The last time Valsef Capital published an article was on XPO Logistics (XPO) in 29 March 2012 and XPO Logistics has since returned 202%. The Redknee Solutions (OTCPK:RKNEF) (Redknee Solutions is listed in the Toronto Stock Exchange) investment opportunity seems equally if not more compelling. Our thesis is as follows.
Redknee Solutions Investment Thesis:
Redknee Solutions is a software company that generates revenue from mission critical software used by Telecom clients around the world. Redknee's solution set provides Business Support Systems (BSS) namely; billing, charging, customer care and payments solutions for voice, messaging and data services (Product/Customer/ Revenue/Order management).
Recent developments since December 2016 have resulted in a special situation opportunity. At the core of this thesis is ESW Capital, a Joe Liemandt investment company that has been acquiring and operating software businesses for over 30 years, with a specialization in turnarounds and restructuring. ESW Capital is part of a larger group of companies that include Trilogy (one of the largest privately held software businesses), Versata and Aurea forming three of the largest operating businesses.
Under ESW Capital's operating model (based on the group's history of value creation), Redknee is capable of operating at 40%+ Ebitda margin. Consequently, at a conservative 8x Ebitda/EV multiple, Redknee should trade at CAD $2.00 = 100% return over the next two years.
The Thesis is structured as follows:
What is ESW Capital? What does it achieve after acquisition? How does it achieve 40% Ebitda margins with software turnarounds? What is the process?
- Before Preferred shares deal
- After Preferred shares deal: (Share price depressed by poor investor communication from newly appointed ESW Capital Board/CEO)
Understanding ESW Capital, its founder/CEO Joe Liemandt and Trilogy group of companies
ESW Capital is an expert software operator and prudent capital allocator masked under poor stock performance of Redknee Solutions. It is arguably among the best in software turnaround situations.
A deep understanding of ESW Capital will provide confidence in investing along with it. What is not obvious is the lack of detailed investor communication which is arguably the main reason for loss of investor confidence in the stock.
ESW Capital lists Trilogy (June 1989) as the first company in its portfolio of companies, followed by Versata (acquired in January 2006). Below is the ESW Capital story.
Trilogy Software Inc.
The roots of ESW Capital date back to 1989 when Joe Liemandt, current CEO of ESW Capital dropped out of Stanford with a few Stanford classmates to start Trilogy Software. Over the next 10 years, Trilogy went onto become one of the largest software companies of that time. It is still one of the largest privately held software companies. By the late 1990s, Trilogy had 1,200 employees and revenue over USD$250 million. In a one-hour talk to Stanford students in 2005, Joe Liemandt explains his passion for entrepreneurship; how Trilogy was built on a stack of credit card debt and how it went on to serve large clients such as Boeing (BA), HP (HPQ), AT&T (T) and GE (GE).
Joe Liemandt understood software pricing power very early
Trilogy Stumbles, But ESW Capital Reinvents Itself
All along the early growth phase, Trilogy went on an aggressive hiring spree. In fact, it went on to create Trilogy University. Liemandt said at the time that: "Trilogy University cost $3 million a month to run, but money wasn't an issue". (Source: statesman.com)
Along came the dot.com bust and Trilogy too went through a rough period. Overall software spending took a back seat, so did Trilogy's enterprise software. In the same talk to Stanford students in 2005, Joe Liemandt explains how he had to restructure and reposition the company which included building an offshore talent center in Bangalore, India which cost him a fraction of the cost of hiring software talent in North America. The foundation for ESW Capital, its acquisition strategy and its new operating model, was being established along with the repositioning of Trilogy Software. In 2012, Trilogy was said to have 10,000 clients in 45 countries.
ESW Capital's Acquisition Strategy Takes Off
On January 2006, Versata (a public company at that time) was taken private by Trilogy. It was followed by a merger of portions of Trilogy, specifically, Trilogy Technology Group, into Versata with a focus on acquiring software companies that need restructuring.
Since 2006, Versata has done 20+ acquisitions specializing in restructuring underperforming or "broken" software businesses. Newly appointed CEO of Redknee, Danielle Royston has been CEO of Versata since 2009 and is CEO of about 18 companies that come under Versata.
Versata Acquisition/Operation Model
Estimate minimum number of employees required to support business locally. Move a meaningful portion of them to contractors and ask them to work from a home office.
Versata processes are typically in place in 6-12 months, in shorter time durations for smaller companies.
From our checks with industry consultants, we have come to know that Versata companies operate at Ebitda margins in the 40-50% range (in some case even higher). The processes described under "Versata Acquisition/Operation Model" highlights how it achieves high profitability in a short time.
