Teradata Systems is the largest independent high-end data warehousing software / hardware provider for large companies. The company was founded in 1979 and gained prominence after signing up industry leader Wells Fargo in 1983. Teradra was sold to NCR in 1991 and subsequently spun off to NCR shareholders at the top of the market in September 2007 to avoid a large tax bill at the NCR corporate level.

Since the spin off, the stock has lost approximately half of its value, declining from the high 20s which were reached on takeover rumors to as low as $11 per share at the November 2008 market bottom. Teradata has no debt, substantial free cash flow, a promising niche position in a secular growth business, and a solid recurring revenue stream from well-capitalized customers that gives the business staying power through this great recession. Nonetheless, Teradata has fallen victim to the relentless selling of hedge funds, negative investors, economic weakness, etc.

As of November 2008, management has guided Teradata to earn $1.35 in FY2008, giving the Company a valuation of 10.5x EPS, which approximates the multiple of the S&P 500. At its best, Teradata was projected to earn $1.50 by the sell-side. The 10% decline in earnings is clearly disappointing. But relative to other companies and the enormous decline in P/E from 20x at the peak to 10.5x a lower earnings number, Teradata offers a compelling risk-reward.

Teradata competes primarily with IBM, Microsoft, and Oracle. However, its competitive advantage comes from the strength of its product offering.  Field checks indicate that Teradata’s customers believe the product is fantastic. For example, the retention rate is 98% annually and Teradata boasts industry leading clients including Coca-Cola. FedEx, Wells Fargo, Mizuho Bank, Metro AG, and many others. All in all, Teradata has over 850 customers globally with over 50% of the revenue from outside of the United States. Teradata has clients as diverse as the US Air Force to the Shanghai Stock Exchange.

Teradata’s business has huge barriers to entry. Massive scale is required for profitability as it took Teradata over 20 years from its 1979 inception to generate even mediocre margins. Customers are reluctant to switch because of high switching costs. Teradata sells a system to a customer for approximately $1.5 million upfront and then charges recurring fees on an annual basis according to capacity needs. Approximately 85% of revenue is recurring.

The business is 1/3 software, 1/3 hardware, and 1/3 services. The current margins are in the low 20s but have the potential to expand into the mid 20s over time, according to management.

Teradata believes that its software / hardware makes category killers more powerful. This reputation is shared by many industry experts and comes partially from its long-standing relationship with Wal-Mart. Apparently, there was much confusion over the Wal-Mart relationship which made investors nervous. When former NCR CEO Mark Hurd left NCR to join H-P, he recruited former Wal-Msrt CIO Randall Mott to run data warehousing. Due to Mott’s contacts, Wal-Mart decided to give some of its new business to Hewlett-Packard. However, Teradata denies that Wal-Mart terminated its existing agreement and explains that the cost of switching Wal-Mart’s account would be astronomical not to mention enormously complex.

Fortunately, the business is not concentrated with no customer exceeding 5% of revenues and the top 10 customers accounting for only 16% of revenues.

Due to the economy, Teradata will probably earn about $1.10 in FY2009, which is 20% below FY2008 numbers based on a 27% tax rate. Sales should be flat due to declining domestic revenue offset by growth overseas. This implies an attractive valuation of 13x trough earnings.

Over a full-cycle, management estimates that to-line growth could reach 7% to 9% due to secular growth in the industry and increased market share. EPS growth could reach 15%+ due to the fixed cost nature of the business.

Teradata has a good chance of being acquired in the foreseeable future. The CFO Stephen Scheppman used to be at Per-Se Technologies before it was sold to McKesson in 2006, so he is very experienced in this arena.

Teradata also benefits from a fairly attractive M&A market in technology. Many cash-rich technology firms such as IBM, Microsoft, and Oracle, have the wherewithal to finance a takeover of Teradata and gain access to a lucrative customer base and solid revenue stream without relying on the capital markets.

In 2007, IBM and Oracle acquired companies in the space for 4.2x and 4.4x training sales. At this valuation, Teradata would be worth over $50 per share, representing upside of over 400%. Obviously, this is aggressive.