Teradata: Has Light Been Seen At The End Of The Tunnel?

| About: Teradata Corporation (TDC)

Summary

Teradata has been in operational decline for at least three years now.

Company management has been both greedy and short-sighted in addressing material changes in the business environment.

The company's Q4 had a few signs of stability in terms of revenue generation although product gross margins were pressured.

The company has a transformation program that will address some of the marketplace issues that have halted growth.

The company, because of its compressed valuation and the high growth space in which it operates, is seemingly an ideal candidate for acquisition.

Introduction:

February 4th, 2016, proved to be a seminal day in the history of Big Data Analytics. On the one hand, industry leader Tableau (NYSE:DATA) hit one of the more dramatic speed bumps of all time with a significant license revenue miss and very soft guidance, particularly in the current quarter.

And then there were the results of industry laggard Teradata (NYSE:TDC). Just to be clear, TDC does not compete with Tableau in any meaningful sense. Yes, they both sell software solutions that are used in the broadly defined analytics space. Tableau essentially sells software that allows users to create charts and graphs and other visualized reports from all kinds of data. TDC mainly sells data warehouse solutions to large enterprises. They really don't compete against each other for specific deals.

And also to be clear, TDC did not have some kind of breakout quarter. Revenues still dropped 1% in constant currency although that was significantly better than prior expectations. There were some signs of life in the Americas region that grew by 3% in Q4 and among the largest TDC customers where revenues actually grew, reversing a decline in the mid-single digits that had been seen during the first nine months of the year. The results for the company's Big Data Appliance - primarily the results of what used to be called Aster Data - were up 50% on the year and Big Data consulting grew faster than that. There were some green shoots apparent in the company's very nascent cloud offering where revenues doubled off a very small base. On the other hand, gross margins declined by almost 500 basis points, partially reflecting the transition to cloud as well as the mix of what the company sold. Indeed, product gross margins which took the brunt of the transition-related pressures, declined by more than 800 basis points. And, of course, the company's legacy products business, its flagship Enterprise Data Warehouse (EDW) solutions fell by about 10% in the period. It was hardly a pretty picture although less dire than the results of prior quarters.

The shares did respond to these less than disastrous operating results with an 11% rise to a peak on February 4th. Since that time, in the wake of the Tableau miss, they have essentially retraced 80% of that inter-day move which has left the shares scarcely above where they had been before Q4 earnings were announced.

But there is a case to be made for investing in the name, I believe, and I think that the shares, battered as they have been, are now at a reasonable entry point. For better or worse, the weak stock market overall and the reaction to the unpleasantness at Tableau have limited the upside reaction to the company's Q4 earnings and guidance. While up by hardly more than 1% from the share price reached just before earnings, the shares are still down by about 10% since the start of the year. I will discuss valuation in a bit of detail below, but the fact is that TDC is the closest thing to a value name in the data analytics space. And while it has an arduous transition through which it must go that is undetermined in terms of length, it also has some attributes that may be unexpected.

Background:

Some readers may be unfamiliar with TDC although it is not an insubstantial player in the analytics space with revenues above $2 billion. The company was first to market with a data warehousing product and that continues to be and is likely to remain a mainstay of the company's solution set for the foreseeable future.

TDC was founded as a venture between Citibank's Advanced Technology Group and Cal Tech at the end of the 1970s. Not surprisingly, the company concentrated on solutions that were particularly applicable to the banking industry and, as a result, it was eventually purchased by NCR. The banking industry and financial services in general have remained a key vertical for the company till this day. Again, there is nothing on the horizon that suggests that banks are not going to continue to need data warehouses - data warehouses are pervasive in financial service, pharma, retail, healthcare, etc.

The company was spun-out from NCR back in 2007 at which time it was doing about $1.7 billion of revenues and earning $1.24 per share non-GAAP. Back then, the company's CEO was Mike Koehler, a position he had been in since 2003 and a position he still holds today.

Fast forward to today, and the company has achieved just a bit more than $600 million of revenue growth including one significant acquisition for a compound growth rate of less than 5% since it became independent. It is hard to believe that a company started with a leadership role in a high growth space and could get so much wrong over its time as an independent company. Management really does matter.

The company is forecasting another marginal decrease in revenues this year, net of the impact of divesting its marketing applications business. Company earnings guidance is for about $2.35 per share, up from $2.06 for 2015. Much of that increase is the product of divesting the marketing applications group although some of it is what the company describes as its transformational initiatives.

I think it is worth discussing what went wrong at TDC as a prelude to see if the ship can be righted. Basically, what went wrong here was that company management was both greedy and short sighted and missed coping with several significant industry trends. When TDC emerged from NCR, its business model was quite simple and relatively easy to operate. It would sell users a package of hardware and software in which the users could store their data and use tools and templates to extract it and to put it into very simplified reports. TDC basically took off the shelf storage hardware, primarily from NetApp, marked it up significantly, loaded its proprietary software and sold it to the customers. It then sold loads of consulting services that users more or less had to buy in order to implement the hardware/software bundle they had bought.

