The market hates uncertainty. It's within this context that opportunities can be found. Rimini Street (Rimini Street) is one such opportunity in the form of a high-quality business trading at a cheap valuation, caught up in some - what I believe to be - temporary issues.
This idea came from my small ecosystem of like-minded investors, and I initially passed on the name during the summer due to lack of time to dedicate to the research process, and the lawsuit that Rimini Street was (and still is) engaged in with Oracle (NYSE:ORCL) regarding their business practices. The idea has been written up by Laughing Water Capital much more eloquently than what unfolds in the following paragraphs.
I revisited the company recently, as both the common shares and warrants have been among the most volatile of names I’ve followed this year, and only just realized the market has been consistently providing me with favorable purchase prices. Greystone owns both the common stock and warrants, which both offer the type of favorable return profile with low downside risk given the balance sheet, minimal cash needs of the business, the potential for a favorable legal outcome, and sticky customer base providing plenty of recurring revenue. Founder and CEO Seth Ravin also owns 22% of the business and has navigated legal and operational issues deftly as he continues to build the business.
The opportunity exists due to a variety of reasons, including RMNI's small size, lack of IPO (and subsequent roadshow) as a result of going public via SPAC, low float (31k avg volume, insiders own nearly 80% of the company), inability to screen well due to reduced profitability given high levels of sales and marketing expenses, a complicated capital structure with multiple avenues for dilution, and most of all, RMNI's ongoing lawsuit with Oracle dating back to 2010, stemming from claims of copyright infringement. More on that below. The market appears to be underestimating RMNI's ability to continue to grow their business, as the current valuation appears way too pessimistic, given the company's economics as well as higher valuations of tech/software company peers. Valuations of less than 6.0x steady state EBIT and less than 2.6x revenues seem unwarranted.
For a brief business description, Rimini Street is a third-party enterprise software support company. They are the leading software maintenance provider of Oracle and SAP (NYSE:SAP) software products based on number of customers supported and industry analyst ratings. The company was founded in 2005, and as mentioned above, became public via SPAC in late 2017. Since inception, RMNI has grown to over 1,500 clients, including Fortune 100 and Fortune 500 businesses, boasts 90%+ customer retention rates, and earns 100% of their revenues through software subscriptions, providing a solid base of sticky annual recurring revenue. They've done this by essentially 'undercutting' Oracle and SAP on pricing, billing customers 50% of the annual fees charged by software vendors for support. This is due to both Oracle and SAP cost structures (higher % of revenue on G&A, and 100k and 178k employees for SAP and Oracle versus 1,050 for RMNI) as well as RMNI providing service only, without the costs of building/selling the software products.
The thesis is simple. As software maintenance and support is a substantial part of the total cost of ownership for businesses, the option to buy software support at a reduced price from a third-party maintenance provider (3PM provider) may be more cost-effective in certain cases. The cost of software vendor support has consistently increased for businesses while the value prop declines, resulting in an emergence of third-party support providers such as Spinnaker, Rimini, Alui and Support Revolution. Add in the increasing need for businesses to combine different software and subscription services into an integrated business platform able to be deployed across their own systems (known as Hybrid IT), the cost of operating and supporting these environments can consume too high a percentage of financial resources otherwise needed for things like R&D, capex, and sales and marketing.
For CIOs interested in making a change, Rimini Street offers a welcome alternative with a huge value proposition as the leading provider, with an incredibly high level of customer service and tech expertise. The risk for CIOs interested in switching their organization to 3PM is thus minimized by going with the leading provider who offers a track record of successful support, trained engineers, and lower costs. Although the 3PM space is incredibly competitive, the software support market is massive, with room for multiple players, and I think RMNI will be able to capture a significant portion of share with their broad support offerings for multiple products and global reach. In addition, RMNI is selling what customers already know they need. These are customers with large budgets allocated for support, often times much larger than what RMNI would ever charge.
