Is It Takeover Time for Quest Software?

Quest Software (QSFT) is in a state of suspended animation - lots of murky questions surrounding what is fundamentally a very healthy business with 20%+ EBITDA margins. There has been wide-spread speculation that QSFT could be a takeover target with a take out value of between $16 to $19.

In our view, QSFT's short term stock trajectory is flat to down until there is a report from the board investigation into the stock option granting practices. Once the extent of the accounting damage, if any, is understood, we would expect a number of companies to show serious interest in QSFT, even if the investigation does not lead to any adverse results.

Our list of potential QSFT strategic suitors includes EMC Corporation (EMC), BMC Software (BMC), Symantec (SYMC), CA Inc. (CA), Oracle (ORCL), HP (HPQ) and IBM (IBM), as well as a number of private equity firms such as Silver Lake, Golden Gate Capital and Vista Equity. The financial buyers would be drawn to QSFT's strong franchise and profitability. The MGI view is that a mid-size private equity firm or BMC Software or EMC are the best positioned candidates to win the prize and acquire QSFT. Before the trophy is awarded, however, more fireworks will happen and the smoke needs to clear.

First the Fireworks

With a former CFO unwilling to talk to an independent board committee investigating the company's options plan, Quest Software is on shaky ground. Are there accounting issues beyond backdating options? Why did this well-paid executive resign so abruptly? Was he going to be the scapegoat? What else does he know? For the company to move forward, several things need to happen.

The internal investigation needs to run its course. The bad news needs to get out. Potential outcomes include:

a) The removal of management

b) The reconstitution of the board of directors

c) An indication of the extent of the needed financial restatements -- just how bad is it, if at all. A lack of transparency and confidence in this regard will signal even worse problems to come.

Scenarios

One scenario is that Quest significantly restates earnings, shifts/removes management, and the company is in-play with strategic buyers such as BMC and EMC in the lead. Second scenario is that Quest has a minor re-statement of results, retains most of its current management and is taken private by a group combining management and a private equity firm.

The "MCs" Win the Trophy

Of the industry buyers, we believe BMC and EMC make the most sense. Our preliminary analysis indicates that folding Quest into EMC via an all or mostly cash transaction would be accretive day one. From a strategic perspective, EMC could inject its SMARTS technology into Quest, and leverage QSFT DBA and apps management tools in the VMware marketplace.

Most importantly, EMC has a decent track record of making software acquisitions work operationally. For BMC, buying Quest would increase their revenues by at least 25% to over $2 Billion and increase EBITDA to over $550 Million. BMC has plenty of cash, its stock is up nicely over the past year, and the products fit from a channels/customers/strategic perspective.

Ironically, Quest CEO Vinnie Smith sold his previous company, Patrol Software, to BMC. Quest has been a thorn in BMC’s side ever since Quest was founded by Smith. History can repeat itself, even though BMC acquiring Quest is not a new idea. The timing may soon be right for it to finally happen.

QSFT/BMC 1-yr comparison chart