Versant Corp. VSNT W
August 19, 2008 - 1:13pm EST by
tim321
2008 2009
Price: 27.05 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 102 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Software
  • customer stickiness
  • High ROIC
  • Great management

Description

I think Versant has at minimum an easy 50% upside from here in a stock market that should continue to be anything but easy.   

Mr. Market has largely ignored the dramatic transformation that has taken place at Versant since CEO Jochen Witte took over 3 years ago. Investors today are likely to get the double whammy benefit of continued strong earnings growth coupled with a re-rating of that earnings stream as he continues to produce. I will highlight the current valuation, the attractiveness of the underlying business, and Witte at the helm as the primary reasons why Versant stock should be significantly higher a year from now. 

Snapshot:

Shares outstanding

               3,777,000

Stock Price

     27.1

 

 

Market Cap

         102,167,850

Cash

           25,000,000

EV

           77,167,850

 

 

Income From Operations 08

              9,800,000

 

 

Earnings Yield

13%

 

In this environment, a high quality earnings yield of 13% (earnings approximate free cash flow) is acceptable but nothing to be necessarily pounding the table on.  Indeed, the hurdle for getting jazzed up about a smaller cap, illiquid name has never been higher in this environment and rightfully so. Versant, a maker of data management software, meets this higher return requirement threshold, and it has more to do with the predictability and growth of the future earnings yield versus the current yield status.  

If you spend two minutes looking at the past financials, you will notice that something seemed to happen to the company in 2006. This year would mark the transition year where the company goes from a consistent history of losses (which have generated a current $80mm U.S. NOL $40mm for Europe) to a consistent and growing history of organic profitability.

Financials Snapshot:

2003

2004

2005

2006

2007

2008E

Revenue

17.4

17.7

15.7

16.7

21.2

26.0

Net Income

(2.4)

(11.9)

(14.6)

4.3

7.6

10.3

EPS

(1.8)

(3.9)

(4.1)

1.2

2.1

2.7

 

 

Upward bound: Top line, bottom line, and profitability:

Quarter:

2nd

1st

4th

3rd

2nd

1st

4th

3rd

2nd

1st

4th

Quarter Ending:

2008

2008

2007

2007

2007

2007

2006

2006

2006

2006

2005

 

 

 

 

 

 

 

 

 

 

 

 

Total Revenue

$6,721

$6,284

$5,561

$5,248

$5,190

$5,151

$4,585

$3,755

$3,780

$4,625

$5,095

Gross Margins

92%

91%

94%

89%

89%

89%

81%

86%

80%

81%

64%

 

 

 

 

 

 

 

 

 

 

 

 

Operating Income

NM

$2,733

$2,123

$1,985

$1,837

$1,719

$1,240

$968

$584

$723

$126

Operating Margins

 

43%

38%

38%

35%

33%

27%

26%

15%

16%

2%

 

 

The Difference Maker: Jochen Witte

In July of 2005 with the stock at an all time low ($3 a share), the board decided to give Jochen Witte, a managing director of their European business, the title of CEO. Jochen had joined the company a year before when a company he co-founded, Poet Holdings, merged with Versant. Jochen immediately announced a restructuring of the business that would entail slashing the workforce in half and focusing Versant on its core object oriented software. On the fourth quarter call that year, Jochen laid out his plan that would center on focus and execution.

Q4-2005:

“I think what this company needs to do and what it is doing is to focus. In the past, Versant has tried many things. We’re focusing on very specific niche markets, and we are having very targeted sales approaches. I think what it comes down to – just do one thing and do it right. A lot of it is execution.”

-          Jochen Witte

3 years later, the results have been astounding, with the top line growing over 60%, net income going from a consistent history of losses to a consistent history of gains. The chart below shows how Jochen has taken gross margins from 63% to over 90%, profit margins from negative to over 40% and ROIC to over 100%. The high return on invested capital level combined with the high operating margins and the low need for investment (really the R&D line which is captured in the profit margin) means that by growing the top line at double digit rates, you are going to generate meaningful cash flow. Indeed, this is exactly what has happened; cash on the balance sheet has grown from $4mm to what should be over $30mm by year end.  

