Description

Teradata Corporation, TDC, is a global leader in analytic data platforms, marketing and analytic applications, and related services.  TDC is a former high flying/highly valued momentum stock that began to experience some headwinds towards the end of 2012, which led to a dramatic selloff through 2013.  I believe the concerns about competition are overblown and that the general malaise in IT spending is more cyclical in nature than secular, so we have been presented a great opportunity to purchase an extremely high quality company at a very good price, as the stock undergoes significant shareholder base rotation.  The stock is worth $55-60 in a 12-18 month timeframe and potentially a double over the longer term with limited downside risk.

TDC was founded in 1979 inDayton,OH.  In 1984 it launched a relational database management system, which it partnered with NCR on in 1990 to develop next generation systems.  In 1991 AT&T acquired NCR and subsequently NCR acquired TDC.  AT&T spun off NCR several years later in 1996 and NCR spun off TDC in 2007.  The company has been well managed by CEO, Michael Koehler since 2002 when it was still part of NCR, and by CFO, Stephen Scheppmann, who joined in 2007.

TDC enables customers to access and manage data, as well as extract business value and insight from their data, so that they can make better informed decisions about their business.  TDC’s Unified Data Architecture integrates its data platforms with multiple technologies including third party products into a cohesive ecosystem.  Once customers are better able to collect and manage their data, they can leverage it to improve organizational effectiveness in marketing to customers, determining customer and product profitability, forecasting, and discovering new insights.  So TDC is helping its customers achieve a competitive advantage by empowering them to exploit the information already in their possession.  Long story short: they take data from disparate sources (different departments, systems, geographies), aggregate it, run queries, and analyze the data, so that an organization can learn more about their business and make better decisions.  Its revenues are split 55%Americasand 45% international, and 44% products and 56% services.

TDC is focused on three large and growing markets: integrated data warehousing, big data analytics, and integrated marketing applications.  The majority of its revenue consists of data warehouse management software, and the requisite appliance hardware and services.  TDC has expanded through acquisition and internal development into adjacent markets, like marketing resource management via the acquisition of Aprimo, and Hadoop-MapReduce software via the acquisition of Aster.  For 2014, Gartner estimates the total addressable market to be approximately $26 billion and growing at a ~10% CAGR.  This addressable market includes data warehouse management software of about $11 billion, hardware of $11 billion, as well as marketing resource management and Hadoop related software of $4 billion.  TDC has about 1,200 customers worldwide and has penetrated less than 25% of the Global 3000, which is its stated target market.  It continues to add to its sales teams at a rate of about 35 per year, or 5-6% growth, to address new territories and customers, so its addressable market is underpenetrated and there is a long runway of growth.

As cracks began to appear in the big data story in late 2012, growth investors began to exit en masse.  The selloff accelerated in 1Q13 when product revenue dropped 19% yoy and total revenue fell 4%, and management began lowering guidance; a process that continued into 1H14.  For the full year, 2013 ended with product revenue down 5% and total revenue up 1%, as services revenue slowed from double digits, but maintained a respectable 7% growth rate.  Expectations remain tempered in 2014 with total revenue growth around 3%.  Operating margins fell 230bps yoy to 19.7% in 2Q14 because TDC experienced negative operating leverage as it continued to invest for the future, while sales stagnated.

Clearly, there are legitimate concerns about the business model and competition since the company was slowing from >20% growth rates in 2010 and 2011, and had averaged approximately 10% since 2005.  However, I believe the competitive threat is overblown and the franchise value will remain intact during what will be a drawn out, but temporary slowdown.  To be sure, TDC’s success in data warehousing has encouraged increasing competition, and this remains the principle risk, but at present none of the emerging technologies that operate on the lower end as single purpose platforms present much of a threat, like Hadoop.  And new offerings, like AMZN’s Redshift for example, are not robust enough to handle the needs of large enterprises.  Furthermore, many of the incumbents can pose a risk due to their scale and breadth, but have inferior products.  Management on the 2Q14 earnings call stated that despite weaker growth they have not seen a change in the competitive landscape and pricing environment.

