Description

It’s Like Deja Vu All Over Again” - Yogi Berra

We believe that shares of Tangoe (the “Company” or “TNGO”), a leading provider of telecom expense management (TEM) solutions, are grossly overvalued and represent a compelling short opportunity. At current levels, they do not adequately reflect the risk inherent in (1) the inaccurate characterization of the Company’s business model, (2) a highly questionable organic growth rate, (3) continued outperformance from Company’s non-core business, (4) emergence of accounting red flags, (5) one-time boost to operating cash flow from acquisitions, (6) persistent insider selling, (7) a highly dubious management team and (8) fundamental threats to the TEM industry.

We estimate fair value between $7.48 - $14.75 per share, implying downside of 40.3% - 69.7% from current levels. 

Company Description:

Tangoe  is a leading global provider of communications lifecycle management (CLM) software and services. The Company offers on-demand software and related services that enable enterprises to manage and optimize the complex processes, expenses and usage policies associated with the complete lifecycle of an enterprise's fixed and mobile communications assets and services. Founded in 2000, Tangoe went public on July 27, 2011 at a price of $10.00 and has significantly outperformed the broader indices to date.

The Company generates ~89% of its revenue from its core business (Recurring Technology and Services) and ~11% from its non-core business (Strategic Consulting, Software Licenses and Other).

Key services offered through its core business include Asset Management (catalog management, procurement, provisioning, tracking, maintenance, disposal), Usage Management (security, policy management, monitoring, compliance, performance, support), and Expense Management (contract management, billing, auditing, dispute, allocation, payment, optimization). Tangoe deploys a subscription model based on total telecom spend and number of devices managed along with contract minimums.

Key services offered through its non-core business include strategic consulting services comprised of sourcing, strategic advisory services, bill auditing, inventory optimization, mobile optimization and policy administration. The revenue model is based on fixed project, incentive fees and professional services fees.

As of December 31, 2012, more than 1,080 end customers were using Tangoe’s software/services. According to the Company, each independent division or subsidiary of a larger enterprise is counted as a separate end customer with no single end customer accounting for more than 10% of total revenue. The Go-to-Market strategy is primarily through a direct sales force as well as through indirect distribution channel partners. Tangoe employed 1,383 employees at the end of 2012.

Market Opportunity:

Gartner estimates that the global TEM market is expected to grow at a CAGR of ~22% from $894 million in 2010 to $1.9 billion in 2014. The industry is characterized as being extremely competitive with multiple participants that are aggressively competing for their share of enterprise telecom spend. Specifically, we believe the following participants are worthy of attention:

• Service Providers: Interested in deepening their relationship and upselling to existing customers. They offer solutions equipped with a combination of their own products as well as leverage partnerships with pure-play vendors.

• System Integrators: Able to leverage their professional services expertise and software partnerships to offer companies a full suite of solutions and strategic guidance.  They too tend to partner with pure-play providers to offer a complete solution.

• Pure Play Vendors: Specialized providers that may offer limited elements of a managed solution (i.e., TEM only) or a full life-cycle solution. Offer concentrated solutions but to extend their reach and product portfolio may consider partnerships with complementary pure-play vendors.

Tangoe management estimates that global spend on telecom is approximately $425.0 billion and are constantly touting the tremendous runway that exists for continued growth. As of June 30, 2013, the Company managed a total of $26.0 billion in annual communications expense, of which $6.4 billion is non-U.S.

Short Thesis:

Key Concern 1: Inaccurate Characterization of the Company’s Business Model

Wall Street analysts have been quick to position Tangoe as a high growth SaaS company. Furthermore, Tangoe enjoys significant Street sponsorship with a median price target of $27.00 and all 6 analysts covering the Company rating it a Buy.

“We view Tangoe as having “category killer” status in the TEM market, and as a solid player in the fast emerging MDM space. With solid profitability and organic growth well established, we believe the company should become a “premium player” in terms of valuation in the SaaS space, although a limited track record has likely gated this move somewhat.” – Wunderlich, April 5, 2011

“Tangoe’ early market share lead could be amplified by a differentiated, SaaS-driven product story, investments in growth acquisitions, and strategic alliances. The financial model offers a nice balance of 20%+ top-line growth and much faster growth in operating profit and cash flow as the business gains scale. We believe the company could become a true SaaS category killer, with potentially significant valuation ramifications going forward.” – Raymond James, September 6, 2011

Moreover, Tangoe’s business involves significant manual and custom processes related to technology integration that are more reflective of a BPO/IT Consulting business rather than a low-touch SaaS offering.

Note: Adj. Gross Margin excludes SBC

Key Concern 2: A Highly Questionable Organic Growth Rate

Organic recurring revenue growth does not seem to reconcile with management commentary. Management on multiple occasions during earnings calls has made references to the Company’s organic recurring revenue growth rate as being in the low to mid 20s. For example, on the Q2, 2012 Earnings call, the CFO stated that “on an organic basis, we estimate that our organic recurring revenue growth was in the low-to-mid 20% range, which was a strong performance that exceeded our expectations for the quarter.”

