In a recent edition of Value Investor Insight, Jim Roumell of Roumell Asset Management described why he believes QAD (QADI) is misrpriced. Key excerpts follow:
Walk us through some examples, starting with enterprise software company QAD, Inc. [QADI].
JR: The company specializes in enterprise software that helps mostly manufacturing companies run all aspects of their business. The classic appeal of a business like this is that once the systems are installed, they’re tough to pull out – roughly 95% of QAD’s customers renew annual maintenance contracts. Overall, half its annual revenues are recurring in nature.
The company has traditionally generated $10-15 million per year in free cash flow (after working-capital adjustments), which fell to around $2.5 million in the fiscal year ended in January. The drop seems to have finally gotten management’s attention to start addressing an unnecessarily high cost structure – they recently announced a plan to cut annual expenses by $14 million – so we’re comfortable QAD will remain solidly cashflow positive even if revenues fall 6-7% this year, as management expects.
To give you an indication of how low the valuation has gone, acquisitions of companies like this are usually done at around 3x the level of maintenance revenues.
The margins on maintenance are typically extremely high, so acquirers can almost get their purchase price back within three years while getting a free option on selling new licenses. At the current share price [of $2.70], taking out $19 million of net cash on the balance sheet, QAD’s enterprise value is only $64 million. That’s just 0.5x the level of maintenance revenues.
Is an acquisition in this environment a reasonable assumption?
JR: That is one of the main risks here. The founders, Karl and Pamela Lopker, still own 60% of the shares and have shown no real inclination to sell. If you speak with them, they’re very worried about what would happen to the level of customer service if QAD was sold to a bigger firm. On the one hand that’s great, because the emphasis they put on service is a big reason their customers love them. On the other hand, it makes one avenue of value realization less likely, at least in the near term.
So that leaves us with the economics of the business, which we believe are ultimately quite healthy, and one other thing: the company is situated on 27 acres in Santa Barbara, California, looking out at the Pacific Ocean. On the land they have a building complex, which takes up three acres, and the rest is essentially open space. We hired an independent appraiser to study what they could do with the property and how much it could be worth under different scenarios. The range of values is wide, but we think a conservative value of the real estate is around $50 million. That’s nearly 80% of the enterprise value right there. While we doubt we’ll see them sell the business any time soon, we think they may do something with the real estate, which would likely have a significant impact on the share price.