Criticism of Teradata Is Overstated

Teradata (TDC) is the market leading pure-play vendor of data warehousing hardware, software and services. The stock has been trading at depressed levels because of temporarily elevated sales & marketing expenses, a temporary foreign currency headwind, the broader market decline, and skepticism around the company’s ability to execute in a difficult IT spending environment. These concerns, while somewhat valid, are fleeting, and have created a compelling opportunity for significant capital appreciation over the next 24 months with meaningful downside protection. For 4.5x EBITDA, 7.0x P/E less cash and a 13-14%+ FCF yield you get an established market leader and major share repurchaser with a significant moat in a large, mature, consolidating technology market.

A brief look at the market

Choosing an enterprise data warehouse (EDW) platform is one of the key decisions an IT staff will ever make. Companies are generally pretty good at storing data, but bad at harnessing it. EDWs directly impact a company’s ability to gain critical, timely insights into disparate data stores that drive critical business decisions. EDW platforms underpin such critical applications as business intelligence, performance management, data mining and business-process optimization.

The EDW market is driven by electronic data growth and an increased need for business analytics, which I doubt I will have to convince anyone is are enormous and continuing trends.

Competitive moat is large – driven by technology leadership and customer stickiness

1. Technology Leadership

Teradata competes primarily with Oracle (ORCL) and IBM. It is the clear technology leader in the space – it is “best of breed” in scalability, performance, flexibility, services and reliability. Additionally, it has the most diverse and increasingly most affordable product set. Always considered the “high-end” vendor in the market, the recently released 2550 and 1550 platforms offer more cost-effective, lower-end, yet massively scalable solutions to “land and expand” among a broader group of customers.

2. Customer Stickiness

EDW solutions are incredibly sticky, so once you pick your pony, you’re pretty much stuck with it. In addition to a contributing a healthy dose of high margin maintenance revenues, Teradata customers purchase additional capacity and/or add additional users and applications to the platform at a relatively predicable rate. A typical Teradata customer will double his initial purchase over the next 18 months, and add from there. For example, a decade ago eBay (EBAY) had ~10 TB. Today their EDW is >5 PB. Over 85% of a given quarter’s sales are from the existing customer base, limiting material downside and improving forecasting.

3. Numbers

TDC’s technology leadership and customer entrenchment can be seen in outsized ROIC (50%+) and ROE (30%+).

“Teradata’s longtime leadership in the EDW market, coupled with a substantial installed base among large enterprises and an appliance-based product strategy that is growing ever more scalable, modular, and cost-competitive, gives it a strong competitive advantage.” – Forrester (2/6/2009)

Downside limited by technology value, customer value, relative valuation and historical valuation

(Admittedly back of envelope). Capitalizing R&D and S&M expenditure and depreciating it straight line over a 5-year period implies a “hidden asset” of roughly $1.5 billion. This likely underestimates both the technology and customer moats, as TDC has built its advantage on both fronts over its 3 decade operating history.

If you’re willing to make the above leap, adding current assets and net PP&E and subtracting liabilities at carry value suggests that TDC trades at only a slight premium to adjusted book.

TDC currently trades at a moderate discount to infrastructure software names on an EV/EBITDA and P/E less cash basis, and a larger discount on a FCF yield basis. This is disconnect is magnified considering TDCs returns on capital and competitive positioning vs. peers.

TDC trades at a large discount to the only other pure-play EDW company, Netezza (NZ), though the latter is much smaller and growing more rapidly.

Reversal of 2008/9 margin compression and FX headwinds will lead to outsized gains as investors turn to 2H09 and 2010

Post spinout, TDC invested in a large-scale sales force build-out – they plan to add 30 new sales territories in 2008/9/10. Due to the nature of the EDW sales process and Teradata’s focus on Global 3000 customers, the company’s sales teams take a long time to be productive. This inflection point should occur in the back half of 2009 and really start paying off in 2010.

TDC has also been investing in new product lines that require significant S&M and R&D expense. As the 2550 and 1550 begin to ramp, this headwind should correct quickly.

Finally, guidance was reduced last quarter, largely (3% out of 4% drop) due to an unfavorable shift in FX. This has held steady since the conf call (10/31). Also, depending on your belief in the direction of the dollar (probably not much disagreement on the likely direction), TDC could see this headwind shift to a significant tailwind.

Business is well-equipped for a tough IT spending environment

Street analysts often cite a weak IT spending environment (particularly among high-end solutions) as a reason to be cautious on TDC, my checks indicate that they are wrong. Customer purchases even in a difficult IT spending environment often cannot be avoided, as rising data volumes degrade system performance at a predictable rate. In my view, customers can delay purchases for no more than 6 months, or 12 months in desperate situations.

Another often-cited criticism is Teradata’s concentration among financial services and communications customers. However in Q3, financial services was actually the highest growth vertical, with communications posting good growth as well. Clearly, collection, integration and transparency of data across the enterprise is becoming a major concern for many major customer verticals.

In the last tech spending downturn, business held up nicely. Revenues grew from $1,123 million in 2000 to $1,139 million in 2001 and $1,217 million in 2002. Though management did reduce revenue growth guidance last quarter from 5-8% to 1-4%, only 1% was due to the shift in the economic environment. The vast majority of the revision was due to unfavorable moves in FX.

Teradata’s maintenance revenue stream continues to grow, and should surpass $500 million in 2009. Also, as I mentioned previously, a full 85% of each quarter’s revenue is driven by existing customers.

Major buyer of its shares

TDC has been putting its cash flows to good use, repurchasing $137 million worth of stock in the first 3 quarters of 2008. They should continue at this clip for the foreseeable future. I project that the company will buy back 11.4 million shares in 2009 at an average price of $15.81, increasing EPS by 6.6%, and another 9.0 million shares in 2010 at an average price of $19.94, increasing EPS by another 5.3%.

Option value in new product launches

The introductions of the 2550 and 1550 complete TDC’s product portfolio. Analysts are largely ignoring their potential. In particular, the 2550 should see good uptake from customers looking for Zales and not Tiffany (TIF).

Option value in strategic acquisition

I stress option value here, because my thesis is not based on this. That being said, Teradata’s technology, customer base, maintenance stream and significant services business should be very attractive to SAP, Oracle, HP (HPQ), IBM and a few others.

The catalyst here could be the recent acquisition of DATAllegro by Microsoft (MSFT). Other vendors will likely need to respond and TDC is the only player of sufficient scale to be immediately competitive. It would be a moderate negative if any of the aforementioned companies purchased Netezza, ParAccel, Greenplum, or any of the other smaller vendors.

Valuation

Conservative 12-month price target of $20 (53.3% upside) is based on 8.5x forward earnings ex-cash, limited margin expansion, partial reversal of FX headwinds, sustained share buybacks. Further upside will be driven by any uptake of the new product lines, an acquisition, increased buyback, IT spending recovery or broader market recovery.

Catalysts

Execution in a difficult market refutes Street concerns, new products provide material upside, Street begins to look at lucrative 2H09 and 2010 numbers, valuation leads to more aggressive buyback, reversal of FX headwind, new sales team productivity, acquisition/recap

Risks

Catalysts don't materialize, Q4 looks like a tough hit (earnings on 2/12)

Disclosure: Long TDC, MSFT

Comments

[Market Folly:]

very good points. TDC has piqued our attention as well, and we've noticed that numerous hedge funds have been building positions including dan loeb's third point: www.marketfolly.com/20...

and george soros: www.marketfolly.com/20...

among many others. will be interesting to watch

Feb 12 04:37 PM