Hadoop is more complementary than an existential threat, although it is causing some disruption.  It is an open source file management system that allows users to achieve storage and high quality queries on large amounts of data inexpensively.  Due to the increasingly large scale of data organizations are trying to collect and analyze now, it has become popular.  However, performing higher level, more value added analysis still requires an enterprise data warehouse like TDC provides.  There is a transition happening though where a Hadoop cluster of appliances can be run along side an enterprise data warehouse more efficiently and inexpensively handling a small amount of the workload.  TDC has stated that approximately 4-8% of the workload being handled on its systems could potentially be migrated to Hadoop to extract, transform, and load data.  Cloudera, a Hadoop based startup, has corroborated TDC’s evaluation of the situation. In February, 2014 the VP of Sales at Cloudera confirmed that their customers were not abandoning enterprise data warehouses, nor was Cloudera encouraging that, but rather a larger enterprise that has one or many data warehouses could move some workload to Cloudera’s Hadoop clusters, which would save a lot of money and free up enterprise data warehouse capacity for running mission critical analysis.  So the reality of the situation is that it is not so much a threat, but rather a complement, and it can potentially grow the market as more organizations are able to easily and cheaply filter their data, generating more analyzable and structured data.  The real negative is that it has created some temporary disruption in the short term because some IT departments are pausing their enterprise data warehouse spend in order to evaluate how to incorporate Hadoop into the ecosystem, and furthermore if they do decide to transition some work to Hadoop this frees up some capacity on TDC appliances, which enables the customer to defer spending on TDC products a while longer.   TDC also has addressed this part of the market through its acquisition of Aster, the introduction of the lower end 1000 series appliance, and through partnerships.  Although there has been a lot of talk about Hadoop over the past two years, on the 2Q14 earnings call management said that it has not seen much activity of workloads being transferred to date and no material change in customer behavior or buying patterns of those that are running some Hadoop clusters versus those that are not.

The real competition is IBM and ORCL.  Forrester and Gartner have ranked TDC the undisputed leader in the analytic database space in terms of performance and vision for years, but due to numerous acquisitions and vast financial resources IBM and ORCL are formidable competitors.  Most incumbents position their product portfolios to build on top of relational databases and legacy products through newer products that were cobbled together through acquisition, which ultimately is not as competitive as solely focusing on data warehousing and analytics.  The incumbent approach tends to focus on transactional database, which can be fast, but more adept at handling simpler queries because these databases were designed to be operational, capturing structured information in the normal course of business, whereas TDC was purpose built for complex queries through massively parallel processing specifically to analyze data.  IBM already had a strong position in enterprise database and IT services, but improved its position through $6+ billion of acquisitions in the business analytics market, and its acquisition of Netezza for $1.7 billion in 2010.  Netezza was the closest pure play standalone competitor to TDC, but its data warehouse appliance is well suited for smaller data warehouse environments, and TDC is better positioned for large scale enterprise-wide deployments.  ORCL, obviously, is a serious competitor also with the largest market share in the database market.  Its key selling point is that it can reduce hardware cost because its product, Exadata, can be integrated into the existing database.  Exadata takes a transactional oriented approach, which is a natural extension to its relational database, so it is better suited to relatively small amounts of structured data.  TDC is more capable at managing a large data warehouse that is consolidating data from across platforms across the enterprise into a central location and perform more complex analysis.  While these products do not perform as well as TDC’s, IBM and ORCL are a considerable threat more because of their ability to bundle and cross-sell.  Their offerings might also be sufficient for smaller organizations.

Lackluster results are more the result of economic conditions and a general malaise in IT spending, which is impacting TDC more acutely than some others for a couple of reasons.  TDC’s business is by nature lumpy because of the large upfront cost, which causes long sales cycles and requires high level approvals.  Some of the largest enterprises in theUSwere earlier adopters of integrated data warehouses, sometimes spending tens of millions on implementations.  TDC’s top 50 customers are now experiencing a digestion period, following large recent investments and budget constraints, which are putting pressure on further large capital investments.  These customers are waiting longer to upgrade, i.e. do a “floor sweep,” and pushing their utilization higher, i.e. “sweating” their assets.  This has caused the softness inAmericasproduct revenue, but has also driven maintenance revenue higher.  Management has noted that growth outside the top 50 customers remains double digits.  Top 50 customers as a percentage of revenue spiked to 37% in 2012, and then declined to 33% in 2013, and will fall to 25-28% in 2014, so this headwind will abate in 2015 as smaller customers become more significant and deferred spending at larger customers creates pent up demand.

