Microstrategy: Has The Enfant Terrible Of The Software World Finally Matured?

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Summary

MicroStrategy has achieved a significant, if unheralded, operating turnaround during the course of 2015.

Q4 results demonstrated the potential profitability of the company's business model, with non-GAAP operating margins reaching 36% coupled with 20% growth in license revenues.

The company has a significant relationship with Facebook which is both a significant customer and a development partner.

The company continues to have what are thought to be leadership positions in various phases of big data analytics for large enterprises.

The company leader, after years of dysfunctional behavior, has apparently aligned his interests with those of shareholders and has suspended his cash compensation and has been holding conference calls.

Introduction:

MicroStrategy (NASDAQ:MSTR) is one of the older enterprise software companies having been founded as long ago as 1989 and it has been basically run by a single individual, Michael Saylor, since its inception. In the late 1990s, it was one of the shooting stars of the dotcom era, and it went public at the height of that bubble at some enormous valuation. It was a poster child for all that was wrong with many of the IPOs of the era, making no money and never really creating a business franchise. That being said, Mr. Saylor, a graduate of MIT and in the top 1% of his graduating class, has undoubtedly been an industry visionary and he pioneered what are today standard solutions in the Business Intelligence space using what was then a new technology called ROLAP in which data is stored far more efficiently and at a greater scale than can readily be done in standard Relational Databases (RDBMS). Mr. Saylor's vision has encompassed such areas as mobile and data visualization. Needless to say, along the way there have been some clinkers in the stack that have cost MSTR more than a little in time, money and emphasis. Most recently, Facebook (NASDAQ:FB) has been a prominent customer and development partner of MicroStrategy. Other prominent customers of its flavor of Big Data Analytics include Starbucks (NASDAQ:SBUX), Lowe's (NYSE:LOW), Four Seasons, Target (NYSE:TGT), Hilton (NYSE:HLT), eHarmony, Campbell Soup (NYSE:CPB), MetLife (NYSE:MET), Swift and Adidas (OTCQX:ADDYY). I would say that most of these customers chose MicroStrategy as their vendor because of what they perceived as the company's leadership in analytical technologies which apparently overcame its reputation as a vendor with whom it was difficult to do business.

The company announced a significant upside surprise in both earnings and license revenues when it reported Q4 operating results after the market closed on Jan. 27th. At that time, the shares spiked by more than 20%, although they never quite reached the levels that they had sold for at the start of 2016. In the wake of the disappointing results announced by Tableau (NYSE:DATA) last Thursday evening, the shares have retraced much of that move and now sit 10% above where they had been before the company announced its earnings. Shares have decreased by about 14% year to date.

Background

MicroStrategy has struggled for many years now and has had more transformations than some folks have had hot dinners. The company was a pioneer in what is called Relational On-line Analytical Processing (ROLAP) which is still the basis for many of the solutions that the company offers. It was one of the first vendors in developing mobile apps to display the answers to complex queries. It built an engine that combined its query capabilities with desktop visualization. It made its applications available for cloud deployment and on a subscription basis reasonably early in the game. Today, cloud revenues are running at a bit more than $30 million/year. MicroStrategy entered the social media space through a relationship with Facebook, a significant customer these days. And it recently introduced its "Usher" security platform in order to ensure the integrity of all of the data its analytic engines process. And with all of these product advantages, the company simply never made it into the first tier of business intelligence vendors. Q4, as I will discuss, may possibly have been a breakthrough quarter for MicroStrategy, with license revenues up 20% year on year, and up about 40% sequentially. But license revenues were still shy of the levels that were reached in 2011.