The ESW Capital group includes Trilogy, Aurea, Versata, DevFactory and Crossover with Joe Liemandt as the key decision maker across the group. Versata's CEO Danielle Royston specializes in turnaround operations, while DevFactory and Crossover specialize in providing world-class technology talent at lower costs than in North America and Europe.
What is DevFactory?
DevFactory started with Trilogy realizing that India has talent comparable to North America, but at a much lower cost. This outsourcing model was expanded to Ukraine and China. However, over time, all of DevFactory employees were asked to join as contractors via oDesk. Today, that process has evolved into:
"A low cost delivery model that enables project tasks to be done by a geographically dispersed network of service providers."
ESW Capital & Upland Software Inc.
Redknee Solutions is in fact the second time ESW Capital has invested in a public company. The other public company is Upland Software. Publicly available information shows that ESW Capital owns 31.82% of Upland Software. ESW Capital increased its position from 2.5 million shares at IPO in 6 November 2014 to about 5.5 million shares today, with aggressive buying as the shares fell.
In fact, ESW Capital and Upland Software have another connection. On March 14, 2016, Versata (an ESW Capital company) bought EPM Live from Upland. The press release regarding acquisition says the following:
"Integration will begin with implementation of Versata's Customer Success program, a proven method for driving successful customer relationships and alignment of product development investments with customer priorities."
Veteran Versata executive Danielle Royston will take on the role of CEO for EPM Live. "I am pleased to lead EPM Live into the future with its world-class customers and innovative products. Moving forward, we will create even more value for EPM Live customers by advancing product development, enhancing support and instituting a near obsessive focus on customer success," Royston said.
The Upland Software Story
Upland Software is a leading provider of cloud-based Enterprise Work Management software that helps organizations to plan, manage and execute projects and work. Upland was built through acquisitions but the initial focus was to position the company for organic growth through these acquisitions; but that changed quickly once the share price dropped from $11.00 at IPO to about $6.00 in three months - 40%+ drop.
Throughout the IPO process, and the first quarter after IPO (Q4, 2014) Upland was focused on gaining scale to drive organic growth.
John T McDonald CEO, Upland Software Q4, 2014: - First Call as public company
"We remain committed to our goal of acquiring an additional $20 million of run rate revenues this year, again"
"As you know, we're focusing on getting the businesses scale and we believe that M&A is the most efficient way to get to scale at this stage and we're always looking to buy companies that can grow 10% plus organically."
"As we achieve scale and start - we'll start to focus more and more on organic growth in the future as the M&A portion of our growth decreases over time."
Within the next quarter (Q1, 2015) Upland changed focus to improving Ebitda and profitability.
John T McDonald CEO, Upland Software Q1, 2015 Earnings Call:
"So if you took - and we'll only do acquisitions if they're EBITDA accretive within the first year, post acquisition."
John T McDonald CEO, Upland Software Q3, 2015 Earnings Call:
"We are looking at 58% sequential - quarterly sequential growth in EBITDA and 94% increase year-over-year."
"So again, strong EBITDA quarter, strong EBITDA guidance for Q4"
"As you know, we are de-emphasizing the lower margin parts of the business, including professional services." - Similar to Redknee Solution's new revenue visibility number of $120 million given by ESW Capital.
"I'd just say, Bhavan (sell-side analyst), that the emphasis going forward is growing EBITDA"
"We're also looking at acquisitions that are going to be accretive to EBITDA to adjusted EBITDA within the first year that they are purchased"- The focus earlier as in Q4, 2014 call was to grow revenue (by $20 million) gain scale and focus on organic growth as Upland becomes bigger.
Upland Raises Ebitda Guidance Consistently
There is strong reason to believe that Upland's change in business strategy is driven by ESW Capital's growing relationship as the biggest shareholder. At the least, there is clear proof that an ESW Capital public investment can move from losing cash to profitability in less than 12 months.
Upland Software Uses DevFactory (a ESW Capital company)
As per Upland's filings, 11,000,000 shares of common stock were issued to DevFactory based on an agreement the two companies had in the past. Upland continues to use DevFactory to its benefit.
John T McDonald CEO, Upland Software Q3, 2016 Earnings Call:
"We measure that success using industry standards like net promoters score or NPS as it's known, by surveying our customers twice a year and redirecting that feedback into further operational improvements and we're heartened by our progress and our level of customer loyalty."
Interestingly, the customer satisfaction survey is a feature that was used by Trilogy where Trilogy gets paid only if the customer gets value (a % of incremental revenue or cost saving that Trilogy is able to drive).
