Compuware (CPWR) 10%, and Empirx (private) 9%.
Valuation:
10.26 shares * 2.12= Mkt cap $21.75mm (assuming full conversion of preferred)
Cash $ 8.54mm
Debt(convertible) $ 2.0mm
EV= $15.21mm
Revenues= $38mm 2002E
NOL = $55mm (over 3x EV)
1st qtr company did $8,046,000 in revenues before taking $1,000,000 charge to revenues for IBM startup costs (training for IBM global consultants). This is the first uptick in revenue qtr/qtr in 4 qtrs and significant because going from strongest to weakest qtr seasonally.
Revenues Estimate 2Q02: $8.4-9.2mm
OPEX for 2nd quarter ’02: (I am very confident of OPEX #’s this qtr)
G&A $4.3mm
R&D $1.3mm
S&M $1.4mm
COS $1.5mm
OPEX $8.5mm
Net B/E $8.5
Dep. $0.5mm
CF B/E $8mm
What is the probability of beating $8mm this qtr?
So the big question is: does SEGU show seq. Revenue growth
I think revenue will come in between $8.4-$9.2mm here is why
1st qtr $8.046mm (this is the weakest qtr of the year traditionally)
I believe that 1st qtr was particularly weak due:
Firing head of sales Feb 2002,
CEO spent much of his time working on closing IBM deal (and not on the road closing biz)
Despite these factors the company grew revenues sequentially from strongest 4th qtr to weakest 1st qtr
2nd qtr has several factors working in Segue’s favor:
Seasonally stronger than 1st qtr,
IBM has 50 reps selling Segue products that they did not have last qtr,
CEO has spent nearly everyday on the road working on closing business. Any revenue growth over 1st qtr is operating income
Addition of 10 person inside sales team , which they lacked in the 1st qtr.
3rd and 4th qtrs. should have even more favorable revenue dynamics:
Additional partnerships
Seasonally stronger qtrs.
Possibility of IT spending improvement
IBM partnership gains additional momentum, as IBM should have 400 consultants selling SEGU by yr. end vs. 50 today.
If I am right in my projections of $8.4-$9.2mm that would mean $400,000-$1,200,000 in operating CF (have not had for 5 qtrs.) and would be 4.4%-14.4% qtr/qtr revenue growth (best in 6 qtrs.).
3rd and 4th qtrs. could be much stronger than second qtr. I think potentially $10mm in 3rd and $11.5mm in 4th qtr. These numbers are obviously difficult to predict. If these revenues numbers are hit we could see Operating income: 3rd $1,500,000 and 4th $2,000,000.
So next 3 qtrs. Potential for $4,000,000 in operating cash flow or nearly .40 per share in CF min. Capex .05-.10 per share vs. EV $1.75 per share.
Strong operating leverage every incremental $1mm in revenues drops $.10 in net income.
EV/sales EV/EPS (fwd) Revenues
MERQ 7.64x 48x $360mm (100% overlap with SEGU)
SEGU .40x $ 38mm
CPWR 1.30x 15x $1,700mm (2.6% overlap on total revs)
RATL 2.61x 19x $ 680mm (5.8% overlap on total revs)
Avg. 3.02x 28x
Arguably this understates SEGU comp value by including RATL and CPWR.
Smaller cap Internet Infrastructure names (that sell into similar markets)
QSFT 4.98x 61x $241mm
PRSE 4.60x 35x $ 61mm
Avg. 4.79x 48x
Averaging the two groups gets 3.90x ev/sales which implies $14.54 for SEGU, however
Segue deserves a number of discounts due to past performance. The question is if segu gets on track and becomes profitable this qtr? What kind of multiple does it deserve given peer group?
Valuation Milestones
CF+ 1st in 7 qtrs = 1x EV/sales $3.95 per share +107%, this would be approx. 25% of peer group valuation (should see this qtr)
Net Income + 1.5x EV/Sales (possibly this qtr) $5.70 per share +200%, this would be approx. 40% of the peer group valuation.
Signs additional Tier I partnerships 3 qtrs of Net Income & Top Line growth = 3.9x EV/Sales, which would be in line with the current peer group multiples. $14.52 per share (514%)
12 March 02
“Under this exclusive three--year agreement, all related IBM hosting locations around the globe will use Segue's SilkVision for the monitoring services. By cross-packaging this offering with other services, IBM will enable its more than 2,000 consultants to bring Segue's SilkVision and SilkPerformer V to new markets. Beyond host monitoring and scalability, Segue will also benefit from the joint marketing and selling of Segue's extensive reliability solutions to IBM's customer base. Finally, the agreement allows for Segue and Tivoli to work to integrate the SilkVision application performance monitoring solution with Tivoli's leading system management platform, creating a premier enterprise monitoring and reporting system.”
“According to Merrill Lynch survey work, many CIOs underspent in 1Q 02 but don't see an unusual 4Q 02 IT budget "flush". There will be some growth in software spending, up 8% for 2002 in most recent survey. We still could see certain software segments rally late in the year on 4Q seasonal sequential improvement, especially Infrastructure Management (names like MERQ)” (this should help SEGU as well) (source: briefing.com from ML on 5-31-02)
Board
Segue chairman, Jim Simons manages Renaissance capital (#1 performing hedge fund, see link below, +2478 in 11 years (1989-99) now manages $5bn +). Chairman (owns 14% of segue) bought 667,000 shares of series b preferred equity paid premium to market $3 when stock was $2.75 in March 2002. Insider buying: 2 directors have bought 233,000 shares and CFO bought 7800 last 18 months, No selling.
Simons has attracted a number of strong members to the board: Ted Kelly, President and CEO Liberty Mutual, Robert Powers founder of Applied Value, Leonard Baum investment manager Lebam Advisers.
Chairman of Segue (source: Institutional Investor Jan 2001) http://www.cyberfutures.com/a200101.html
Catalyst
Catalysts:
I believe now is the inflection point: should see this qtr 1st operating profit in 2+yrs and possibly net as well, Could see 2H of .30 in net and .40 in CF on depressed numbers. Operating Leverage, Valuation, Profits, Potentially solid # 2 player in the industry or part of IBM/BMC, Improving financials and distribution network, Installed base (recurring revenue), Product reputation, DISTRIBUTION silk elite and IBM others coming, Attractive sector (low ASP, Software, IT front end infrastructure essential ) R&D Austria (top computer engineering program hire professor and top student develop, IT spending returns. Buy out from BMC, RATL, CPWR or IBM/Tivoli to gain market share or enter fast growing industry