Description

In 1999 and 2000 alone, more than 500 dot coms came public. They raised Billions of dollars. Many of them went under because they never really had a good business plan or a decent product. While most of the money was burned on lavish offices, trips to the beach, overpriced web consultants for portals that no one cared about, some companies focused on a concept called the “extended enterprise.” These companies basically wrote software to help companies managed their business in a new digital world. Everything from supply-chain management, to collaboration, to content management, to database mining software was tried. Most of it failed, and many of the better products were absorbed by the largest players, and some businesses continue on for no reason other than that they haven’t run out of cash yet.

Call me an optimist, but for a long time I thought to myself, “If billions were spent on new types of software focused on helping enterprises run smoother, better, more efficiently, perhaps there are a few companies still around who have hit the hammer on the head, and that are being completely ignored by the market, and simply tossed into the dust bin along with all the other dot.bombs and failed tech incubators (whatever an “incubator” is anyway…)” I believe that I have found such a company, and they are called SupportSoft (NasdaqNM:SPRT).

Overview: The description from Yahoo profile says what they do best,

“SupportSoft, Inc. is a provider of support automation software. The Company's Web-based family of software solutions is designed to help corporations automate and personalize the service and support they provide to their employees, customers and partners. SupportSoft's software helps reduce manual steps in the service and support process and specializes in automated problem resolution. Products are organized into three software application suites to address the needs of different market requirements. These suites are the Resolution Suite, a product for corporate enterprises interested in providing support automation to their employees; Broadband Resolution Suite, a product designed specifically to address the needs of broadband service providers, and the Satisfaction Suite, a product that enables companies to provide service to its customers over the Internet.”

SupportSoft used to be called Support.com until recently when they changed their name for obvious reasons. They are currently doing about 40M revenue/year, and are projecting pro-forma break results for q3. They have been net cash flow positive for the past 2 quarters (1Q 02 and 2Q 02), which is a result of significant client wins, who place deposits for their software, but SPRT must recognize that revenue over about a year (the term of the software license), as per FASB’s new “software subscription” accounting rules. Therefore “Bookings,” that is, the total size of the deals they are singing, has been rising very significantly, demonstrated by customer deposits listed as “deferred revenue” on the balance sheet (up 46% on an annualized basis from 12/31/01 to 6/30/02). Also this revenue recognition model helps smooth out earnings. The company has guided for 10.6 to 11.1M Revenue for 3q02. Of that already 70% is in the bag as per the revenue recognition policy.

Revenue Mix: 73% of revenue comes from software licenses, and 27% from services. Services revenue comes from SPRT installing the software in client’s enterprises and then billing them for the installation and configuration work (smart company, get you for the software AND the installation). Of the licenses revenue, about 70% is from subscription licenses (in other words pay for the software 1 year at a time.) And the other 30% is from Perpetual licenses (pay up front, keep the software forever, (until the next release.) As I said before, subscription licenses are recognized over about 1yr, Perpetual all up front, and services on an accrual (% completion) basis.

Now assuming 10.6-11.1M in revenues, SPRT’s cost structure will look about as follows:

Cost of license fees: .07M (99% gross margin!!!)
Cost of Services: 1.83M (38% GM)

R&D: 2.14M
S&M: 5.46M
G&A: 1.30M

+ interest income of 0.11M

Now if we use this to calculate proforma earnings we get: -.09M. So proforma breakeven is very doable. But the question on every one’s mind is whats the GAAP number? Well I don’t believe they will take any restructuring charges. So that just leaves stock based compensation expense of 0.11M and amortization of purchased intangibles of 0.6M (they bought some source code from GoWonder about 2 years ago and have been writing off the purchase price over that time.) From the 6/30/02 balance sheet we can see that only 0.6M of purchased intangible remains. So q3 will be the last quarter they will expense that. Therefore the GAAP number will automatically improve by 0.6M Q4 over Q3. The proforma number and GAAP number will be exactly the same for 4q02 except for the .0.1M of stock based compensation expense.

Significant Revenue Growth: SolutionSoft's revenue has been growing very rapidly, even through this tech spending drought. I see topline growth from an annualized revenue rate of about 25M to about 40M over the past 2 years. In other words their products appear to be very valuable, and has a market niche not addressed by the larger players.

