Cloudera & Hortonworks - Looks Better On Paper, But Good Enough?

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About: Cloudera, Inc. (CLDR), Includes: HDP
by: The Value Investor

Summary

Cloudera and Hortonworks are combining their operations in a ¨merger-of-equals¨.

I like the deal, at least on paper, as the combination still has a lot of margin work ahead of itself.

While sales multiples look reasonable in relation to the growth rates reported, disruption could be seen in the integration process, as losses remain steep.

With M&A action running still pretty hot I must say that I was quite surprised with one deal which has been announced. That is the merger-of-equals between Cloudera (CLDR) and Hortonworks (HDP), or better said the acquisition of the latter by the former. Investors initially reacted very favourably to the deal, for good reasons (sizable synergies and strategic rationale) but shares sold off a bit, in part amidst a wider market correction.

I feel that shares are under reacting to what is a good news event, although both firms have lots to prove and stand-alone valuations (driven by heavy losses) could never really attract me as an investor.

Next Generation Data Platform & Enterprise Data Cloud

Cloudera and Hortonworks announced quite an interesting tie-up as both firms are merging in an all-stock deal which gives investors in Cloudera 60% of the combinations outstanding shares, while the remainder of the new combination is held by investors in Hortonworks. In reality that means that investors in Hortonworks will receive 1.305 shares of Cloudera for each share which they currently own.

The reason for the tie-up is that of a strategic nature, that of creating a more complete set of offerings. Hortonworks is strong in end-to-end data management, which will be combined with expertise of Cloudera in data warehousing and machine learning. This integrated approach should be positive for the combination´s clients and should not just allow for cross-selling, but for further market adoption as well.

The Pro-Forma Numbers

Cloudera is the bigger of the two parties. It generated $411 million in revenues on a trailing basis while Hortonworks reports $309 million in sales, for a pro-forma revenue base of $720 million. Based on the share of revenues, Cloudera should be entitled to 57% of the shares of the new combination, instead of the 60% as agreed to now.

While the difference is small, investors in Hortonworks have a point by saying that the percentage is low given that revenues of its business are growing by 42% year-on-year, about 9 points quicker than growth reported by Cloudera. Reported non-GAAP gross margins equal 87% at both firms as reported operating loss (margins) are fairly similar at both firms.

The Expectations Game

The press release reports an equity price $5.2 billion based on the value of the share prices ahead of the deal. With Cloudera reporting 149.5 million shares outstanding at the end of Q2, the combination has roughly 250 million shares outstanding upon consummation of the deal. As shares of Cloudera were trading at $17 ahead of the deal announcement I come up with a $4.2 billion price tag instead of the communicated $5.2 billion valuation.

Trusting that I am making a mistake somewhere, I am calculating with the $5.2 billion valuation which includes half a billion in cash, for really a $4.7 billion enterprise valuation, equivalent to 6.5 times pro-forma sales.

That multiples remains pretty reasonable given that pro-forma sales are growing by roughly 35-40% per annum, as the growth rate in combination with the sales multiple make investors in recent IPOs quite jealous.

Nonetheless the company has a real ¨earnings¨ problem. Cloudera reported an operating loss of $186 million on a GAAP basis. While adjusted losses of $78 million more closely represent actual cash flows, the discrepancy is largely the result of the stock-based compensation, being a real expense for investors.

Hortonworks reports a similar $173 million GAAP loss and $55 million adjusted loss. The combined $359 million loss is pretty sizeable yet will come down quite a bit thanks to $125 million in anticipated costs synergies.

Enthusiasm Cools Down?

Shares of Cloudera initially jumped from $17 to $20 in response to the deal announcement but ended the week at $18 per share. Working with the $5.2 billion valuation, that made that the pro-forma valuation initially jumped by $900 million, as just $300 million in value creation is left at the end of the week.

That looks a modest amount given that $125 million worth of costs of synergies should at least be worth a billion, and probably more. The real kicker is the strategic nature of the deal which should ensure a continuation the growth of the business, and perhaps even acceleration of growth. Note that projection for synergies are sky-high in relation to sales (at 17% of pro-forma sales to be more exact) as the integration might involve some challenges/disruption.

This modest reaction to the deal announcement and the fact that shares trade at little over 6 times pro-forma sales (given the growth rates) makes that the story looks quite compelling. I have one big issue however with the earnings number as both companies are posting a combined GAAP loss of $359 million and adjusted loss of $123 million. If we include the projected synergies of $125 million, the company would indeed break-even on an adjusted basis, while GAAP losses remains very steep.

What Now?

Do not get me wrong. The strategic nature of the deal, that of securing sales growth and new clients, while promising on $125 million in synergies is probably worth far in excess of a billion, if delivered upon (which is a big if). Hence it is rather strange to see just modest value accretion in response to the deal.

That does not automatically create appeal. The reason for that is simple, that is that I did not find the stand-alone valuation of either firm very appealing. After all, GAAP losses still come in at $234 million on a pro-forma basis (that is after accounting for synergies) being a very steep number, even as sales multiples sound reasonable given the growth.

Hence I see a short term underperformance/under reaction in response to the positive news, that is the deal. While the overall sales growth numbers look reasonable given the growth, the steep losses (as we really ought to focus on GAAP accounting in this case) makes that it is still reasonably challenging to be very compelled to the story, even as the news certainly is positive.

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.