Mattersight: Sentiment And Valuation Bottoming Out

| About: Mattersight Corporation (MATR)

Summary

A material weakness cited in Mattersight's 10-K pertained to the documentation of company controls, NOT the actual controls (and certainly not its financials). Investors' overreaction has created a buying opportunity.

Larger customers are spending more with Mattersight. Bearish investors view this as an increasing customer concentration risk. Bullish investors view it as a sign that MATR's products add tremendous value.

MATR's valuation now reflects greater potential reward at much lower risk. It's trading for less than 1.5x 2017 revenue estimates, a level at which subscription revenue companies often get acquired.

Mattersight (NASDAQ:MATR) recently crossed over the $75 million public-float threshold (in June 2015). As a result, the company became subject to 404 audits, the first it has gone through in a while. During the audit, a material weakness was uncovered. However, the weakness was only related to the documentation of company controls, not the actual controls… or anything related to financials.

Specifically, it was related to documentation of control over access to a software portal. The portal is where user accounts can be accessed. Internally, within the company, MATR didn't have the proper documentation related to who actually has access to add or change users. If actual controls over this were not in place, it is believed that a rogue user could affect revenue.

However, the company does have controls over this system. It simply didn't have formal documentation of those controls.

The situation has since been remedied. However, rules stipulate that they can't formally say that it's been remediated until Grant Thornton sees the documentation for two "periods" (monthly or quarterly). To be clear, a review was completed which confirmed that there was no impact to anything material within the company.

In short, the company feels good that everything is running smoothly. This situation was just part of living in a Sarbanes-Oxley world.

But this wasn't the only thing that concerned investors about the 10-K. Specifically, customer concentration concerns have resurfaced. I find this perplexing, since customer concentration has been a well-known issue for some time now. That being said, the 10-K did show that MATR's concentration increased in 2015:

In fiscal year 2015, United HealthCare Services, Inc., Progressive Casualty Insurance Company, and CVS Caremark Corporation accounted for 31%, 15%, and 13% of total revenue, respectively. In fiscal year 2014, United HealthCare Services, Inc., Progressive Casualty Insurance Company, and HealthCare Service Corporation accounted for 25%, 20%, and 11%"

However, it could just as easily have read:

In fiscal year 2015, United HealthCare Services, Inc., Progressive Casualty Insurance Company, and CVS Caremark Corporation accounted for 31% ($12M), 15% ($6M), and 13% ($5M) of total revenue, respectively. In fiscal year 2014, United HealthCare Services, Inc., Progressive Casualty Insurance Company, and HealthCare Service Corporation accounted for 25% ($7.6M), 20% ($6M), and 11% ($3.3M)."

Notice the difference? If those big customers were spending less with MATR and representing a bigger piece of total revenue, that would be quite bearish. However, they are clearly spending more and more.

Meanwhile, new customers have just started flowing in. New customer revenue contribution ramps slowly, due to MATR's subscription model. This can cause larger customers to look even larger.

This is also why ramping expenses is not an automatic cause for alarm. Like secondary offerings, if the money contributes to growth, it's bullish. A study done by Roth Capital showed that software companies that ramp expenses faster grow faster. Basically, if your product is software and in demand, you should invest in accelerating your growth rate.

Of course, the product has to be good to be in demand. From that perspective, my industry consultants were very well paid (5-figures) to investigate and tell us if MATR's offerings qualify. The results were bullish enough that I made the stock a Top 5 position in my personal portfolio.

Since then, nothing has occurred to materially alter my outlook. If anything, I believe that the valuation now reflects much greater potential for reward with much lower risk. The stock is trading for less than 1.5x 2017's revenue estimates, a level at which subscription revenue companies often get targeted for M&A. However, companies like that typically have very little (if any) growth. In contrast, MATR is expected to grow by nearly 30% this year and 25% annually over the next 5 years.

Even if those numbers are halved, MATR's shares are greatly undervalued from a risk/reward standpoint. After hitting the top of our Risk/Reward chart back in October, the stock has predictably pulled back toward the bottom of its channel. As a result, it is now a hair's breadth from bottoming out:

Click to enlarge

Bottom Line: Mattersight is a small company and small companies' stocks have been decimated over the past 12 months. Further, considering the large deal sizes with which MATR deals, investors should expect bumps in the road until customer concentration decreases. But this is why early investors get rewarded with outsized gains when things work out. As a result, I've learned to 1) focus on small companies that have the best shot of success relative to their valuations and 2) ride out the volatility.

This is a requirement of small-company investing, because predicting ups and downs is impossible without insider info (which is something nobody wants any part of).

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Disclosure: I am/we are long MATR.

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

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