Description

I am recommending the purchase of Versant Corporation (symbol: VSNT).  This small object oriented database company has recently shown very strong top and bottom line growth, has a very strong balance sheet, has a history providing conservative guidance, and trades at a very attractive multiple.  Interestingly this company exhibits many of the characteristics of stocks targeted by BOTH Joel Greenblatt’s “Magic Investing Formula” and William O’Neill’s “CANSLIM”.   In my experience it is a rare company that exhibits traits of both investing styles, but I believe VSNT may be an exception and provides an excellent investing opportunity.

Versant develops and sells object oriented databases which allow companies in verticals such as Telco, Defense, Medical, and Engineering to manage data in environments that have high performance and high availability requirements.  Telco has been the strongest vertical of late as each of the last two quarters has seen a Telco company make a large purchase which has represented approximately 20% of quarterly revenue.  (It was a different Telco company in the two quarters.)  I direct you to the company’s web page for a fuller description of their products. (www.versant.com)

I by no means can claim any expertise in database software. However, I am able to see though financial statement analysis that this company has done an excellent job of executing, and as a result, the company has delivered strong sales growth, strong cash flow generation, and done this with minimal invested capital.  Additionally the company has a history of conservative guidance and appears even cheaper when one looks at the companies recently issued guidance for 2008.

On Dec 4th, the company announced its 4^th quarter and fiscal 2007 earnings.  If you look at a chart you see that the market reacted very favorably to the companies 22% year over year quarterly top line and 50% bottom line growth.  On an annual basis the company grew revenue by 26% and grew net income 76%.   For the year the company reported $2.06 in EPS.  Perhaps more importantly, the company guided 2008 EPS to $2.50.  (The stock currently trades at around $25)

Magic Investing Formula

As most on this website know, the magic investing formula looks at two key metrics.  Return on Invested Capital and Earnings Yield.  Both are very attractive in VSNT’s case.   On an as reported basis, VSNT’s  ROIC would be as follows:

ROIC

(EBIT)/Current Assets-Current Liabilities+ Net Fixed Assets

$7,664/ $21,922 – $6,627 + $825 =  0.475 or 47.5%

However, the number becomes even more appealing once we adjust for the cash on the balance sheet that isn’t necessary for the business operations.  Nearly all of VSNT’s working capital is cash. ($19.086mm).  I think it could be argued that none of this cash in necessary for on going operations, but if we give the cash a hair cut, and assume 25% of this cash is necessary for ongoing operations, VSNT’s ROIC vaults well above100% return.

$7,664/ $7,607[25% of cash balance($4771.500)+ $2,836 other current assets] - $6,627+ $825= 4.24 OR 424%

In other words, it isn’t necessary for VSNT to invest large amounts of capital to generate a very handsome return.

Earnings Yield:

On a trailing basis VSNT trades at an attractive earnings yield.  But when we adjust for forward earnings, the valuation becomes even more attractive.  On a trailing basis, VSNT generated $7,664 in income from operations.  As of the writing of this piece, VSNT is trading at $25.25 per share with 3.74mm shares outstanding.  That gives us an equity value of $94.4mm.  The company has zero debt and $19.08mm in cash.  From this we arrive at an enterprise value of $75.3mm.

At these numbers, the company’s earnings yield is an attractive 10.1%. 

Furthermore the company has guided 2008 net income to $9.5 mm. (The company has historically been conservative in its guidance and this will be discussed more below).  So if we are to adjust the earnings yield number to a forward earnings number, (as Greenblatt suggests in his book) the earnings yield increases to an even more attractive 12.6%.

The combination of these two metrics suggests that this is a good business with small capital needs that trades an attractive price.  This would be irrelevant if the company had a flaw in its business model or if the market was diminishing.  But as I will expand on below, the company, in fact, has a strong potential growth opportunity which I believe the market is not recognizing.

CANSLIM

In my experience it is exceedingly rare for a company that looks good on a value basis (magic formula) to also look good on a growth basis (CANSLIM).  But I believe that VSNT is the rare exception.  CANSLIM is much more qualitative than is the magic formula, so there is some room for debate, but I do believe this is the type of stock that disciples of William O’neill could get excited about.  I will quickly try and make the CANSLIM case for this stock that I feel truly trades at an  attractive value.  CANSLIM stands for the following:

C – Current EPS must be up 18 to 20%

VSNT saw quarterly Year over year EPS growth of 50%

A – Annual EPS up 25% each of last three years

In fiscal 2007 EPS grew 76%.  Fiscal 2006 saw earnings go from significantly negative ($-4.11 to strongly positive $1.20);  growth greater than the 25% threshold.  And guidance would suggest that management expect EPS growth of at least 20% next year.

N – New Markets

As I will discuss in greater detail below, the online gaming market (VSNT refers to it the MMOG market) is a potentially very large market that has a great need for software similar to the Versant’s.  The company has been getting traction in this new market, and expects to see revenue begin in the second half of 2008.