It's no secret that the software maintenance support business is terrific, characterized by sticky contracts, pricing power, and recurring revenues, with Oracle and SAP providing the best examples of the outstanding economics. These businesses have historically reported profit margins in excess of 90% on support revenues and are fiercely protective of this income, as reflected in Oracle's litigious behavior over the years. These upgrades provide an incredible source of high margin revenue for the big guys, but often leave customers resenting the extra time and hidden costs needed to undergo these services. Rimini Street essentially cuts the vendor out of the equation, by providing third-party enterprise software service at a nearly 50% discount to incumbents, offering both a business-critical service and a favorable cost profile. The high customer value prop smacked me in the face. In addition, during a recessionary period or economic downturn, enterprise customers can’t cut back on things like enterprise software maintenance, so the Rimini Street discount would be a welcome offering and helps explain why customer count has been growing in the mid-teens, and retention rates remain above 90%.
Furthermore, the addressable market for software maintenance is in the hundreds of billions, with RMNI stating their TAM being multiples of their current customer base.
As of today, despite Oracle's attempt to litigate the company to death, RMNI has made a significant push into Oracle and SAP markets, and legal rulings to date make me comfortable that the odds Rimini makes it through the litigation process without facing an adverse outcome are quite high. If they do - probable, not guaranteed - and they are able to continue to grow revenues and their customer base, RMNI should be worth multiples of the current price.
In addition to RMNI's competitive advantages that include barriers, pricing, level of service, high switching costs and global reach, the valuation seems favorable given the attractive characteristics of the model. Although RMNI is not a pure play software company, the current valuation of less than 2.6x EV/Revenue seems way too pessimistic given the growth runway, margin profile and economics of the business. In addition, limited cash needs (negative working capital due to large deferred revenue) and the ability to slow growth in order to generate more cash flow provide a decent margin of safety, although as mentioned above, RMNI is not quite out in the clear in terms of their lawsuit with Oracle and associated legal costs weighing on earnings.
So, where are we in the lawsuit?
- In 2010, during Rimini I, Oracle filed a lawsuit alleging copyright infringement based on the fact that Rimini was downloading copies of Oracle software onto their servers as opposed to servicing the software on client servers, where they had purchased the software licenses. Oracle filed two motions seeking summary judgement in 2012, which was granted in 2012.
- Rimini had to revise their business processes which they did in 2014, in order to eliminate the processes determined to be infringing.
- After trial on Rimini I in 2015, a jury returned a guilty verdict that Rimini was liable for innocent copyright infringement, but determining that the copyright infringement did not cause Oracle to suffer lost profits, and was not willful.
- Oracle was awarded $124mm (they issued convertible preferred debt to pay the damages, more in this below).
- In addition, a permanent injunction was placed on RMNI prohibiting certain business processes (not the right or ability to deliver 3PM) - such as those that were amended in 2014. RMNI appealed the injunction arguing that the injunction language was too vague and included some processes that had not been considered infringement.
- Following the ruling, Rimini appealed some of the charges, including the injunction, and the Court of Appeals reversed certain awards made in Oracle's favor, including $50mm of the $124mm judgment, and vacated others, including the injunction.
- In 2014, a separate lawsuit was filed by RMNI (Rimini II) seeking declaratory judgment that their revised processes did not infringe certain Oracle copyrights. Oracle also filed a counterclaim, alleging more copyright infringement, which includes the same claims made in Rimini I, as well as additional allegations that RMNI's revised support processes also infringe Oracle's copyrights.
- Discovery ended in early 2018, with RMNI expecting a trial to occur no earlier than 2020.
To sum up, Oracle sued for copyright infringement where RMNI was found guilty of innocent infringement and revised their processes. Then filed another claim following a suit filed by RMNI alleging that copyright infringement is still taking place, and added a host of new allegations.
To give a quick overview of the revised processes, I'll first provide some quick background on most 3PM support strategies.
Third-party support providers usually deliver their services on an infrastructure where the customer is licensed to run the system. Rimini was found liable for maintaining copies of some Oracle products on their own infrastructure. Although this is occasionally permitted with some Oracle licenses, it's not permitted with every product. To be safe, 3PM providers should basically deliver service remotely to a customer's system.