Sales were pretty easy back then, primarily because few companies were major competitors. User data requirements expanded at a rapid pace and every few years TDC would introduce a new series of enterprise data warehouses that had significant improvements in price/performance. At that time, the users were encouraged to do what were called "floor sweeps" and replace their old equipment with the newest offering from TDC. The strategy had worked for many years and company management saw little reason to tinker with the model.

The Great Recession hit the company quite hard. The company's financial services and retail verticals were greatly impacted and the impacts of the recession lingered into 2010. The company started to enjoy a strong recovery, and by 2012, sales reached just short of $2.7 billion and EPS was $2.44 for the year. At that point, the shares hit an all-time high of $80 and it has been a long slow grind lower to current levels.

Although management did buy Aster Data in 2011 in an effort to capture the emerging market for the analysis of extra-large data sets, it basically ignored the market for what are called converged systems or data appliances which were far cheaper and could deal with queries far more quickly than standard EDWs. Management would barely allow the sales force to sell TDC's appliances and refused to scale the company's own offerings in appliances for fear of disrupting its own base. The problem for TDC is that its competitors which included Netezza and Oracle (NYSE:ORCL) Exadata were under no such constraints, and they started to enjoy some competitive takeaways and forced TDC to respond to aggressive pricing. While data appliances were a problem for TDC, the cloud has proven to be a disaster as many users have begun to locate their data warehouses in third party cloud repositories. Users have been less and less willing to pay TDC some huge mark-up to buy what by now are commodity storage boxes whose prices themselves have been pressured by the advent of solid state drives. Management had a chance to be a leader in converged systems, it had a chance to be a real leader in Big Data and it might have lead the revolution into the cloud. It did none of those things and kept reassuring investors that nothing had fundamentally changed and that the business was on the cusp of renewing its erstwhile growth pattern.

There are, to be sure, similar stories of frustration in the enterprise software space. Symantec (NASDAQ:SYMC) comes to mind along with I-Two and Manugistics that proved too adept at snatching defeat from the jaws of opportunity. But TDC is certainly in the running for having been one of the more frustrating names to own or to follow over the past three years.

The Investment Case

Much of the investment case is predicated as much on valuation grounds as on growth. As I have written in former articles, my predilections are to recommend fast growing names which for one reason or another are under-appreciated by investors. That is not the case here. Management guidance, to the extent that it can be trusted, yields a P/E on 2016 non-GAAP earnings of a bit less than 10X. The company has a current EV/S that is probably not much greater than 1.1X depending on the actual price it gets for its marketing applications division. The division generated just shy of $200 million of revenues last year which was more or less flat in constant currency and should be able to fetch $500 million from a raft of interested buyers. The company generated just greater than $400 million of operating cash last year and free cash flow was about $280 million, roughly comparable to non-GAAP net income. At the end of 2015, the company had a small net positive cash balance. Once it completes the sale of its marketing applications unit, it will have a positive cash balance that should handily exceed $500 million. Looking at 2016, it should be able to generate somewhat closer to $500 million of cash and free cash flow out to rise to about $350 million which provides a free cash flow yield of close to 13% on the company's enterprise value to be after its planned disposition.

Are those levels of valuation enough to support a buy recommendation? I think I would be on the cusp in trying to make a recommendation. Teradata, as an independent vendor, is going to spend a lot of time, a lot of effort and lots of money trying to migrate as much of its base to the cloud as it can, and during that period, EPS growth and reported revenue growth are likely to turn out to be very modest.

But at these valuations, the company is surely an attractive candidate to be consolidated. It has an unrivalled installed base in the data warehousing segment and its overall solution set in the EDW space remains unmatched. It has been run by a management team that has to be labeled inept. Many potential buyers are going to see ways in which they can either dramatically improve margins or the growth rate or achieve other revenue synergies or perhaps all of these at the same time. The Aster property in different hands would almost surely create significant sales synergies that for one reason or the other have been unrealized by this management. And it is certainly plausible to think that an activist investor could demand a change in management and a plan to maximize the company's returns, even if it remains independent.

Conclusion

Teradata is a rare valuation play in the enterprise software space, run for many years by an inbred, stodgy management who has basically been in denial about rapid changes in the industry. That being said, the company retains its leadership position as the single largest supplier of EDW systems to the market. It has a strong and rapidly growing big data solution. Despite all of its trials and tribulations, it is comfortably profitable and generates significant operating and free cash flow. And it exists as an underperforming, independent vendor in a space that has been consolidated to a significant extent and will continue to be consolidated in the future. TDC is not the "prettiest" of companies at which to look but it does, I believe, offer investors favorable risk/rewards and the potential for a home run if the company is consolidated is hardly minimal.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.