Teradata - Handicapping the Start of a Party
I have written about Teradata (NYSE:TDC) several times over the past year. I first wrote about the company and the start of its transition a bit more than a year ago, and while it seems surprising to recount, the shares have appreciated by about 35% since that point. That compares to the 46% appreciation of IGV over the same span. It can be hard to recollect just how harsh the correction in tech shares was a year ago, and how strongly they have appreciated since that point. The QQQs have "only" appreciated 33% over the past year.
It is far easier for many analysts, as opposed to commentators on this site, to write favorable reports on fast-growing cloud companies. There is to a greater or lesser extent, far less intellectual energy involved in recommending a company growing at 30% than recommending the shares in a company whose revenues are shrinking. The problem for investors with the share price appreciation seen by many of these leading companies in the past year is that many of them have little real potential for positive alpha and create requirements for ever-escalating valuation metrics. Running very hard to stay in the same place so to speak.
A positive element for investors in considering Teradata's shares regardless of any other factor is that valuation metrics are not particularly stretched at the current time and one might fairly call them compressed. Of course, the other side of that equation is that investors, perhaps, need to suspend disbelief that there is a new life for this company. Many observers are unwilling to do that.
And like many of these transitions, it is inevitable that the evidence one has to consider is more than a bit murky and subject to differing interpretations. I think I see signs of spring. Other observers believe they see signs of a late season blizzard. The weather forecast from my iPhone for this weekend around here is really for unseasonable warmth - one day is supposed to reach 60F. Perhaps it is the same for TDC's shares.
Part of the difference in outlook is perspective. TDC is an older company that is not perceived as a leader in its space in terms of its solutions. I think the evidence there is a bit more straightforward that it is a formidable competitor and that its strategy will see it with an increasingly competitive set of solutions.
The company was one of the pioneers in big data and analytic solutions and then became unresponsive to some of the more significant market trends over the past few years. I can't say I really know why that was so, nor does it much matter, as the company replaced its CEO and has a new team of senior leaders in most key spots as I documented in prior articles.
A few months ago, the company held an analyst meeting and discussed its transformation plan in some level of detail. Either analysts didn't believe that the company would achieve its goals or they felt that the goals were inadequate or would take too long to realize. The shares sold off in the wake of the meeting and have been mainly marking time over the past few months. The shares have participated to some degree in the "Trump" market and did enjoy a positive response to the most recent earnings release. But I am still inclined to believe that the preponderance of opinion on the part of both analysts and investors regarding TDC is that it is a has-been company whose best days are behind it.
At one time, Teradata was the "go to" vendor in its space. While there have always been competitors, the company was able to amass a solid base of users who were very happy with the company's Enterprise Data Warehouse (EDW) offering.
These days the company faces loads of competitors of various stripes and sizes. The business results of the past several years during which the company has gone backward have convinced some analysts and investors that TDC has lost its relevance in the market. That really hasn't been the case.
Gartner has TDC comfortably in the leader's quadrant of its product analysis for data warehousing and data management solutions for analytics along with Oracle (NYSE:ORCL), IBM (NYSE:IBM), Microsoft (NASDAQ:MSFT) and SAP (NYSE:SAP). The Forrester Wave study on enterprise data warehouses reaches the same conclusion. TDC has a core of loyal users who have been looking for the company to provide the appropriate solutions in order refresh their installed technology. The new management team is apparently taking the steps necessary to become a responsive partner with its installed base, and some signs that its initiatives are making progress were visible last quarter.
It is inevitable in writing about this space that one mentions the cloud. The advent of the cloud was one amongst several factors in upending Teradata's business model, and the failure of the company to respond promptly was a principle factor in costing the former CEO his job. AWS is a significant competitor in the EDW market, but TDC nowadays offers a solution set that incorporates its technology on AWS. At this point, it seems that TDC and AWS have evolved a reasonable co-option model.
But we are still a long way from the start of a party to celebrate the return of the company to growth. The odds are that headline numbers are going to show minimal progress this year, although it is possible that the company will see some significant growth in either bookings or deferred revenues or some of the other metrics that are important to investors during transitions from on-premise and perpetual streams of revenue to a ratable model.