My conversations with the management team, as well as customers regarding the initial reason for RMNI hosting Oracle products on their software revealed that this was done at the customer's request as opposed to RMNI attempting to infringe on Oracle's copyrights or find a loophole through which they could deliver service. According to RMNI, it made no difference to them where the software was hosted.
As mentioned above, RMNI revised these processes back in 2014, by discontinuing the practice of supporting software hosted on their own systems. They now provide service for clients on their own servers, hosted servers, or in the cloud.
From what I understand, the trial will conclude sometime in the back half of 2021 or into 2022, where the court should provide a definitive ruling on how RMNI is able to move forward.
In the meantime, RMNI can continue to grow and expects to spend between 1% and 2% of revenues on amending processes (taken out of COGS). The company will also continue to litigate the appeal of Rimini I as well as the claims and counterclaims of Rimini II. Gross margins remain in the mid-60% range, even with additional costs to support the changing of processes, and the model may provide for a decent amount of operating leverage moving forward.
Source: Author Data, SEC filings
The company took significant steps during the quarter to improve their competitive positioning, including strengthening their balance sheet, paying off legacy debt (with terrible terms) by issuing a convertible note, and lifting restrictive covenants on growth spending which are now being plowed into additional sales and marketing resources. Employee headcount is up 20% YTD, and it’s clear that Rimini Street sees a significant market opportunity with their product, pricing, and high customer value proposition. As a shareholder, I'm happy to see an increase in expenses and the forgoing of short-term earnings in order to acquire customers at favorable LTVs (4.0x LTV/CAC as of December).
GAAP net loss has widened considerably YTD due to litigation costs and finance expense write-downs, but now that Rimini has paid off all but $2.8mm of their debt and moves through the litigation process (which will cause them to incur additional costs), I see a path to meaningfully improved earnings and free cash flow. With a huge US and international opportunity in front of them, and an industry made up of large customers unhappy with their current IT services costs, locked into contracts that are difficult to break on which key parts of their business depend, I can’t think of a better setup for RMNI moving forward. I think we will be looking at a much different and improved business within a few years.
During the most recent quarter, Rimini reported a 16% increase in revenues on the back of 19% customer growth, while winning multiple customer service awards and achieving revenue retention rates over 92%. Gross margins in the enterprise software maintenance industry are huge, and as RMNI moves through their litigation and debt financing issues, we should see each incremental dollar of revenues fall closer and closer to the bottom line. Rimini should be able to earn high returns on capital moving forward due to the competitive advantages RMNI enjoys as the leading provider of third-party software support.
- Software and support services are a necessity for most business. CTOs and CIOs have the chance to save money by using a discounted provider, freeing up budgets to go on offensive initiatives. In addition, nobody gets fired for going with the leading provider. During times of cost cutting or economic slowdown, RMNI may actually be able to attract more business - 50% discount to software support during a recession sounds like a high-quality deal.
- SAP and Oracle have recently engaged in discounting to restrict the deal flow to 3PM providers and win customers back. However, very difficult for them to do this at scale given cost structure, large installed base and the fact that support revenues bring in majority of operating profits.
- Research and conversations within the industry point to lack of new entrants at scale despite superior 3PM economics - startups are worried about being litigated to death. RMNI has shown no signs of slowed growth, even with old restrictions from debt covenants on sales and marketing spend (now lifted).
- Private businesses using vendor supported software may risk damaging their current business by developing 3PM capabilities in-house.
- While I'm not totally focused on market share at this stage, Rimini is the leading provider based on number of customers served, and the first-mover advantage provides them with a solid head start against new industry entrants (this matters when a higher level of service is required).
- Won't bore you with my primary research, but testimonials, management conversations, talking with customers all point to the client services aspect of Oracle and SAP's business being a nightmare for most businesses.
What follows are notes on the industry, management team, capital structure and valuation.