First, we find this to be extremely odd as they cannot provide a point estimate and have resorted to making vague statements and talking in ranges. Second, utilizing all company disclosed data (public filings and earnings call transcripts), we have attempted to model out the real organic recurring revenue growth which we believe is significantly below the growth rate as disclosed by the Company. Our analysis shows that the organic recurring revenue growth in FY2012 was ~16%, missing Management’s own guidance provided on their Q4, 2011 earnings call where they stated that they “are currently targeting revenue of $137 million to $139 million or growth of 31% to 32%. This assumes organic recurring revenue growth in the 20% range.”

Moreover, continued deceleration in H1, 2013, below long-term target, sets the Company up for ~21% growth in H2, 2013 in order to meet the mid-point of management’s guidance for organic recurring growth of between 16% - 18%.

Note: Where split been recurring revenue and consulting revenue is not disclosed, we have assumed a 90%/10% split

Net net we strongly believe that Management continues to obfuscate the true organic growth rate of the business by intentionally being vague and imprecise.

Key Concern 3: Continued Outperformance From Company’s Non-core Business

Non-core gross margins continue to trend significantly above core gross margins. Specifically, non-core gross margins have exceeded core gross margins by an average of 420 basis points per quarter over the Q1 2011 – Q2 2013 period. Further, overall gross margins have received a boost of 50 basis points per quarter on average due to the beneficial margin impact from the non-core business.

Note: Adj. Gross Margin excludes SBC, which has been allocated for each of the business segments in proportion to their revenue contribution

Additionally, strong growth in non-core revenue growth has helped Tangoe meet and exceed consensus revenue estimates on multiple occasions. After posting declining revenue growth over the Q3 2010 – Q2 2011 period, the non-core business has shown tremendous growth. Non-core revenue growth has exceeded core revenue growth in 2 of the past 6 quarters (albeit of a much smaller base but nevertheless a disturbing fact).

Key Concern 4: Emergence of Accounting Red Flags

Worsening DSO metrics and ramp in Accounts Receivable (“A/R”) growth rate might signal possibility of aggressive revenue recognition. Specifically, DSOs have increased significantly (Y/Y) with Q2 2013 up 17%, and Q1 2013 up 8% from the comparable period last year. Surprisingly on the Company’s Q2 2013 Earnings call, not one analyst questioned this rather substantial jump and management did not raise it either in their prepared remarks. Additionally, A/R growth has been outpacing revenue growth on a Y/Y basis. A/R growth has exceeded revenue growth for three straight quarters with the variance increasing from 1% in Q4 2012 to 21% in Q2 2013. Analysts once again failed to question this development on the Company’s Q2 2013 earnings call.

Also, growth in deferred revenue has failed to keep pace with total revenue growth, and in some cases the growth has actually turned negative. Moreover, deferred revenue from implementation fees has largely been flat despite new customer additions. Management has repeatedly mentioned that deferred revenue is not an accurate metric given that they bill customers predominantly on a monthly basis. However, this does not reconcile with the statement made under the Risk Factors section of the 10-k filing stating that “the aggregate effect of significant downturns in sales of our solution would not be fully reflected in our results of operations until future periods.” If majority of billings are on a monthly basis, then any slowdown in the business should become immediately apparent in the operating results.

Key Concern 5: One-time Boost to Operating Cash Flow from Acquisitions

As a serial acquirer, Tangoe has been the beneficiary of several one-time boosts to operating cash flow from the balance sheet of the acquired company. Though perfectly legitimate, we would like to emphasize that looking at the Operating Cash Flow in aggregate is highly misleading, as it materially overstates, as shown in our analysis, the true cash flow generation capacity of the business. We believe Management has significantly boosted operating Cash Flow through one-time working capital adjustments related to acquired entities.

Note: Assumes that working capital of acquired companies converted to cash over 180 day period

Key Concern 6: Persistent Insider Selling

Insiders have been net sellers since the IPO on May 27, 2011 with not a single purchase on the open market being made by Management or any of the Directors of the Company since that time. Moreover, Insiders have taken every opportunity of an increase in share price to offload their holdings. It is worth noting that the Company priced a secondary offering less than a year after going public. This is in stark contrast to the bullish comments that the CEO of the Company often makes highlighting the formidable position of Tangoe and the substantial greenfield opportunities that exist. For example on Tangoe’s Q4 2012 Earnings Call, the CEO stated that “from a longer term perspective, we have never felt better about Tangoe's market position and ability to be the primary winner in the multi-billion-dollar CLM market opportunity”. Yet two of the largest shareholders (Edison Venture Partners and Sevin Rosen Funds) have liquidated their holdings since the IPO. We ask the question that if the market opportunity is so massive, then why are Insiders selling en masse?.