"Our premier success program, our customer-informed product road maps, our quality-driven R&D that leverages the DevFactory platform and our enterprise class cloud and operating platform.
"use DevFactory platform, to drive quality-focused R&D"
"The results they deliver are clear, they're rallying point for our team internally, they drive top and bottom-line growth through strong renewals and expansion sales and customer references that support efficient new customer sales and thereby drive shareholder returns" "We have also improved the efficiency of our sales and marketing organization by reducing cost while exceeding quarterly bookings target." - How is this possible?
This is from Crossover.com website (Crossover is a ESW Capital company): "Crossover teams will deliver a 50% improvement at a 50% cost reduction to your current teams in under a quarter."
Sell-side analysts are surprised how Upland can provide such rapid margin expansion. Here is a question from a Q3 2016 call.
Richard Baldry, Analyst:
"I guess I'm a little surprised that the number of data centers and offices can be consolidated both maybe this quickly and down the numbers are coming down to. Can you talk about -- was that -- did you expect it to be that easy to pull it down between your headcount challenges, personnel, I guess? Do you think you can get it further still, or do you think you get to a certain level, you know we need to be geographically representing these areas so it doesn't make any sense, you could push really much further than where we're at?"
John T McDonald CEO, Upland Software:
"Again, it's a purposeful by-product of the model that we've built here, which is a customer center model where we have a core common set of processes [ph] right, around all the products. So it's one orders and renewables team, one account management team, a consistent premier success offering across all of our products, one R&D platform, where we're leveraging third-party platforms like DevFactory to help reduce our headcount, increase our efficiency, have more automated testing, improve quality."
"One 24/7 global customer support operation -- again supporting all products -- and then efficiency on the sale side as well. We haven't talked as much about that, but using and leveraging low cost inside sales and then a small SWAT team of enterprise sales people that can really do rolodex, they selling and leverage strong customer references where we need to penetrate new accounts and even those sales people are going to be focused principally on the great opportunity we see in larger expansion deals inside our fortune 2,000 account."
"We love the model, it takes time to get it all in place and at 75 million roughly of revenue, I really start to see it coming together. I think it's an inflection point for the business and now it's about growing the top line both organically and executing against a more aggressive M&A schedule over the next year or two. And again, you never know what M&A's exact timing and that kind of thing, but we've got the platform, we've got the resources to do it and we're optimistic."
Confirming DevFactory Competitive Advantage
A look at the range of salaries from payscale.com for senior software engineers from India confirms Upland Software's explanation on DevFactory. At current USD/INR = 66.6 the median salary is USD $10,950 to USD $15,015. A same software engineer median salary in Canada cost $67,692 USD. The median salary of software engineers in Canada is higher than the high end of the range in India by a factor of 4x. While there is a reasonable range in salary based on talent and specific skill sets, our checks with industry consultants also confirm that the largest recruiters of software engineers in India namely; Infosys (INFY), TCS (OTCPK:TTNQY), Wipro (WIT), HCL Technologies (OTCPK:HCTHY) compare with the range shown on payscale.com
>>All facts point to ESW Capital/DevFactory contributing tremendously to Upland's success<<
>>Upland stock price is up 105% after renewed profitability focus<<
>>Will Redknee Solutions be the next Upland Software<<
The Redknee Business: Built by 2 significant acquisitions
Redknee's software solutions provide Business Support Systems (BSS) predominantly for communication service providers (CSPs). This includes but is not limited to;
The software is used by over 250 operators in over 100 countries, representing 24B transactions per day. The mission critical nature of the software makes the revenue "sticky".
Growing revenue through acquisitions, but losing Cash
From 2008 to 2012, Redknee hovered around USD$50 million in revenue. Founder/CEO Lucas Skoczkowski believed that given the relative small size of the Redknee business, they did not have the scale and infrastructure to build a global, sustainable, profitable business. To remedy that, under CEO Lucas Skoczkowski's leadership Redknee made two transformational acquisitions - (1) Nokia Siemens Networks BSS acquisition (June 2013) and (2) ORGA Systems acquisition (October 2015). Redknee's stated long-term strategy to use acquisitions to:
(1) Nokia Siemens Networks BSS Acquisition (June 2013)
Redknee bought Nokia Siemens Networks business for
Reason for these poor results: "Poor Execution"
(2) ORGA Systems Acquisition (October 2015) - Makes things worse!