Not to put too fine a point on the discussion, but I believe that the basic reason for the checkered performance over the past decade and more, and really for the lack of historic performance overall, has been the company's CEO, founder and control stockholder, Michael Saylor. There is little doubt that Mr. Saylor is an industry visionary as can be seen just by looking at some of the areas in which MSTR has been first to market with leading-edge technology. On the other hand, he has been more than a little arrogant, irascible and disrespectful of other stakeholders, including investors and customers and his co-workers/employees at various times. At the height of the dotcom craze, Mr. Saylor was worth several billion dollars and was reputed to be the wealthiest man in the DC area. He was trumpeted as the Washington area's most eligible bachelor and reputedly partied very hard. He is now 51, worth lots less (although still around $500 million according to various publications) and is married with two children. Even his yacht, the 154-foot long Usher is now part of a pool that is available for charter (Mr. Saylor has founded a company that is described as the Netjets of the nautical world). The company started to hold conference calls with investors for the first time in almost a decade in July 2014, and Mr. Saylor gave up his salary and bonus in September of that year.

The company has seen multiple restructurings and changes in emphasis over the years. The last growth spurt that occurred back in 2010/11 was a function of an incredible burst of spending that basically did little to increase shareholder values. Since then, the company has been through a couple of changes of sales management and much of its field sales force turned over as well. The real issue for investors going forward is whether or not the company can take its assets - its technology, its visionary status and its customer roster - and create an engine for sustainable and profitable growth.

Investment Thesis

I have to confess that there have been times in my analytical career that I have pledged to avoid turnarounds and restructuring stories like the plague. The risks involved are not insubstantial, and explaining away one's premature or misplaced enthusiasm is always an uncomfortable exercise. But at the heart of my thesis is that although Big Data Analytics is no longer the Alpha and Omega of investing in enterprise software, it remains as one of the great growth opportunities, both now and in the foreseeable future, and MicroStrategy has a combination of the right technology and relatively reasonable valuation. Given the track record of the controlling shareholder, it would be impossible for me to suggest that there is a 100% chance that company will always be run on sober and rational lines going forward, but there is some evidence that at the least the CEO is in a phase of maturation and attempting to align his interests with those of shareholders.

Trying to evaluate the plethora of Big Data Analytics offerings is tedious at best, and for me, it has to be left to professionals in the field. For better or worse, the company has been in the Gartner "Magic Quadrant" for years. I think the Gartner report on the BI space sums up MSTR's situation quite effectively. I will just quote an extract. "MSTR offers an enterprise-grade and organically grown end to end BI platform that is well-suited to large and complex system of record reporting… It has a compelling product and vision for large-scale governed data discovery and has invested early in cloud and mobile BI..."

"Executive turnover and restructuring may have contributed to eroding the customer experience… We need to see execution at MicroStrategy… if it is to remain a Leader in the Magic Quadrant in the future..."

It is my belief that the company is on the cusp of a potential breakthrough, although my confidence level cannot be terribly high. There is an old saying about "a single swallow not making a spring." But I do think that some of the metrics seen in Q4 and frankly throughout 2015 are encouraging signs that need to be considered objectively and not as afterthoughts of Mr. Saylor's lengthy record of inconsistent performance.

I should point out at the outset of reviewing the financials and the valuation that MSTR's shares are not going to be suitable for some investors. The company continues to be controlled by its founder Michael Saylor through his ownership of more than 2 million class B shares with options of several hundred thousand additional shares around current prices. The company has a float of just 8.6 million shares, a function of the company repurchasing much of its capitalization over the past decade or so. In total, 97% of those shares are held by institutions, a function of the high absolute price of the company's shares and its history of not being accessible to many investors until 2014. The company's shares are below both their 50-day and 200-day moving average. On the other hand, its short interest is above 10% of the float, a relatively high percentage and one that has led to significant upside gaps when and if the company is able to exceed consensus expectations. The company, while holding conference calls and presenting its product vision, has still not yet provided guidance, either of the short-term variety which is quite understandable, but not of the long-term variety either, which would be somewhat helpful.