2005

2006

2007

2008E

Gross Margin

63%

81%

90%

91%

Profit Margin

-

24%

36%

39%

ROIC

100+

100+

100+

Cash on B/S

4.0

8.2

19.0

31.0

 

If the book “Good to Great” (or really here, bad to great) had a chapter on small cap case studies, Versant would get one of my nominations. Fortunately, I’m betting that the chapter is still being written and that we are still in the early innings. While recognizing this transformation in late 2005 would have made you a bundle, I think you can still recognize a nice gain from here with much less risk as Jochen has already “walked the walk” – we just need him to continue walking.

Dissecting Jochen:

I would describe German-based and born Jochen Witte as serious, honest, diligent, dour, humble, thrifty and extremely conservative. If you ask him about the dramatic turnaround, he will tell you that it was all because of the “low hanging fruit” and because he has a great sales manager. If you try to get him excited about the future, he will tell you about the uncertain economic climate and the top line growth challenges Versant faces. 

Jochen’s management style is very much “in the weeds” (he was acting CFO early on to save money, so he is very close to the all details – he has since hired CFO Jerry Wong who seems very capable) and tries to lead by example with loyalty, hard work and humility. While Jochen might not be the most dynamic CEO you will ever encounter, he is exactly the kind of person you want steering the ship as a shareholder.

Extremely conservative” in action: a history of earnings guidance under Jochen:

Conference Call Guidance:

Q4 – 2005:

“We project our Fiscal year 2006 net income to be in the range of 1.6 to 2mm dollars.”

Actual – 2006:

$4.3mm

Q4 – 2006:

 “Anticipate 4.4mm to 4.6mm in net income before taxes for 2007 representing growth of 10-15% when compared to 2006. “

Actual – 2007:

$7.3mm

Q4 – 2007:

“We anticipate revenue of 24mm and EPS of $2.50.”

Actual – 2008:

TBD   (although already revised upward to 26mm and EPS of $2.60 to $2.70.”)

 

The Business: A toll road masquerading as a software firm:

If you’re still reading, hopefully I have convinced you that Versant is well managed, extremely profitable and fairly cheap. But what about the actual business? I will argue that you have a very strong business model here with highly recurring revenues within a sticky customer base, high barriers to entry due to a niche market, and an attractive market opportunity going forward.

Background:

Versant operates in the niche object oriented database market which is a sub-segment of the $7 billion + general database market that is dominated by the Oracles of the world. Today, Versant controls about 30% of the object oriented data management market with their object oriented database offering which they have spent an estimated $70mm developing since their inception. An “OOD” is particularly good at handling very complex data (non-squared data) or data that doesn’t fit well into tables. This is used in all kinds of applications and Versant argues that wherever you have relatively complex network like data, this data can be used much more efficiently with Versant technology. Versant customers are separated into different verticals with the key vertical being telecom, followed by defense, logistics, and medical.

Recurring/Sticky Revenue:

There are two kinds of customers for Versant, the end user and the independent software vendors/value added reseller. The end user client will build applications on top of the Versant database, deploy the application internally to its workforce, and Versant will recognize a one-time license fee. Once the deployment has finished, Versant will begin to recognize an ongoing maintenance fee. Jochen realized early on to focus more on reaching the ISV’s versus the end users since they could effectively become his distribution outlet or indirect sales channel. Jochen has given the example of Ericsson who is a value added reseller for Versant. Whenever Ericsson deploy’s an application that has a Versant database (for managing the network, customer billing etc.) to a telco provider, say Vodafone, they then resell Versant product as part of the transaction.

Let’s take a look at the 2007 revenue stream:

License: $12.6mm

Maintenance: $8.2mm

Consulting: $0.2mm

Total: $21.1mm

 

The smallest portion is consulting revenue which Jochen has deemphasized since his arrival due to the low margins of this business. It has gone from 13% in 2003, to not meaningful today.

Around 40% of the revenue stream is maintenance which is obviously very profitable. Over 90% of the customers have typically renewed their maintenance contracts annually according to management. Of the license revenue, approximately half is from “royalty reports”.  This is from existing ISV license agreements and paid based on how many applications they sold. When you add it all up together, management estimates that around 30% of revenue “is up for grabs each quarter.”  

Part of the explanation of this largely recurring revenue base, are the large switching costs involved in terminating a contract. For a customer to switch, they would basically have to rewrite the entire code to get rid of Versant. The best evidence of this “stickiness” is 2005 when the company was on the verge of bankruptcy, Versant couldn’t get new business orders but still maintained a revenue base of over $15mm. 