Acquired from German insolvency process; cost structure reduced prior to close of the acquisition
>>Despite meaningful "recurring revenue" management was unable to generate free cash flow<<
>>Poor Management leads to Breach of Debt Covenant<<
2016: Breach of Debt covenant & Strategic Review
- Announced restructuring, with expected cost of $25 million to $30 million
- Announce delays in several customer purchasing decisions
Superior Offer from ESW Capital
Under the Constellation Agreement, the Company would have completed a private placement of 800,000 Preferred Shares and a common share purchase warrant to the Constellation Investor for gross proceeds of USD$80 million. However, the Warrant to be issued to the Investor under the ESW Agreement will be exercisable to acquire a number of Warrant Shares that will result in fifty percent (50%) less dilution to shareholders as compared to the warrant that would have been issued under the Constellation Agreement.
Constellation Software Vs ESW Capital
Constellation Software founded in 1995 is one of the best capital allocation stories in the software businesses and CEO/Founder Mark Leonard is a standout "Outsider" at par with the greats in the widely famous book "The Outsiders" by William N. Thorndike.
Constellation software was the first bidder for Redknee Solutions. This illustrates the following:
A Summary Of Events So Far
>> Debt concern alleviated <<
>> Top turnaround team (ESW Capital), manager (Danielle Royston) join Redknee"
>> Share price decline since ESW Capital = 44%. <<
>> Despite a series of Value creating events! What happened? <<
Answer: Poor investor communication!
A look at Redknee Investor Communication - After ESW Capital Preferred Shares Deal
While all the events that took place are value creating in nature. The seems to be a critical feature of capital markets that ESW Capital missed completely -"Clear Investor Communication = Investor Confidence"
Valsef Capital Research Vs. Street Research - Closing the Gap
ESW Capital is a relatively unknown entity. Beyond ESW's website and the portfolio company websites, there is very little information that is readily available.
Current "Poor" ESW Capital Communication Regarding Redknee
ESW Capital has been known to not waste time and get things done quickly. While this is a great business trait, it got the better of management & board; resulted in poor communication (probably in the interest of doing rather than speaking); which in turn caused utter loss of investor confidence. In mere three press releases the stock was beaten down 35%+ and with valid reason. The three press releases and the flaws in each of them are discussed below.
January 26, 2017: Redknee Announces Closing of Private Placement and Changes to Board of Directors
February 15, 2017: Redknee Solutions Inc. Announces Changes to Board of Directors and Executive Leadership.
Investor Communication Turns From Bad to Worse: "Investor confidence crushed"
February 15, 2017: Redknee Announces New Strategic Plan for Long-Term Growth and Sustained Profitability
Capital Markets Best Practice: Public companies typically announce such material changes in strategy and restructuring with a "Business Update Call". In the call management and sometimes the Board give investors more details about the strategic plan. However, in this case the announcements were complete opaque.
What is Redknee Solutions Worth?
Valsef's valuation of software businesses is based on a combination of two factors (1) our experience in assessing great software companies in the public market and (2) buying software companies the way Constellation Software buys them - as a function of recurring revenue and recurring revenue retention/customer retention. The general Constellation principle is that if a "sticky" vertical market software business (most of them are "sticky" by virtue of being very vertical specific) is bought under 2x recurring revenue, a good operator such as itself can make handsome returns and not too much can go wrong.
Amdocs - A Redknee Solutions Competitor
A recent Canadian restructuring example: Halogen Software (OTC:HGENF)
Upland valuation, a ESW Capital company as a Proxy
Redknee Valuation Assumptions
Investor communication: There is no assurance that ESW Capital and Redknee will improve communications to investors in the near future. It could be 6-12 months before the results of restructuring start showing.
Risk of Dilution:
ESW Capital Controls the Redknee Board
"For so long as any Preferred Shares are outstanding, the holders of Preferred Shares ("Preferred Shareholders") shall be entitled to nominate and elect to the Board a majority of the number of directors of the Company at a meeting of Preferred Shareholders (such directors being the "Preferred Directors"). The Preferred Shareholders' nominees will (subject to certain limitations) be subject to approval by the two directors elected by the holders of Common Shares other than the Chief Executive Officer (the "Independent Directors").
"Each of the Preferred Directors shall have one vote on all matters submitted to the Board, other than the following matters that shall be subject to the approval of the Independent Directors: (I) any redemption of Preferred Shares and any financing necessary to fund the redemption of the Preferred Shares; and (ii) for a period of four years after the Closing Date, and provided that ESW Capital does not own more than 50% of the outstanding Common Shares, any change of control transaction for which the value of the consideration per Common Share to be paid is in excess of 120% of the Warrant Exercise Price then in effect."
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This article was written by
Disclosure: I am/we are long RKNEF. 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.
Additional disclosure: In order to maximize total returns for our shareholders Valsef Capital reserves the right to make investment decisions regarding any security without further notification except where such notification is required by law. Finally, this article is free.