There are not all that many ways that investors can participate in the market for data warehousing and data management solutions for analytics. Some observers want to lump Tableau (NYSE:DATA) and MicroStrategy (NASDAQ:MSTR) as well as Qlik Technologies (NASDAQ:QLIK) in the group, and some investors have gone along with that analysis. In the market well, it simply isn't quite happening that way. The reason that IBM, Oracle and SAP are in the leader's quadrant has to do with the business intelligence leaders that they bought a decade ago, and Microsoft has been developing Power BI for more than a decade now. The only other company in the space was Actuate that was bought a bit more than two years ago by Open Text (NASDAQ:OTEX). There are reasons to buy OTEX's shares - its ownership of Actuate is a minor component of that investment case.
The market for data warehouse revenues and associated analytics is large and continues to grow at low-double-digit rates. Most market research companies nowadays look at big data, analytics and EDW as a combined market. It is really the market space available to TDC. That represents a potential TAM for the company of $200 billion.
TDC has always been a specialist company in that space, and while it may have lost its way in the past couple of years, it hasn't lost its customers who remain exceptionally loyal. TDC ran off the rails and lost share because of an unwillingness to sell solutions in the space packaged the way users wanted to buy and not because of something that went wrong with its technology, or even of its support. One of the things that can happen to market leaders is that they grow complacent and sloppy. TDC was slow in selling what are called data appliances in the market for fear that doing so would upset its very profitable EDW business. When the cloud came, it was slow to offer solutions that delivered for its users using that architecture. It has paid a substantial price for those miscues.
Rather than looking back, it is more relevant to attempt to determine if the company has a reasonable opportunity to grow at rates consistent with the overall market. In addition, one needs to look at both the profit implications of the company's strategy and the length of time the transition can be reasonably expected to take. Investors bid up TDC's shares 10% last week in the wake of the quarterly results. I believe that the results were a sign-post that some components of the company's strategy are gaining traction. The positive alpha implications that would be inherent in the company reestablishing its position in the EDW/Analytics market are more than significant. It is worth taking a detailed look at both the quarter and the guidance to see what has been happening at the company
An Early Sighting of Spring?
Last week, Teradata reported the results of the end of its fiscal year. The headline numbers included a noticeable earnings beat and a negligible miss in terms of reported revenues (less than 0.5%) that was a product of a combination of FX headwinds coupled with a more rapid cadence in its customers moving to ratable revenue alternatives. The company did not provide full-year guidance primarily based on its judgment that it had an inability to forecast with any precision just how much the ratable mix is going to grow the current year. Given the rather inaccurate forecasts that have been a hallmark of similar transitions throughout the IT space, this is a prudent tack.
I would be happier if the company would choose to introduce a bookings metric as part of its set of forecasting metrics but that has not yet happened. The company is introducing other metrics to track progress in terms of revenue proxies. One of these is something called T-Cores, which the company has developed as a tool for measuring the consumption of its products (The company defines T-Cores as both physical CPU cores as well as throughput for its systems). The company is also going to introduce an ARR metric. Shipments of T-Cores apparently started to grow in Q4 compared to declines earlier in the year. The company said it expected to see decent growth in the ARR metric this current year; it probably was flat based on what was said during the call during Q4. While TDC has consumption options that span the gamut between on-prem to public cloud and all the way in between, it is expecting that most of its large deals in the future are likely to be based on hybrid cloud deployments.
The company forecast Q1 revenues of $500 million, noticeably greater than the pre-announcement consensus expectation of $486 million with an EPS of $.25-.30, consistent with the prior EPS forecast of $.30 for the quarter. Because of the company's historic track record in terms of making numbers, the potential impact of the transition and the lack of more than one quarter of guidance, the dispersion of estimates is far greater than is usually seen for a company of this scale. What can be gleaned from the forecasts, however, is that the consensus simply doesn't believe the transformation project is likely to be successful - not this year and not in 2018 either.
Most analysts are not particularly enchanted with the opportunity here, a function of terminal "backward lookingness" I believe. 23 analysts report their ratings to First Call. Of Those 23, 14 have hold ratings, another five rate the shares as underperform and a couple rate the shares as a sell. That leaves just a couple of lonely buy ratings of which the most prominent is offered by JMP. While the present consensus price target is less than the current price of the shares, the ratings suggest that there is enormous upside if this transition succeeds, most likely significantly greater than more fashionable names in the cloud space that sport valuations to match the consensus view.
