We are long shares of VRNT.  At $33 per share, we think VRNT is an attractive risk-reward trading at almost a 20% discount to its three-year mean of 13x and a 30% discount to its nearest peer, NICE, which we believe is unwarranted.  

In its call center solutions business (i.e., Enterprise segment), the Company misexecuted after an acquisition they did a few years ago and took guidance down for the past 3 consecutive quarters.  In its security business, where its software mainly helps governments address national security and terrorist threats, the Company is facing macro/FX headwinds, which significantly impacted Q415 #s and guidance.  At current multiples, the Company is trading as if it has structural impediments in both segments --- which we disagree with.  The Company continues to have a #1 position in its call center business which has high barriers to entry given how sticky the business is.  In addition, they seem to be finally turning the corner there re: execution.  On the security side, they continue to win the same # of contracts; however, given budgets constraints, esp. among emerging market governments, and FX impacts, the dollar values of the contracts are lower.

On its Q415 earnings call, we believe the company simply reset the bar for expectations, which provides a bottom for the stock.  Our estimates aren’t much higher than consensus at $3.46 FY17EPS (vs. $3.42).  However, we believe as VRNT’s execution improves over the next few quarters and the market realizes the recent issues VRNT faced aren’t structural --- their multiple should rerate.  At 13x on $3.46 FY17EPS, VRNT is worth $45 per share or almost 35% upside.

What does VRNT do?

VRNT has 3 segments: 1) enterprise Intelligence (55% of revenues), 2) Video Intelligence (11% of revenues) and 3) Cyber Intelligence (formerly Communications Intelligence) (34% of total revenues).  Enterprise intelligence is the highest margin business which makes up 60% of the total (excluding unallocated expenses).   60% of the its revenues come from services while 40% comes from product sales.  Americas is 51% of the business, EMEA is 31% and Asia-Pac is 18%.

In the Enterprise Intelligence segment VRNT sells software that captures and analyzes data mainly for call centers --- the industry is called Workforce Optimization (“WFO”).  The goal is to make customer reps more efficient, figure out the # of agents needed at a particular time of the day, etc.  The data capture and subsequent analysis is what VRNT calls “Actionable Intelligence”.   Years back, WFO used to revolve around storing and analyzing voice calls (i.e., call recording/quality management).  Fast forward to today, it has broadened to multi-channel --- vendors now need to analyze not only calls, but web traffic, live chat, email, social, mobile, text, etc.  VRNT will tell you WFO is only voice and now that they track these additional channels they play in the Consumer Engagement and Optimization space --- really just means they (and their competitors) have been able to upsell these additional channels and broadened their TAM.  

The core WFO market is saturated --- # seats are flat.  Market is growing single digits at best re: replacement cycle (~6 years) and VRNT and NICE essentially own this market (60%+ share combined); hence, bears will say it’s a low growth business.  However, the industry is only now in the first innings (to sadly use a baseball analogy) of spending on data and analytics --- i.e., speech analytics, desktop analytics, performance management.   People have data and now they want to use it --- human capital is a cost in the contact center --- each minute is a cost so the more you can eliminate the more you can save and that requires analytics.  The data & analytics part of WFO is growing 20-25% annually --- so the overall WFO market is still projected to grow 8-10% over the next few years.    

The performance piece of the industry isn’t just in call centers --- VRNT’s software can track individual or departmental performance goals based on relevant KPIs in any enterprise. 

Other 2 key player segments:  1) infrastructure guys (i.e., Avaya, Genesys, Cisco) and 2) more cloud-focused guys (i.e., InContact and Aspect). 

§  Infrastructure:  NICE and VRNT have better products than the infrastructure guys – in fact, Avaya’s WFO is a white label of Verint’s suite of applications.   Also, VRNT and NICE are the most advanced in upper tier analytics.  Smaller player don’t offer some of the desktop analytics.

§  Cloud:  Bears will point to cloud-based solutions disintermediating the space; however, 95% of WFO solutions are still on prem and will stay that way for the foreseeable future in large enterprises --- its simply too much data to manage off-prem, too complex.   That being said, cloud remains a risk at the margin in smaller organizations --- there are deals that guys like inContact and Aspect are winning.  Cloud could grow 20-25%.   Both NICE and VRNT provide an off-prem and a hybrid offering – as they don’t want to be left out.   