Beyond the temporary pauses in customer activity, several of TDC’s larger industry verticals are facing secular challenges.  Communications and retail were 28% and 19% of sales, respectively, in 2007.  In 2013 they contributed 19% and 14%, respectively.   Telecom is a shrinking business with technological changes causing line attrition and price deflation.  Retail is also suffering from technological disintermediation, which has hurt store traffic and margins.  Fraud detection and security have also become bigger focus areas in retail.  Furthermore, weak consumer spending since 2008-2009 has not helped the situation.  Although they are still important parts of the business, as these two areas struggle, they become less relevant to overall top line growth and other areas will begin contributing more.  Financial services has been very robust since 2007 growing from 24% of sales to 31% in 2013.  Manufacturing and healthcare are two smaller verticals, chipping in 13% and 8%, respectively, that have great growth prospects.

Understandably, sentiment on the stock has become quite negative as growth slowed, guidance was walked down, and the downgrades piled up, so with all of this bad news what’s to like? 

This is a tremendously high quality company averaging a ROIC of 25% and ROE of 29% since 2005, when financials became publicly available.  The ROE declined to 20.7% in 2013 because margins which had been steadily increasing slipped a bit during this slowdown.  Asset turnover and lower leverage have also contributed to the decline in ROE as earnings have compounded and cash has piled up on the balance sheet.  Book value per share has grown 19.4% in this timeframe.

One of the hallmarks of a quality company is pricing power.  TDC prices its offerings at a large premium to peers on a terabyte basis (often ~$50-60,000/TB for its flagship 6000 line, which is about 80% of hardware revenues and has an ASP of ~$1.5 million) but the comparison is difficult to make because TDC offers better performance, stability, scalability, and reliability than peers, according to customer and IT surveys.   TDC’s lower end appliances, which have fewer features, cost in the $1-2,000/TB range, which is more inline with the rest of the industry. The only real complaint about TDC is that the total cost of ownership is high, but since it generates an attractive ROI for the customer, it is justifiable.  Due to the very high levels of customer satisfaction, TDC’s customers are extremely sticky; it is almost unheard of for it to lose customers.  Part of the reason for this is the large investment in time and money that customers spend on TDC, but it is also because TDC’s sales teams are very high touch and develop a high degree of specialization becoming almost long term partners to their customers, completely getting to know and understand each business, and then helping to customize each implementation.  TDC is creating an end to end solution for its customers, not just selling a point product.  There is also a recurring component to its services revenue.  As a result, TDC’s laser like focus on this one niche, its extensive history of heavy investment in innovation, and large installed base with long-term customer relationships, make it extremely difficult for a competitor to kill or recreate this franchise.

In addition to TDC’s wide moat, it is benefitting from some very powerful secular tailwinds.  According to Gartner and other surveys, next generation analytics and big data are still top strategic priorities.  Data itself is growing 30-50% annually.  More important than the sheer volume of data being generated is the complexity.  The different types of data available are continuously increasing, as is the complexity of the types of queries and analyses organizations can run.  Also, the processing of data into analytics increasingly has to be done with no downtime and in real time.  All of this plays into TDC’s core competency and competitive advantage.  Also, as pricing for processing power falls, vast amounts of data and new types of data, that were previously uncollectable, unmanageable and un-analyzable, become economical to delve into.  It is rare to find a tech company that benefits from the creative destruction and deflation that innovation bring.

Furthermore, as growth slowed, TDC has continued to invest in expanding its sales territories and R&D, so negative operating leverage exacerbated the slowdown, but this investment should pay off longer term.  As growth resumes, TDC will again benefit from operating leverage causing already strong margins to rise further.  Selling expense has continued to rise without seeing a commensurate return yet because it often takes two full years before sales teams become productive, since sales cycles can be 18 months or longer.  It appears that this investment is beginning to bare fruit.  On the 2Q14 earnings call, management commented that 1H14 was the second highest ever for new data warehouse customer wins.  There is a large upfront outlay once an implementation hits performance targets, so revenues should begin to benefit from this in the next several quarters. 

Another way to think about it is the following: at the end of 2007 TDC had 385 sales teams and had around 600 at the end of 2013, so it has added roughly 35 teams per annum.  Using a two year lagging average of sales teams should approximate the number of productive sales teams in a given year, so by the end of 2014 there could be well over 600 total teams, but closer to 540 productive teams.  The upfront cost of ramping up a team (which has three members: an account manager, an engineer, and a developer) could be in the order of $1 million with little to no sales for the first two years.  Revenue/productive team peaked in 2012 around $5.8 million.   About 40 teams annually will become productive in 2015 and 2016, and the current consensus expectations for revenue imply that revenue/productive team will decline back to <$5 million; levels not seen since the recession in 2008-2010.