In Q4, the company reported revenues of $$626 million, a decline of 13% from the level reported in Q4 2015. The company divested its marketing application business this year so the apples-to-apples comparison was a decline of 8% and 7% in constant currency. That probably doesn't look much like any early spring investors are looking for.
The cost side of the equation did exhibit strong positive trends, but as the saying goes, no one ever saved their way to prosperity. From my perspective, the investment case for TDC is not that the company is being right-sized, but that the company will be able to grow going forward. That being said, selling, general and administrative expense on a GAAP basis dropped by 25% year on year, far greater than the 13% reduction in reported revenues. Selling, general and administrative expense was flat sequentially despite normal seasonality. Overall, reported revenues rose $74 million (that is really just seasonality at this point) while selling general and administrative costs remained at Q3 levels and likely will decline further going forward.
On the Q4 conference call, the company CFO talked about $40 million of bookings during the quarter that will be recognized ratably. Of course, we don't know what that $40 million compares to a year earlier and the length of time over which the revenues will be recognized. But overall, it seems likely that Q4 results in terms of bookings were consistent on an apples-to-apples basis with the results reported for Q4 2015. That level of results is better than the results the company has achieved in the past several quarters.
The company is forecasting that it will achieve revenues of $500 million in Q1, net of $50 million of transactions that will be ratable. This is an awkward way of communicating that kind of metric when compared to how other companies in similar transitions choose to report their results. But if that $50 million forecast turns out to be the right number, it will be 20%+ of product bookings for the period. In any event, I would be surprised if the cadence of the swing to ratable transactions turns out to be that modest. I think it is more likely that the swing will be similar to that experienced by PTC (NASDAQ:PTC) in recent quarters, although that really is more of a guess than anything else.
As mentioned earlier, the company is planning on providing a new metric called T-core which is a standard unit of consumption of Teradata product solutions. T-Core is a bit of a made-up number because this company sells both database capacity and analytics, and it is unknown how analytics are converted into T-Cores. The company noted that T-Core started grow in Q4 at "a good rate after declines in Q1, Q2, and Q3."
Again, as mentioned above, the company is planning on providing an ARR metric which is forecast to grow in the high-single digits this year. Given that services revenue, which includes maintenance, is such a large component of revenue at this point, a high-single-digit growth rate in ARR will be a significant attainment that would probably lead to a significant re-rating of the shares by many observers. The company expects to increase the recurring portion of its revenue from 43% to the high 40s percent over the course of 2017.
All the Moving Parts Anyone Could Want to Track
I am not too sure if anyone would want to read about all the moving parts that made up the latest TDC earnings release. Far too many, really. But I will try to highlight a few that might be of some use to readers trying to evaluate the potential for the shares of this company going forward. The net of this for those not disposed to read the balance is that there are going to be lots of cross currents and countervailing forces that are going to be tugging on earnings. The headline numbers to a greater or lesser extent will not mean much. There will probably be some specific proxies that help in evaluating the progress of the turnaround. Last quarter showed some green shoots with regards to sales and the consumption of T-Cores. Most everything else is really on the come.
I think the most important concept to note is that the company is focused on increasing the consumption of T-Cores at a dramatic rate over the next few years. The company has an aspirational CAGR in that regard is about 30%. There are several ways in which the company is attempting to realize that objective.
One of these is the variety of consumption options that have been developed. Users can obtain Teradata solutions just about any way they want them. Teradata offers its database as a service, it offers it as a managed service option, it offers backup/recovery systems, and it offers the service in a private cloud, on AWS and on Azure. It also offers what it calls workload-specific prices that are designed to offer additional flexibility for users that want to use Hadoop or want to user an analytics appliance, or hybrid storage. The company these days offers just about any possible combination of options for ware housing data or analyzing the data in those warehouses.
The net of these options in business terms is to try to increase the recurring revenue contribution for TDC. The company is forecast that recurring revenues will increase from 61% of its revenues in 2016 to 86% of revenues by 2019. That kind of transformation will ultimately lead to a more stable business model with greater profit margins.
The company is planning to grow research and development expense significantly over the next couple of years through 2019. In that regard, it is opening a new development center in Seattle and significantly expanding its other research and development operations. Overall, development spending is likely to increase by 50% or more over the next couple of years.