Indeed a customer from GE, who contributed to this $15mm revenue base, was on the earnings call that year and basically says “we can’t switch so I hope our service isn’t disrupted.”

Q2-2005:

 “GE depends on VDS for mission critical applications, and I heard your response to the last caller about the restructuring detail. We anxiously await to hear the details about that, and we are hoping it won’t affect service to customers.”

-          Don Smirt, GE

 

Note that the Smirt mentions how the applications that Versant supports are “mission critical” applications. This coupled with the fact that Versant royalty payments are typically a very small line item for most of their customers helps explain Versant’s nice margins.

 

The Object-Oriented Database Market: “The wind at our backs”

It’s hard to find many warts with Versant, but maybe one is the small size of the market they operate in - roughly $70mm. A good overview of the market can be found on this Wikipedia page. 

http://en.wikipedia.org/wiki/Object_database

While the small size of the market makes growth a challenge, it also serves as a barrier to entry to new competitors and gives the first movers a stronghold on the market (3-5 competitors depending on classification – only one other public comp which is Progress Software). Management estimates that the market has grown around 10% historically and that at minimum they should be able to grow with the market.

How fast the market grows will play a key role in the upside to this investment. One private company CEO in the space with backing from Vinod Khosla, was quoted as saying the potential market could explode to “$1 billion in three or four years” driven by the increasing need to manage complex data. I ran this by Jochen who said “no way.” However, it does seem like it would be reasonable to assume at least historical growth of the market given the “the wind at their backs” (the increasing need to handle complex data with a scalable solution). 

Other Items:

Gaming vertical upside:

I should also mention that Jochen is moving the company into the gaming vertical which if successful, could also add upside in 2009 (they are doing revenue share arrangements with the gaming companies – there is nothing signed yet but this has been taking up R&D dollars which suggests there is a good possibility of landing something) and tremendous upside in 2010. 

Buyout downside protection:

Besides the $25mm in cash on the balance sheet and the current 13% fcf yield, I think the company could get sold today for a nice premium. When Jochen was asked on recent conference call about any strategic interest in the company he said “we haven’t recently been approached.”

Cash:

The company should have over $30mm in cash by year end. I think management will likely do a combination of a dividend and acquisition with the cash on hand. Knowing how careful and tight Jochen manages the business, I would actually like to see him do an acquisition. I think the odds of him paying a great price are high and I think he has already demonstrated his ability to cut out company fat successfully. How well he executes here will obviously have a large bearing on future value realization.

 

Risks:

Customer concentration: I think this is the most glaring but misperceived risks for Versant once you understand the business. While a telecom customer can be 20% of quarterly revenue, this is almost always going to be an ISV which is selling through the product so “one customer” is deceiving. Additionally, the risk is just much less an issue given how “sticky” the customer base is. The risk is that the ISV doesn’t do as many resells as projected, not that Versant loses the ISV. This risk is very different than say a R.G. Barry Wal-Mart risk.

Management ownership: I think one of the reasons Ebix and U.S. Global were such successful investments was partly due to the fact that you had an extremely motivated CEO in both cases who owned a big chunk of the stock. You knew you were fully aligned with their interests regardless of whether or not you agreed or disagreed with a particular decision. At Versant, management owns less than 5% of the company and there are insider sales although small amounts. Judging by his past actions (e.g. low option issuance, frugal habits like switching headquarters to save money etc.), I’m comfortable that Jochen will continue to do the right thing by shareholders. Nevertheless, it is a risk and should be monitored.

My understanding of the technology: limited.

 
Conclusion:
 

I haven’t set a price target on Versant as I think one of two likely scenarios will play out. The most important aspect of any scenario given the scary macro environment is that I think downside is extremely limited.

Scenario 1: Versant will grow the top line with the industry at 10% which should translate into 15%+ earnings growth which coupled with a 13% earnings yield would give us the 50% +upside over a two year holding period.

 Scenario 2: Either the market grows faster than expected or Versant successfully gains traction in an unexpected vertical like gaming. Earnings grow over 25% (like they have since Jochen took the helm) over the next 3 years and the multiple people are willing to pay on that earnings stream rises from the current 10x to 15x resulting in the “multi-bagger” scenario.

 

 

 

Catalyst

Valuation coupled with continued execution

There is only one way to go from zero analyst coverage

August 26th earnings – “in the bag” versus “on the come” if you care about history
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