Security is 2 pieces – video surveillance & cyber (formerly communications intelligence).  25% of security revenues come from US, 25% developed markets and 50% emerging markets.

Video is what is sounds like – VRNT enables the capture of video, provides the ability to store the data that was captured and provides software to analyze it.  Its more than video capture – its not just recording and compliance to see what happened in the past --- its about analytics to see how to predict if something will happen in the future.  This includes things like surveillance; analytics that integrate facial detection and recognition and license plate recognition; analysis of public safety data by EMTs, police and fire fighters.   Example: Port Authority of New York and New Jersey uses Verint’s IP video solutions to capture images at the World Trade Center PATH Transportation Hub in lower Manhattan.

Cyber intelligence (formerly communications intelligence) includes cyber security threat protection and network intelligence --- this includes government and law enforcement agencies, as well as private communications companies.  VRNT’s software enables law enforcement, national security, and intelligence agencies to capture and analyze data to investigate and proactively address criminal, national security, and terrorist threats.  Here they do very little in the US --- its really governments around the world and a lot of it is smaller countries (esp emerging markets) that buy packaged product from VRNT because they don't have an NSA to build it for them.  The other big piece of this is fraud risk and compliance.  In the fraud area, their using data analytics to help companies identify all types of fraud.   Example, they have a Voice-by-Metric solution which helps banks identify people who may be calling in to get other people's personal information.

In 2013, they built a cyber security product for the enterprise called Threat Protection System (“TPS”).  They aren’t a firewall company, they sit inside the network and monitor bytes of data, look for suspicious code see if it interacts with other code, try to provide less false positives, etc.  TPS includes detection, prioritization, investigation and prevention, all in a single platform, across multiple attack points.  It analyzes data in real-time as well as post post-attack.  They ramped up a new sales force for the enterprise.

What has happened to VRNT’s stock?

The last time the stock was @ $33 was end of 2013.   As mentioned above, in 2013 VRNT rolled out their enterprise cyber security product.    In 2014 (announced Jan 6^th 2014), they acquired Kana, which had an agent web-based customer mgmt tool.  They paid $514 mm in cash (using $100 mm of VRNT cash and new debt) – almost 3.5x Revenue / 12x Non-GAAP EBITDA.  (Note: Kana’s 2014 CY, they were expected to generate non-GAAP revenue in the range of $140 million to $150 million, and non-GAAP EBITDA in a range of $40 million to $45 million, or ~30% margins). The opportunity was cross-selling--- Kana had 900 customers vs. Verint’s 10,000 but they thought there was substantial amount of overlap.  The hope was to provide a one-stop shop for customer service applications.  

The stock ran up to $65 mid 2015 on elevated estimates and elevated PE multiple of almost 18x … everything positive was priced in – it was fully valued … arguably over valued as VRNT had never traded at 18x before…its average multiple over the past 3 years has been slightly over 13x.  The bull case was the merger and the cyber product expanded their TAM from $3 bn to $8 bn.

They announced Q4 2015 results and outlook in March 2015, when the stock was $58 bucks – where they guided to cc revenue growth of 4-8% (9-13% cc). 

June 2015, they announced Q1 2016 where they maintained their guidance; however, in subsequent quarters they continued to revise that down – estimates and multiple followed.

§  Q2 FY (Jan) 2016: Reported Non-GAAP EPS of $0.70 on revenue of $297mm, above expectations ($0.68/$290mm).  Constant currency revenue grew 8%.   However, they lowered FY revenue guidance to $1.18-1.23B (+2% to +6%) vs. previous guidance: $1.2-$1.25B (+4% to +8%).

§  Q3 FY (Jan) 2016: Reported No-GAAP EPS of $0.78 on revenue of $285M slightly below expectations ($0.79/$299M).  In addition, they lowered FY revenue guidance down again to $1.15-1.19B down (from the previous $1.18-1.23). The $1.17B midpoint represents 1% reported growth / 5% constant currency (down from previous +2 to +6% reported).  They also guided FY Non-GAAP operating margins to 22-23% and EPS of $3.30.  Note: FY 2015 Non-GAAP operating margins were 22.7%.  In addition, they provided preliminary outlook for fiscal 2017 (ending January), calling for top-line constant-currency growth of 5% and slight margin expansion. 