While all these momo guys have been selling the stock, insiders and the company have been buying (although there was a large option exercise and sale last week).  TDC repurchased 4.5 million shares at an average cost of $41.91 in 1H14 and 7.8 million for $48.53 in 2013.  And it has shrunk its share count from 180.7 million in 2006 to 155 million at 2Q14.  The company has another $452 million of authorization remaining on its current repurchase program.  In February, 2014 there was a spate of insider buying at levels similar to where the stock is trading today.  CEO, Koehler, bought 10,000 shares at $41.30, bringing his direct ownership to just under 170,000.  Three directors bought another 3,680 shares around the same time. While insider ownership is low at under 1%, I think this is a fairly strong signal about the valuation and outlook, given that insider buying is quite rare at the company.  

TDC has a very solid balance sheet with $709 million of net cash.  Despite the recent setbacks, it will generate in excess of $400 million of free cash flow annually over the next few years. 

2Q14 was a little stronger than expected as several large deals were pulled in from 3Q, so 3Q will be slightly weak and 4Q will recover somewhat, which means TDC will generate about $2.78 billion in revenue in 2014.  As growth rebounds slightly, TDC should do about $3.07 billion in 2016, and with the benefit of modest operating leverage, a 20.5% operating margin should be reasonable, equating to $840 million of EBITDA and $2.90 GAAP EPS.  Management provides adjusted non-GAAP income and EPS numbers, primarily adding back stock based compensation and amortization of acquisition related intangibles, which the sell-side adheres to, which would translate into $3.30/share.  Normally, I am not a fan of pro forma numbers, but TDC’s free cash flow conversion is almost always higher than net income, averaging 110% over its history, so I think it is instructive to consider it also in this case.  Therefore, TDC is trading at approximately 2x EV/REV, 7.1x EV/EBITDA, 13x GAAP P/E ex-cash, 11.4x Non-GAAP EPS on 2016 estimates.  And giving TDC credit for the $800+ million of free cash flow it will generate by the end of 2016, EV/EBITDA is closer to 6x.  This valuation implies that TDC will not grow in the future and that returns will collapse, and seems much too low for a company that has a strong competitive position generating 20-30% ROE, good growth prospects, and a great balance sheet, so this stock should continue to compound its earnings over the long term and deserves a premium to the market.  Even in a non-growth scenario TDC should generate at least $2 billion of free cash through 2018.   

Even in a dire bear case there is limited downside.  The low estimates on the street are for $2.72 in 2014 and $2.92 in 2015.  Assuming that revenue and margins continue to deteriorate and 2015 EPS declines similarly to 2013, and assuming that the multiple compressed to an average of IBM, ORCL, and EMC of about 11.5x, which would equate to ~$34.  TDC is probably not a likely acquisition target at this point for a variety of reasons, but my sense is that if the enterprise value were to decline that much a number of potential suitors would become interested acquiring this valuable technology.  Similarly, with $934 million of cash and more than $1.7 billion by the end of 2016, any dramatic decline in the stock would be met with a much more aggressive repurchase program.

The outlier bull case is that TDC can return to double digit growth with strong incremental margins driven by operating leverage from its continued investment, generating $4/share in a few years, at which point it could garner a fancy multiple again.

The principal risk is increasing competition either from existing competitors or new entrants hurting TDC’s ability to set premium pricing.  Aside from macroeconomic risk, TDC needs to focus on sales execution and continue to innovate to remain the market leader.  Another more minor risk is that only $157 million of its cash is in theUS, which could limit its balance sheet flexibility.

In conclusion, a number of short term issues have created a compelling opportunity with an attractive risk-reward.  Temporary headwinds have depressed results and single purpose platforms have chipped away at the business model, but left the franchise intact, so that TDC will continue to grow and compound earnings well into the future.

(Note: Normally, I check to see if there have been any other submissions of an idea I am writing up, but for some reason this time I was very confident that TDC was never posted before.  I just realized that it was submitted earlier this year and once five years ago, but I still think that it is worthwhile to expound this situation in greater detail.)

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