Valuation and Recent Business Performance

In the wake of the Tableau disaster and the concomitant meltdown of many tech shares, particularly those in any way engaged in enterprise analytics, MSTR seems to have achieved some reasonable valuation metrics as a combination of better financial performance coupled with some severe multiple compression. The company sells for 2.3X EV/S based on estimates for 2016 sales, a relative modest ratio, particularly if the company can restore its growth engine. (It should be noted that the company has 2 million class B shares outstanding and calculations for valuation ratios have to be adjusted to include the class B shares. The divisors that one sees in some screens are in error as they do not adjust for this consideration). It has a P/E of 16X on forward earnings, although for a company like this, which doesn't guide and has only five analysts covering it, I think the consensus is a less valuable marker than would otherwise be the case. It's worth noting that earnings surprises over the past 12 months, all positive, have ranged from 86% to 5% and were 54% last quarter. Earnings leverage for this company is significant and modest top line upside will inevitably lead to major EPS beats. Of the five analysts who are publishing estimates and reporting them to Thomson/First Call, the average expectation for revenue growth in the current quarter is less than 3%. While part of those estimates are based on declines on the services and support lines as part of the company's transformation process, the estimates suggest that analysts are loathe to extrapolate from Q4 license growth performance. That being said, the average rating at 2.1 on a scale of 1 to 5 combined with a price target average of $210, or more than 35% appreciation from current levels, suggests that there is a bit of inconsistency between published earnings and revenue estimates and real expectations.

It is not too much to describe MSTR's Q4 as the best quarter that the company has printed overall for many years now. The company achieved significant product revenue growth in the quarter and was able to achieve improvements both in gross margins and in operating margins of some significant amounts. The improvement in gross margins was mainly a function of the changes in the company's mix between license and services revenues. What was most impressive and frankly under appreciated was that the higher license revenues came on the back of significantly lower sales and marketing spend which dropped by 16% for the quarter compared to 2014 and was down by no less than 34% for the year as a whole. It should be noted that with the strong performance of license and subscription revenues in Q4, and the likelihood that a fair cohort of sales personnel was making commission accelerators, the 16% decrease in sales and marketing spend was more remarkable than it might seem.

This is not the place for commenting in any detail about sales productivity and the factors that might drive sales productivity for this company or for other software companies, but the improvement that MSTR was able to achieve last year in that category and the lesser but still significant improvements the company made in SG&A spending both during the quarter (down 12%) and the year (down 16%) are quite suggestive of a new approach to running the business which is perhaps not totally appreciated by investors after so many years of disappointment. The company shrank headcount by 20% last year and, in particular, shrank the sales and marketing headcount by 23%. The reductions in headcount bottomed out last quarter during which overall headcount and sales headcount were essentially flat. Overall, the company achieved non-GAAP operating margins of 36% last quarter and 29% for the year. While most software companies talk about the need to "invest" in order to grow, some of that is self-serving. Higher sales, particularly in the current era of the software business, are not always a function of increasing sales headcount - and one has just to look at Tableau to see the validation of that statement. While I would be reluctant to model for significant growth in operating margin percentage for this company if I had to publish an estimate, I doubt that it has reached an apogee in terms of operating margin performance and it still has work to do in rationalizing its delivery of consulting and services revenues.

The company has had a decent balance sheet for years. It has $485 million in cash and equivalents which is equivalent to $42/share or 27% of the current share price. The company's operating cash flow for the year was just shy of $150 million, and for those concerned about the metric, net stock based compensation was just 11% of that amount. Free cash flow was greater than $136 million. MicroStrategy's capital expenditures are minimal, although it does capitalize some software development. The company has a free cash flow yield on its enterprise value of greater than 10%, although it is hard to imagine that the company will be able to continue to have greater free cash flow than earnings given the constituents of 2015's cash flow figures and the potential for future growth in revenues.

Conclusion

While MicroStrategy's shares are not in the deep value category, the recent pullback in the wake of Tableau's disaster, coupled with a remarkable year-long turnaround in operating performance that is unheralded and more or less unnoticed by many, has created an intriguing investment opportunity. Given the value of the company's technology stack, coupled with the favorable dynamics of the market in which it operates, I'm inclined to think that the favorable license sales results of Q4 are not a fluke but are a trend that might persist for some time. Further, the restructuring the company has achieved will allow any success to have a significant impact on earnings and operating cash flows which has not been the case in the past. I don't suggest that this company is going to have a straight upward path to a blue empyrean - I simply have had too much experience with the current CEO to ever imagine that - but I do think the risks and rewards are nicely valued in favor of investors at this point.

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.