Selectica is a software company trading at a very low
valuation despite significant recent improvements in the company’s outlook. The
stock sells for 0.6x annualized June 2007 quarter sales, excluding cash, a very
low multiple for a software company with likely profitable growth. Strong
potential for a $3 stock in a year or two exists, driven by likely 1)
improvement in operating results and profitable growth, 2) stock buyback
program resumption and 3) management stock purchases. Under a reasonable home
run scenario, the stock is about a triple.
The stock is down over 60% since 2004, tracking the
company’s deteriorating financial results. A chief competitor, Versata
(formerly Trilogy) sued Selectica twice for patent infringement, most recently
in 2006. A stock option investigation added to company woes. Both issues created
uncertainty for customers and investors. Prior management consistently missed
financial targets, chiefly their goal of reaching break even, adding to
investor frustration.
The future is much brighter. Selectica cut costs
significantly and is now at or near profitability, replaced the CEO and CFO,
entered a new and fast growing market (CLM), and resolved the patent lawsuits
and the stock option investigation. Growth in the core CPQ business is likely.
The strong software sector provides an added tailwind.
The opportunity exists for several reasons. The last sell
side analyst stopped covering the company five months ago. Recent operating
improvements are obscured by restructuring, legal and stock option
investigation expenses. Some investors could be understandably skeptical of
recent progress, having watched the company’s difficulties under prior
management’s tenure.
There are two prior VIC reports that provide great
background. New developments:
1) Rapidly
growing business of meaningful size (CLM)
2) Foundation
set for likely improvements in the core CPQ business
3) Already
at, or very near, cash flow break even, excluding option investigation and
legal expenses that should wind down by the December quarter, or earlier
4) Road
blocks to customer purchases removed
a. Patent
lawsuit settled
b. Stock
option investigation completed
c. Financial
statements published
5) New,
outside CEO and CFO (the prior CEO was promoted from the CFO position)
6) Sufficient
time has passed to wear out all but the most steadfast investors.
Summary of
investment positives
1) Discounted
valuation
2) Operating
results should improve significantly, with resumed revenue growth and a swing
to solid profitability
3) New
management
4) Likely
resumption of stock buyback
5) Likely
management stock purchases
1. Valuation
Capitalization (000s, except stock price)
|
|
Stock price
|
$1.95
|
Shares out
|
28,400
|
Market cap
|
$55,380
|
Cash*
|
$40,000
|
Enterprise
value
|
$14,980
|
|
|
Federal NOL
|
$155,000
|
State NOL
|
$94,000
|
Present value of NOLs
|
Varies depending on assumptions; see table below
|
|
|
*$52.4m as of 6/30/07, less $10m Versata payment and estimate
of $2m negative cash flow for Sep quarter.
|
Valuation in a year
or two: risk reward seems favorable
($millions, except ratios, share, and per share amounts)
|
Scenario
|
Deterioration
|
No
Improvement
|
Significant Improvement
|
Home Run
|
Probability
|
5%
|
20%
|
40%
|
35%
|
Annual revenue
|
10
|
16
|
30
|
40
|
Operating income
|
(4)
|
(1)
|
3.0
|
7.0
|
Net income at 41% tax rate
|
(4)
|
(1)
|
1.8
|
4.1
|
P/E
|
|
|
15
|
20
|
EV/sales
|
-
|
0.5
|
0.9
|
2.1
|
|
|
|
|
|
Enterprise
value
|
-
|
8
|
27
|
83
|
PV NOL^
|
-
|
-
|
18
|
35
|
Cash
|
35
|
40
|
44
|
48
|
Market value
|
35
|
48
|
88
|
165
|
Shares
|
28.4
|
28.4
|
28.8
|
29.9
|
Per share
|
$1.23
|
$1.69
|
$3.07
|
$5.53
|
Expected value /
share
|
$3.57
|
|
|
|
^NOLs expire at various dates through 2027. I used a 10%
discount rate and federal and state tax rates of 35% and 8.8%, respectively.
|
Notes:
- The probability
and magnitude of downside appears very limited. There are a variety of
ways to look at potential downside for this stock and here is one. Cash of
$40m plus CLM business value of $15m is $55m, or $1.95 per share. The
company’s valuable CPQ technology provides an additional downside cushion.
- Cash
of $40m. The company is very close to break even, revenues are already
improving as evidenced by the June quarter results, and the company’s
cash balance should at least stabilize at $40m. Cash of $40m is based on
June 2007 cash of $52m less a $10m payment to Versata and estimated $2m
burn in the September quarter from legal and option investigation
expenses.
- Valuable
CLM business. Selectica’s CLM business is growing well over 100% y/y and
is at over a $5m run rate. This business is likely worth at least $15m,
or 3x run rate revenue. A valuation of 3x revenue is reasonable for a
software business with this growth profile. A valuation of $15m compares
to a purchase price of $1m in 2005 and approximately $10m invested in the
business since then.
- Valuable
CPQ technology. Selectica’s CPQ software is used by companies like Dell,
BMW, IBM, and GE Healthcare. IBM is using Selectica’s technology as part
of IBM’s new Simple Order product, which IBM will sell for about $5m, of
which Selectica’s portion is $1m.
- Operating
expenses are mostly fixed with a small variable sales and marketing
component. With GM% in the mid 70s, operating leverage is high.
- Although
a big improvement from today’s level of revenue, the $40m home run revenue
scenario (in a year or two) is not unlikely. Before the multitude of
issues hit the company, Selectica generated $30m in revenue from its CPQ
business in FY05. A return to near this level in a year or two appears
reasonable given the reasons outlined in the next section. The company’s
CLM business, which the company did not have in FY05, was at a $5m revenue
run rate in the June quarter and growing rapidly. CLM revenue doubled in
the June quarter versus the prior quarter.