S – Shares; keep them small

The total number of shares outstanding is very small for this company.  The firm has only 3.7mm shares outstand fully diluted.  This provides the opportunity for great appreciation when the market recognizes its value.

L – Leader in its market

Obviously I can’t say that tiny VSNT is a leader in the database market as a whole as it is dominated by the likes of ORCL.  However, the company does have a stronghold in the niche of Object Orientated Databases.

I – Institutional Holders

I think it is probably fair to say that VSNT doesn’t have strong institutional holdings as of yet.  The company is very small, but I think its attributes make it a potentially attractive investment for any institution.

M – Market Trends

This suggests only buying stocks when the technicals are correct.  My feeling is that technical analysis is largely BS; so I will leave it up to the reader to determine if it looks good on a technical basis.

All in all, I am a much firmer believer in the magic formula than I am in CANSLIM.  However, I wanted to point out that VSNT fits nicely into a CANSLIM paradigm to suggest that it is the type of stock that growth orientated investors could get excited by.  And as we all know, when growth investors get involved, you can count on multiple expansion.  I think a combination of a stock with good business fundamentals that is trading at a decent multiple combined with strong growth characteristics makes for an interesting investment.

Conservative Management

In part of my analysis above I relied on the guidance that management has given for fiscal 2008.  It is important to make sure that the company has a track record in meeting or exceeding guidance if these numbers are to be relied upon at all. 

I submit that management historically has been very conservative which suggests that there is potential upside to the numbers that management has given.  In this same earnings release last year, management gave guidance for fiscal 2007.  In that PR management guided fiscal 2007 to EPS of $1.20.  Obviously, the company significantly out did its own guidance by reporting over $2.00.

This is not a management team that over promises and under delivers, in fact I think it is quite the opposite.  I think this track record suggest that management believes they could do even better than the $2.50 to which they have guided.

Balance Sheet

Above I very briefly mentioned that the company has over $5 per share in cash on the balance sheet.  Additionally they zero debt.  The company has publicly stated that they are going to keep this cash available in case any potential acquisitions arise, though they currently do not have any targeted.

 Furthermore, they would like some level of protection in the case that the economy gets significantly worse over the next 12 months. 

Without either of these happening, as the company exits fiscal 2008, I would not be surprised to see the company announce a special dividend or institute a share repurchase program.  Obviously, both of these would be beneficial to people who own the stock at that time.

New Potential Markets

I had previously mentioned that VSNT participates in verticals such as Telco, Defense, and Medical.  These are largely the same markets that the company has participated in the last few years.  The perception that these are mature verticals may be part of the bear story on the stock.  The company (though the financial results would suggest otherwise) has largely been seen as participating in an industry that did not show strong growth characteristics.

The online gaming market is a new market that could potentially be very large for the industry and is well suited to VSNT.  Online games (e.g. World of Warcraft) require great demands on the database that powers them.  Historically the sites have temperamental and have crashed frequently.  The company has said that such sites could benefit greatly from availability allowed by their object oriented database.

Though I am unable to quantify the size of the market, it has the potential to be very significant to VSNT if they are able to get a foothold in this market.  The company has said that they expect revenue from this vertical in the second half of 2008.

Risks

Of course all investments have risk.  Potentially the largest risk that I see with this company is the lumpiness of their business.  VSNT relies on closing large software license deals each quarter.  In each of the last two quarters they had a single customer represent over 20% of quarterly revenue.  If one of these deals fails to close, quarterly results could disappoint Wall Street.  In fact, the company didn’t give quarterly guidance for this exact reason.  But this risk is inherent in almost every enterprise software company.

Secondly, as I mentioned above, the industry in which they compete is largely deemed as a no growth business.  If the online gaming market fails to material as I believe it will, growth could be elusive.

Catalysts

1-If VSNT is able to grab share in the emerging online gaming market growth should exceed expectations.

2- I think it is not entirely impossible that they could be acquired.  Though on the call management mentioned that they had not been approached RECENTLY (key word), it seemed as if they left the door open to the possibility.

3-If growth investors do become intrigued by the story as I suggested they may, the company could see significant multiple expansion beyond the value multiple at which it now trades.

Conclusion

If you buy VSNT you get a company that would certainly appear on the first page of any Magic Investing Formula Screen with its attractive ROIC and Earnings Yield while at the same time exhibiting very attractive growth characteristics.  The company’s conservative management has under promised and over delivered.  It is an in expensive stock that I believe will be attractive to growth investors.  As the company performs next year, you are afforded the downside protection of a value stock; with the potential multiple expansion afforded a growth stock.  VSNT is a good company, in my estimate, in which to invest.

Catalyst

1-If VSNT is able to grab share in the emerging online gaming market growth should exceed expectations.

2- I think it is not entirely impossible that they could be acquired. Though on the call management mentioned that they had not been approached RECENTLY (key word), it seemed as if they left the door open to the possibility.

3-If growth investors do become intrigued by the story as I suggested they may, the company could see significant multiple expansion beyond the value multiple at which it now trades.