The Value is in the Cost Structure:

I project revenues over the next 12 month at around 45-50M and a cost structure of about 41M. So right now the firm is not exactly a slam dunk, but it is chock full o’ operating leverage. I figure variable expenses are 1% of license revenues for cost of licenses, 62% of services revenue for cost of services, and figure in about 8.5% cost of revenues for Variable Selling Expense: So for every dollar of Total Revenue Growth:

Licenses Portion: $0.70
COL: <$0.01
Services Portion: $0.30
COS: $0.19
And Variable Selling Expense: $0.08

Total variable expense per $1 of revenue growth: $0.28!!! Or a Positive Contribution Margin Ratio of 72% for every dollar on new revenue. I have posted a spread sheet analyzing all these numbers. You can see the revenue growth over the past 6 quarters and how positively it affected the bottom line. The link to the Spread Sheet is at the end of my writeup.

Buyout???: But as I continue analyze the income statement, I can't help but notice that Cost of Goods Sold and R&D expense (the true product costs) are only 13.5M of the firms total annual cost structure. The other 27.5M is tied up in Selling, Marketing and General Administrative Expense (Fixed Over-Head). With Selling Expense being the biggest piece of the overhead, weighing in at 22.4M of the 27.4M. This is completely appropriate for this firm, as it takes considerable sales effort to convince companies to buy software from a small dot.com vendor. It is my theory that they could dispose of perhaps 50% of their FOH cost structure by merging with (or being bought out) by a larger player. The cost saving would be driven by consolidation of facilities, and sales force. There also might be some cross selling opportunities, as the product is somewhat differentiated from what the larger players are focusing on.

My EV calculation is as follows: Mkt cap - Cash and receivables + Total liabilities= (92M - 42.5M + 22M)= 71.5M
For simplicity sake I will assume this product can grow at a similar rate than other software products that a suitor has developed or can develop, therefore:

Potential Cash flow/year if bought out: (50M ‘03 Rev + 5M from Cross Selling) - (13.5M Product Cost + 14.3M Residual Overhead) = 22.6M

I figure that a suitor would like to see the acquisition be accretive to earnings. Let us say that for acquitions, software companies like 15 PE on an acquisition with equal potential growth and risk. This bodes very nicely for Siebel, PeopleSoft, and IBM their forward PEs are 27, 28, 18 respectively.. (This acquisition is priced to be VERY accretive to the suitor's earnings.)

So let X=Purchase price of SupportSoft. Therefore X = (22.6M*15), solve for X and we get a Total Purchase Price of $339M. Acquisition expenses will be 15M (consolidation of facilities, sales forces..ect). That puts a $324M price tag on SupportSoft.

So the big question is, what does that mean for the stock?
Current EV: (92M Mkt Cap) - (42.5M Cur Asts) + (22M Tot Liab)= 71.5
Potential EV: 324M= (X mkt cap) - (42.5M) + (22M) + (15M)
X=330M
Now there are out 33.5M shares outstanding, and about 7M out of the money Employee Stock options that would come into the money, thus we make the total share count 40.5M. (330 Mkt Cap)/(40.5M shares)= $8.15. And with the stock at $2.28, this is one hell of a slam dunk.

So Who would Buy, and WHY?: Siebel just launched a product called ERM 7.5. In it they've integrated "support automation applications." The vendor of course is actually SPRT. I think it would make sense for Siebel to just acquire the vendor (backward vertical integration to use a lame MBA term). The merger would knock out 50% of SPRT's FOH costs via a pinkslip party, and would leave a unit that kicks off massive free cash. About 41% operating margins as opposed to –13.9% in 2Q02 or 0% in 3Q02E. So i figure with Siebel's forward ‘03 of 27, they should be willing to pay at least 15x 22.6M FCF, thus a take over price of 300M at least. My only worry is that Siebel and a shoddy investment bank will no doubt trick stock holders into taking less ($5-$6). Still a good return… Which brings me to the Insiders….

Management directors and insiders also own 81% of the firm, so the only way for them to cash in is through a tender offer or merger with a large player. Also RS Investments had ~16% of the TSO in January, and since then has been buying big blocks on the open market. As of 8/27/2002, they now own 23.3% of the TSO as per the 13G filings which you all know how to access.

Finally I have layed out all my numbers and projection on spread sheet. You can access it by clicking the followng link:

http://www.geocities.com/doobadoo/SPRTValuationCalculations.xls

I am looking forward to see what my peers think of my first idea as a value investors club member…

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Doobadoo802

Catalyst

Break Even Earnings in q3 (proforma), followed by profitability (GAAP) in Q4.
Lingering possibility of buyout.