2. Operating results should improve significantly
Efficient cost structure
with high operating leverage. The company has cut costs significantly and is
cash flow breakeven at about $4m/quarter of revenue, excluding stock option investigation
and Versata lawsuit expenses that should wind down by the December quarter. Revenue
growth from $4m/quarter should lead to solid operating profits in the near term
with the company’s very high incremental operating margin of 50%+.
Revenue should
improve. Several recent positives should help drive future revenue growth
in both the CLM and CPQ business. For both businesses, resolution of the stock
option investigation, settlement of the patent lawsuit and publication of
financial statements should smooth the sales process and help sales.
Contract Lifecycle Management (CLM). The CLM business is
already growing, up 100% q/q and over 200% y/y in the June quarter to $1.4m,
albeit off a low base. Growth should continue:
- Recent
CLM wins with Fortune 100 companies, including Motorola, should help
catalyze future CLM sales. These customer wins provide important customer
references. Furthermore, Selectica’s product is being implemented by
Accenture and Huron, both of which provide references.
- The
CLM market is growing at 10-20% according to industry analysts.
- The
competitive environment for CLM should improve somewhat with the
acquisition of Nextance by Versata last September. Versata reportedly reduced/eliminated
the Nextance sales force, cut expenses and will instead focus on
harvesting the maintenance stream. Nextance had been recording about $10-15m
per year in the CLM market.
Sales execution (CPQ). This business generated $30m in
revenue in FY05 before Selectica’s problems hit full force. A return to this
level is not unlikely. This segment was particularly hard hit since it was the
subject of the patent lawsuit, but this overhang is now removed. Other sales
drivers:
- IBM’s
new Simple Order product for service providers contains Selectica’s
configuration engine. IBM sees an average deal size of $5M, of which $1m
would be Selectica’s portion.
- Versata
will now introduce its customers to Selectica as part of the settlement
agreement.
3. New management
The company hired a new CEO, Bob Jurkowski, in August. He
has placed more structure around Selectica’s sales and marketing, focusing the
organizations on key targets, and is supportive of the CFO’s cost reduction
focus. Bill Roeschlein, the CFO, joined Selectica in September 2006. He is very
focused on cost reduction and was instrumental in bringing the company’s cost
structure to break even. Terry Nicholson also joined Selectica in September
2006 and heads the CLM business. Doug Bell joined Selectica in November 2006 as
VP of Marketing.
4. Likely resumption of stock buyback
The 10b5 stock repurchase plan expired during the last
fiscal year and Selectica could not renew the program until it concluded the
stock option investigation. A resumption of the program seems likely given the
recent completion of the option investigation and management commentary on
prior conference calls.
5. Likely management stock purchases
Bill Roeschlein and Terry Nicholson both committed to buying
stock on the 3Q07 (Dec) conference call. The trading window has been closed
with the stock option investigation. With the option investigation recently concluded,
the trading window should open following the 2Q08 earnings report in early
November. Furthermore, in January 2007, the company implemented stock ownership
guidelines for non-employee directors and executive officers. Under the
guidelines, executive officers are expected to own more shares than they
currently own (details in the 10K).
Shareholders
Activist investor Steele Partners owns about 9% of the
company. Management ownership is small, although I do expect them to buy shares
if the stock price stays low.
Business
Description
Selectica has two software businesses, Sales Execution (aka
CPQ: configuration, pricing and quoting) and Contract Lifecycle Management
(CLM).
Sales Execution (CPQ) (87% of FY07 (Mar FY-end) and 68%
of 1Q08 (Jun) revenue)
Product description: Web-enabled
software that automates the quoting, pricing and configuration processes. The
software interfaces with a customer’s existing CRM and/or ERP systems. Examples
of pricing functions include the management of discounts, pricing based on
margin, and pricing based on configuration, channels and customers.
Configuration includes consideration of part compatibility in various
configurations and quotes/pricing based on configuration.
Examples of prior or current customers:
IBM, GE Healthcare, Cisco, Tellabs, 3Com, BMW, Dell
Competition includes BigMachines, Tacton,
FirePond and Ariba.
Contract Lifecycle Management (CLM) (13% of FY07 (Mar
FY-end) and 32% of 1Q08 (Jun) revenue)
Selectica entered the CLM market
with its purchase of Determine for $1m in May, 2005. CLM generated revenue of
$1.4m in the June quarter, up over 100% q/q and 240% y/y. Backlog was up 30%
q/q. From the 10K: “Our contract lifecycle management (CLM) products enable
customers to create, manage and analyze contracts in a single, easy to use repository
and is offered as an on-premise or hosted solution. Our software enables any
and all corporate departments (e.g. Sales, Services, Procurement, Finance, IT
and others) to model their specific contracting processes using our application
and to manage the lifecycle of the department’s relationships with the
counterparty from creation through closure.”
Recent customer wins include
Motorola, ONN Semiconductor, a leading telecom equipment manufacturer and one
of the country’s largest healthcare providers.
Competition includes Oracle, SAP, OpenText
/ Hummingbird, Emptoris, Upside, Imany and Ariba (Procuri). SAP is a new
entrant with its CLM product introduction in early 2007. Selectica sees Upside
in low end, small deals around $30k. Imany is focused on life sciences: Selectica
hasn’t focused here and doesn’t see Imany. Selectica used to encounter Versata
/ Nextance, but Selectica has not seen Nextance since Versata dismantled the
Nextance sales force.
Risks
Customer concentration: 61% of sales came from five
customers in FY07 (Mar)
Patent risk
Financial results improvement. Re-instated stock buyback. Likely management stock purchases.