Description

Upland Software: Software Private Equity in the Public Markets

UPLD is no stranger to the VIC, and for background I would recommend you read yellowhouse’s August 2019 writeup and lars’ January 2020 writeup for background and the bull and bear case. Obviously you have to score one for lars but I believe the market has become much too pessimistic on UPLD and the current stock price represents a compelling opportunity. Some of the key investable technology themes of the last decade-plus have been the stickiness of enterprise software- changing out the software applications businesses rely on represents disruptive distraction, and the related idea that stable software revenue streams can support financial leverage. Private equity firms like Vista Equity Partners and Francisco Partners have made untold billions based on these insights, and vertical ERP software rollup Constellation Software (TSE: CSU) has been one of the best-performing stocks in the world over the last 15 years. I believe Upland Software can accomplish similar value creation, but temporary internal and external factors have depressed Upland Software’s stock price. An investment in the company’s stock at current prices has medium-term upside from a potential private equity purchase transaction, but I hope this does not happen as I believe UPLD has long-term multi-bagger potential.

Company Overview and History

The core thesis behind the formation of Upland Software was the explosion of VC funding in the SAAS space would produce a lot of companies that succeeded in a modest way, but most would not reach the scale needed for an initial public offering, and these assets could be acquired and financially restructured at attractive multiples and high ROICs. Essentially, Upland Software would do in a public company format what the major software PE firms did privately. Founder, CEO, and Chairman Jack McDonald started Upland in 2010 after a successful long-term tenure as CEO of Perficient (NASDAQ: PRFT), a roll-up in the technology consulting space that today has achieved a $2B+ market cap. McDonald still owns approximately 6% of the equity and has spent around $1M buying UPLD stock in the open market over the last year or so. Upland was also privately funded by Joe Liemandt, a software industry pioneer who founded Trilogy Software in the 1990s and subsequently made a large fortune for himself by being early to the private, leveraged software asset purchase strategy, having purchased over 100 small software companies through his investment vehicle ESW Capital. While Liemandt no longer serves on UPLD’s board, I believe he remains a significant shareholder of the company.

Upland has made 31 acquisitions in its history, typically of smallish SAAS software companies that had achieved good product and revenue traction but were not achieving the growth trajectory needed to IPO on a standalone basis. A purchase by Upland represents a good fallback outcome for venture capital investors who can recoup their investment dollars and concentrate their portfolio on the large winners that define success in venture capital. The typical playbook involves moving software hosting to a lower-cost provider with an Upland volume discount, removing G&A expenses, significantly reducing sales and marketing, transitioning some R&D activity to lower-cost countries, and continuing to serve customers dependent on the product. Frequently, their targets operated near breakeven or lost money, but after Upland management implements their cost management initiatives, the companies quickly become profitable. The entire company achieved adjusted EBITDA margins of 37% in 2019. Upland organizes its product lines into five key categories: knowledge management, customer experience management, project & financial management, document automation, and sales enablement.

The stock traded flat to down for the first couple of years after Upland’s late 2014 IPO, but as the company developed a track record of successfully sourcing, closing, restructuring, and integrating acquisitions, the stock went from around $10 in early 2017 to a peak of near $50 in mid-2019 as EBITDA grew from only $4M in 2015 to nearly $100M in 2020. Along the way, the company hired a VP of enterprise sales who built up a sales force to attempt to cross-sell additional Upland portfolio products to existing customers. Since the customers generally came from pre-acquisition sales efforts, there was little customer overlap between the major product lines. While the strategy doubtlessly seemed logical at the time, as it turns out, the products in Upland’s portfolio were generally point products with different decision-makers, and the cross-sales effort generally failed. This realization coincided with the general technology market selloff that began in late 2021, and the stock traded back below $10 by the end of 2022.

Current Situation

Rolling up software assets has been one of the last few years' most successful private equity strategies, and Upland’s apparent success attracted some attention. In July 2022, multi-billion-dollar private equity firm HGGC made a $115M strategic equity investment in a new class of Upland’s preferred stock that converted at $17.50 per share, a 30% premium to the price at the time. The preferred stock carries a 4.5% dividend that could be paid in-kind or in stock and gave Upland the capital to continue its acquisition strategy without pushing its net debt leverage. Upland added a principal from HGGC to its board and committed to working with HGGC on further operational and acquisition process improvements. Importantly, and I believe the market does not generally understand this fact, HGGC expended significant resources on consultants for product and customer due diligence before making the investment, giving me comfort that the software application portfolio is not a collection of melting ice cubes.