The 2 parts of the bull case were breaking down:

1)       Kana cross sell wasn’t coming to fruition

a.       They were trying to bundle Kana’s CRM solutions and VRNT’s WFO solutions and the approvals were taking too long.   CEO: “Our pipelines have been very healthy, both in security side and on the enterprise side. We've been frustrated because we've had difficulty getting those large deals closed in the quarter that we need them closed as a public company.”  I believe Kana was indeed impacting sales cycles….the approvals were taking longer for a larger bundle. 

b.       Also, Kana didn’t have all the functionality they needed; hence, they needed to invest in additional functionality (organically and via acquisitions, hence Contact Solutions acquisition 2016) – analyzing the product showed that Kana’s solutions didn’t have all the omni-channel functionality that VRNT’s customers wanted.

2)       Cyber product was not getting the traction people expected

a.       Strategically – the product makes sense for VRNT --- the pitch is that they have created a threat detection product from years of working with governments around the world.  Unfortunately – it was harder to break into the market than they realized.  Its possible VRNT has a better cyber product than FireEye but the proof of concept is difficult.  VRNT claims they detect less false positives – they create a baseline of normal activity (like a lie detector test) and then analyze from that baseline.  The problem is that baseline takes 6+ months to build --- not many people are willing to take the time to prove that VRNT isn’t selling them snake oil.  (Note: VRNT’s product is a premium-priced product, inline with FireEye).  In addition, no one in cyber security has heard of VRNT – they haven’t done anything in terms of branding themselves.  Only those folks that know VRNT’s call recording / contact center solutions have even been willing to try their TPS product.  

The series of revenue guide downs made people question – was there something structurally wrong with VRNT’s WFO business?  Note:  NICE reported healthier growth than VRNT – albeit much of that was in its financial crime and compliance segment.

Then, this past week, VRNT reported Qtr FY (Jan) 2016 #s --- where they were hit with a 3^rd whammy --- a significant slowdown for their security offerings in from governments in emerging markets re: budget cuts & FX.  They reported Non-GAAP EPS of $0.90 on $282M in revenue, significantly below consensus at $1.16/$319M.  FY (Jan) 2016 Non-GAAP revenues came in at $1.2 bn, up 1.5% cc, and EPS was $3.05 EPS (down from midpoint of guide of $3.30 they gave Q3).  In addition, they said FY 2017 revenue and EPS would be inline with FY 2016.  That was predicated on Enterprise picking up mid-to-high single digits for the year, but security down 10 to 15% with the biggest hit in Q1, down over 22% given their implied guide of $90-100 mm in revenues.

Valuation / Capitalization

At $33, VRNT is trading almost 11x CY 16 EPS and almost 10x CY 17E EPS.  On a 2016E basis, that is a 30% discount to NICE (their closest competitor) and almost 20% discount to its historical forward pe/multiple of 13x. 

We that as VRNT’s execution improves over the next few quarters and the market realizes the recent issues VRNT faced aren’t structural --- their multiple should rerate.  At 13x on $3.46 FY17EPS, VRNT is worth $45 bucks or almost 35% upside.

VRNT has $811 mm in debt – half in floating in term loan at rates of 2.75% over LIBOR (Jan 2016 rate was 3.5%) and $400 million of convertibles notes @ 1.5% coupon (Note: Feb 2016 they executed a pay-fixed, receive variable interest rate swap where they will pay a fixed rate of 4.143% and receive 2.75% over LIBOR on $200 mm notional).   The converts aren’t due till June 2021, the term loans aren’t due till Sept 2019 and they have a $300 mm credit facility which matures Sept 2018 under which they have no borrowings.  With cash on B/S of $420mm, they have net debt of $391 mm, excluding discounts and issuance costs associated with their converts.   Their net debt to Adjusted EBITDA is 1.5x.

Average FCF for the past 4 years (FY13 to FY16) was $143.0 mm.  FCF FY (Jan) 2016 was $131.6 mm or a 6.3% FCF Yield.   FCF FY (Jan) 2016 was lower due to collections issues in Q4 from some emerging markets; however the Company expects FCF to increase in FY (Jan) 2017E.

They authorized their 1^st buyback of $150 mm on their Q4 call – albeit they did say it was 2-year buyback.