Presumably the outcome from the spending will be a broader portfolio that can more deeply penetrate the company's larger clients on which it is planning to concentrate its sales efforts. Much of the effort is going to be focused on providing users with more efficient hybrid cloud solutions and providing potential customers with new analytic solutions.
Because these permutations and combinations are for more comprehensive and complex than what the company has chosen to offer in the past, it has made it difficult to draw trends from demand for one or the other sets of TDC consumption/revenue streams.
Part of the company's strategy that is going to impact near-term financials relates to its focus on altering its consulting business so that it is primarily related to developing analytic solutions and developing big data architecture for its clients. I commented that this is not a trivial undertaking and one whose future is somewhat difficult to forecast. Consulting services, as opposed to maintenance, were about 1/3rd of total revenues when it was last reported specifically. That proportion probably hasn't changed materially in the last few quarters. It is not a trivial component of the TDC business mix, and it is a key part of the company's strategy.
As the transition accelerates in scope, there will be stresses in terms of gross margins in the consulting area. The company is going to have to recruit and train higher cost individuals for its new consulting focus and they are likely to have a lower utilization rate in the short term than the individuals they are essentially replacing. Services margins were consistent on a GAAP basis last quarter compared to Q4 2015, but they probably will not be able to sustain that level in 2017.
There is a new FASB rule (606) that will have to be implemented either this year or next. As a practical matter, it could impact to some extent the way a company like TDC recognizes on-prem revenue by requiring the purchase price of a contract to be tied to specific performance obligations in a contract. I do not propose to get into a detailed discussion regarding the impact of implementing 606 for this company; it is coming, it will have a noticeable impact, and investors are likely to shrug off any revenue deferrals that it creates. It is just another moving part of the company's reported financials.
Valuing a company in the midst of a molt is a difficult exercise. The molt produces some peculiar valuation metrics that aren't representative of anything in particular and really don't help in assessing the worth of a company. This is going to be one of those times.
For the record, however, Teradata reported outstanding shares at the end of last year of 132 million. At the current share price of $31.57, that yields a market capitalization of $4.16 billion. Net cash on the balance sheet is a bit more than $400 million, which yields an enterprise value of $3.7 billion. The current First Call consensus forecast for revenues this year is $2.13 billion, down 8% from the revenues for 2016 just reported and consistent with guidance. That produces an EV/S of a bit over 1.7X and is indicative of the current attitude towards this company held by investors. It does, however, suggest that the company has a valuation that could readily attract interest from potential P/E buyers.
The company, as indicated elsewhere, is not providing EPS guidance for the year. The consensus number for EPS of $1.43 is probably consistent with the revenue forecast. Actual earnings for TDC are going to be very dependent on the cadence of the revenue transition to ratable sources. The faster the transition, the lower the earnings. Ironically, the faster the growth in T-Cores consumed on a ratable basis, the lower the earnings. The P/E of 22X based on the First Call consensus is really not indicative of much and should not be used in trying to value the shares.
Despite all of the uncertainties, the company is forecasting free cash flow of $250 million this current year. Management feels that cash flow for the year is very front-end loaded and more than 60% will be produced in Q1. Needless to say, $250 million is a very depressed number and compares to free cash flow generation of $333 million last year (based on my definition which includes net capex as well as net additions to capitalized software). But even at the compressed level of free cash flow being forecast, TDC's free cash flow yield is almost 6.8%.
I think that the net that can be said of the valuation metrics is that they are very low, and that despite the fact that the company's numbers are at trough levels. Trough valuations off of trough operating numbers can be a formula for very powerful appreciation.
In looking at the IT universe these days, it is fair, I think, to observe that many of the "traditional" of the recent hyper-growth names have valuations that in whole or in part reflect the most likely course of their future operational performance. It is hard to obtain much positive alpha from a story that is already well recognized.
That is not the case for TDC. Basically, no one believes management, and to the extent that it is believed, the cadence of improvement is thought to be too slow. I don't think that is a good way to invest.
I am looking for positive alpha. I believe that analytics and data warehousing are two of the better spaces in the IT space. TDC has a far better market position in that niche than is believed. It is molting and is not pretty during the process, but it is my belief that the molt will produce an attractive butterfly. Q1 was a success for the company, and I think this is reasonable entry point for those looking to achieve positive alpha.
Disclosure: I am/we are long TDC.
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.