Key Concern 7: A Highly Dubious Management Team

Tangoe is run by Albert Subbloie (President, CEO & Founder) and Gary Martino (CFO) who bring with them a dubious past at Information Management Associates (IMA), a company that provided customer interaction software for call centers. During Messrs. Subbloie and Martino’s tenure at IMA, the company was the subject of multiple financial restatements, rapid auditor changes, and ultimately filed for bankruptcy on July 25, 2000. A lawsuit filed against IMA, Subbloie and Martino specifically highlighted the following:

• Restated financials twice in 1998 (restatement of reported service and maintenance revenue and improper recording of expenses related to acquisitions)
• Inflated revenues for the second quarter of fiscal year 1999 by 25%
• Underreported expenses incurred for the second quarter of fiscal year 1999 in an effort to minimize the amount of the loss and show improving profitability – restatement showed IMA losing more than 3x its originally reported loss
• Terminated their auditors (Arthur Andersen and PwC), who had explicitly called out a material weakness in IMA’s internal control and reporting, within ~6 months of each other

Subbloie and Martino have made every attempt to distance themselves from the fallout of the IMA bankruptcy. In the prospectus filed for Tangoe’s follow-on offering, the statement “In July 2000, IMA filed a voluntary petition for bankruptcy under Chapter 11 of the United States Bankruptcy Code with the United States Bankruptcy Court” was conveniently removed, even though it had previously appeared in the original prospectus related to the IPO filing.

The fact that Team Subbloie and Martino did not learn from their previous mistakes related to the 1998 restatements, only to engage in financial trickery the following year, is highly disconcerting, especially given some of the accounting red flags associated with Tangoe and brought up throughout this write-up. It would not surprise us if we are setting up for IMA Redux.

Key Concern 8: Fundamental Threats to the TEM Industry

The TEM market is facing several secular and structural headwinds which can dampen the long-term growth rate of the industry and cause deterioration in underlying unit economics. Below we highlight what we perceive to be the major inhibitors to the profitable growth of this rapidly growing industry:

• Intense pricing pressure: Non-core TEM companies (e.g., ITO/SI providers or Communication Service Providers (CSPs)) are squeezing the market through highly aggressive pricing which potentially narrows growth opportunities for pure-play TEM providers.

• TEM increasingly becoming a loss leader: Large outsourcers and integrators are also taking advantage of their unique business models to extend TEM at cost in favor of pulling through larger network services and/or outsourcing contracts. Additionally, CSPs and mobile network operators (MNOs) increasingly give away basic TEM services as a goodwill gesture.

• BYOD represents a long-term threat: The current focus on transitioning corporate-liable mobile devices and service plans in favor of individual-liable devices may become an increasing inhibitor to revenue opportunities for TEM companies. TEM companies will still have revenue opportunities in enterprises adopting BYOD; however, the revenue potential is reduced greatly, representing a longer-term threat.

• Channel becoming a “double-edged sword”: Outsourcers are less likely to build their own service delivery organizations for implementation and management of the TEM software platforms they are purchasing from the TEM providers. Instead, outsourcers are abandoning organic solutions and relying on the TEM providers themselves to include staffing as part of the engagement model, not just the software; thereby pressuring TEM provider margins and creating a drag on that revenue uplift.

Tangoe, on multiple occasions, has been the beneficiary of outsized performance in its non-core business that has enabled it to beat consensus earnings estimates. In addition, a prolific acquisition strategy ensured that the Company was able to gin up revenue and earnings when needed to preserve its perfect record. However, this perfect record has come to an end with Tangoe failing to beat Consensus estimates for 2 consecutive quarters after beating estimates for 6 consecutive quarters as a public company. With Management indicating a lack of sizeable acquisition opportunities, the Company will be forced to increasingly rely on flawlessly executing its organic growth strategy to meet/exceed future earnings estimates.

Valuation:

Note all estimates based on FactSet consensus; Adj. EBITDA defined as EBITDA less SBC and one-time items; FCF defined as OCF less Capex

Street analysts focus on positioning the SaaS attributes of the company to justify high valuation multiples despite the significant BPO component associated with the business.  We believe Tangoe should be valued closer to its Telecom Software (Amdocs, CSG Systems, Comverse and Neustar) and BPO/Consulting (Accenture, Cognizant, Genpact and Infosys) peers. Applying a generous 25% premium to the median multiple of each of our comparables set, we derive an intrinsic value in the range of $7.48 - $14.75 per share, implying downside of 40.3% - 69.7% from current levels.

Note: Adj. EBITDA defined as EBITDA less SBC and one-time items        

As a result, we believe that the above illustrative valuation range indicates considerable downside from current levels and would look to build short positions in Tangoe.

Catalyst