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On Friday April 27th, the betaCRACKER picked up on atypical activity on surrounding the in the month expiration calls of Cognos Incorporated (COGN). Our team at the Kelley School of Business is gradually building a position in Cognos, as the name has made the potential acquisition target rounds several times and we think Cognos may soon be gobbled up by a larger player, following the same path Hyperion did when it was absorbed by software giant Oracle (NYSE:ORCL) a few months ago.

Business Overview

Cognos all about helping businesses foster intelligence. The business intelligence [BI] and performance management software firm delivers robust CPM applications to business who analyze corporate data, compile reports, plan budgets, and distribute and deploy information throughout their organizations. Cognos generated $877.5 million in sales through 3,500 employees in 2006. The company's applications are designed to work with products from leading database and enterprise application vendors including Oracle and IBM (NYSE:IBM).

Investment Thesis

According to research firm IDC, the Business Intelligence market is expected to grow ~10% over the next % years: COGN is well positioned to upgrade and upsell its 23,000 customer base. Greater regulatory scrutiny in key end markets has driven demand for Cognos’ planning products. In corner offices everywhere, CFOs have been laser-focused on two major challenges: implementing solutions to better address the complex compliance environment and enhancing corporate performance across the board. With 40% of sales stemming from renewal maintenance contracts, COGN enjoys the benefits of a recurring revenue stream. Significant free cash flow yield is another attractive attribute of Cognos. Although the firm is under a SEC investigation for revenue recognition issues, once those are cleared, we think Cognos could be gobbled up.

The BI industry is already well concentrated (5 players control half the market) and we think a pure play like Cognos ($3.9B market cap, no debt) could prove attractive for a larger player who may already have BI integrated into their core applications but has come to terms with the industry-wide trend called vendor rationalization, or the law of “buyers buying more from fewer vendors.” This trend will persist, we think, and drive further industry consolidation.

cogn

Options Start Cooking

The option market surrounding software stocks like Cognos has been anything but placid . There was no news surrounding COGN on Friday, and yet shares ratcheted higher by 2.3%. Option premia spiked and volume on near out of the money calls exceed open interest across the board, indicating the opening of new positions ahead of the weekend. Although shares appear rich @ 25x (Cognos EPS is expected to grow 15% next year), less risk averse investors may want to take a look at the out of money calls 2-3 months out.

Source: Cognos Incorporated: Vendor Rationalization Could Spark Buyout