As Upland learned the sales strategy of hiring reps to make in-person visits and cross-sell products was not working, it began working with HGGC’s software operational advisors on a product portfolio review and new sales strategy in the second half of 2022. After this review, the company made some changes that would reduce revenue and margin in the near term but put the business on a better footing to create value over the long term. Upland decided to sunset certain products representing about 10% of the revenue the company felt required more ongoing development resources than fit its model and move to a digital-first, inside sales motion more typical of a point software product company with moderate average selling prices. Upland hired sales and marketing leaders from successful private software companies like Infor and Tibco to implement this change. Upland announced this new strategy, which required taking EBITDA margins down in the short term to build its new sales and marketing team while forgoing some revenue from sunset products, in its Q4 2022 earnings call in early 2023. Based on the lowered sales and profitability guidance, the stock sold off from just under $9 to around $5.

The company then ran into a modern stock market inefficiency. The selloff caused its market cap to drop just below the Russell 2000 small cap index inclusion cutoff, which resulted in a further cascade of index fund selling, sending the stock as low as $2.43, although recently the stock significantly rebounded. Today, the stock has been removed from relevant indexes, and 75% of the analysts that continue to follow Upland have a “hold” rating on the stock, not that they pay much attention to a $150M market cap company.

Forward Prospects

I believe the situation has produced an investment with attractive forward return prospects and multiple ways to win over different time horizons. As of today, the stock trades at an EV/EBITDA of only 7.8x and an estimated FCF yield to equity holders of 21%, eye-watering levels for a company experiencing no financial distress. Upland has over $275M of cash against $514M of debt with almost no covenants maturing in 2026, an interest rate locked at around 5.4%, and $115M of preferred stock with a 4.5% dividend. Revenue should decline around 5%, but I believe outside of sunset products revenue will be flattish. In my opinion, a 9x (purposefully depressed) EBITDA multiple and a mid-teens FCF yield would be on the conservative side of appropriate for a stable SAAS business, and achieving this valuation would put the stock around $7 or up around 60% from today.

I am sure the low valuation and high FCF yield to Upland equity is not lost on their private equity sponsor, HGGC. Right now, the preferred stock does not convert until it gets above $17.50, and in the meantime, HGGC only earns 4.5% on their preferred stock investment despite their capital, due diligence, and ongoing operating support investment. The firm engaged significantly with Upland before and after making its investment, and I believe it might want to own the entire company at today’s valuation. Given their asset base, it does not seem difficult to see HGGC making an offer to take the entire company private for $8 to $10 per share, a manageable $275M to $340M equity check that would enable them to build the business without the distractions of day-to-day public markets and re-ignite the acquisition engine. I doubt Jack McDonald wants to take the company private near the IPO price after this many years of work, but the potential premium to the current price might be too large for a public company board to ignore.

The company has stated a near-term goal from the ramp in sales and marketing spending of returning to 5% bookings growth in 2024. Should this occur, I think questions about the long-term sustainability of Upland would significantly reduce, and as VIC members probably know, double-digit FCF yields on growing software companies are few and far between in today’s market. A 10% FCF yield on my 2025 model would equate to an approximately $12 stock price, up around 175% from today's price.

Due to the changes in Upland’s sales and marketing strategy and the inflated valuation expectations of private software companies resulting from the 2019-2021 market boom, the company paused its acquisition efforts and has not bought a software company in over a year. In the meantime, VC funding of the industry has continued apace, and Upland has a large potential acquisition pipeline. I believe as the valuation reality of the current market sets in, and VC funds get nearer to the end of their investable lives, Upland will again become an attractive exit option for moderately successful SAAS companies. At the same time, Upland should be plugging these companies into an improved operational model. The company indicated it may be ready to restart acquisitions in the first quarter of 2024 or earlier in its most recent conference call. If this all comes together, Upland could resume its growth trajectory and even get its stock price back to the levels of 2019-2021 over several years. My fondest hope is I can own UPLD over multiple years as it gets the acquisition flywheel going again and regains its former glory.

Catalyst

• Company hitting stated goal of 5% bookings growth in 2024 causes valuation re-rate
• Resuming acquisitions results in growth and upward analyst estimate revisions
• Potential takeout by HGGC or another software private equity investor