Software Maintenance and Support Industry
If one were to take into account the entire on-premise as well as cloud maintenance opportunity sets, Rimini's potential addressable market is enormous.
Source: Company Investor Presentation
I'm not a huge fan of estimating TAM (subjective, always higher than it really is), but taking into account just a fraction of the potential opportunity set reveals that Rimini has a chance to penetrate an industry many times larger than it is today. The runway for reinvestment is large, and if RMNI can continue to grow their customer base and recurring revenue, the low capex needs and negative working capital attributes of the model should result in high free cash flow generation. Competition is and will be fierce, especially following any favorable legal rulings, but there's room for multiple competitors, and Rimini's scale and global reach provide comfort they will be able to capture additional share.
Seth Ravin is the founder and CEO of Rimini, with extensive experience in software maintenance and support. Ravin founded a business in 2002 called TomorrowNow Inc., another supplier of software support, which was acquired by SAP in January 2005.
It's important to note that TomorrowNow was subject to a lawsuit filed by Oracle in 2007, following SAP's acquisition of the business. Oracle was awarded $1.3 billion, with a final judgment following appeal of $356.7 million. Oracle has a history of litigious behavior, filing suits against other 3PM providers, including Service Key Inc. and CedarCrestone. It would be difficult to imagine that the management team isn't prepared for litigation this time around. As mentioned above, Ravin owns 22% of the business, with his CFO Thomas Shay owning an additional 9% of the shares.
Source: Company Proxy Statement
Both the SPAC sponsor, GP Investments (owns 21% of the business), and private equity firm Adams Street Partners (owns 40%) have been invested since 2009 and participated in the recent convertible preferred offering. The sponsors/PE firm could seek liquidity at some point in the future, but it appears that incentives are aligned allowing RMNI to create long term business value.
In July, RMNI issued $140mm of Series A Convertible Preferred stock as well as 2.9mm additional common shares in order to pay off in full their former credit facility that contained horrible terms and restrictions on growth spend that was borrowed to finance the company's litigation.
The preferred pays a 10% dividend, a 3% PIK dividend, is convertible to common stock at $10 per share, with the company able to force a convert after 3 years at a stock price of $11.50 or above. In addition, the preferred is mandatorily redeemable after 5 years if not previously converted.
Rimini has now lifted all restrictive spending covenants, simplified their balance sheet, and is guiding for $95mm in savings on financing related costs over the first three years.
As mentioned above, the cap structure allows for multiple avenues for dilution, and in my valuation, I will use the fully diluted share count excluding the $11.50 strike warrants (RMNIW) (due to potential for the company to repurchase them), which stands at 93.6mm in order to calculate enterprise value.
Source: Author Data
*Of note, the 'litigation cost' number is my assumption.
**The $65mm cash from options and warrants consists of 12.3mm options @ $3.77 and 3.4mm warrants @ $5.64.
***A recent S-3 filing indicates a potential secondary offering in the future.
At $8/share, representing ~40% upside, RMNI would trade at 3.5X 2018E revenue and 16.5x EBIT. While nearly 17x EBIT doesn't look cheap today, the valuation remains undemanding given the company's investments in growth (dragging down short term EBIT), higher run rate G&A costs for 2018, and assuming an unlikely zero growth revenue scenario from Q3.
I don't believe the current valuation is pricing in any scenarios surrounding improving margins, a favorable legal outcome, or the company's huge runway for growth. Pure play small cap software companies w/ similar margin/growth profiles trade at 7-12x revenues (Apptio (NASDAQ:APTI): 7x revenues, Everbridge (NASDAQ:EVBG): 12x revenues, Appian (NASDAQ:APPN): 8.7x revenues), while tech consulting businesses can fetch EBIT multiples in the 12x - 30x range (ICF International (NASDAQ:ICFI): 19.7x EBIT, ManTech International (NASDAQ:MANT): 12.8x EBIT, Virtusa (NASDAQ:VRTU): 36x EBIT).
Of note, sales and marketing spend at 12% of revenues below is used to provide a 'look-through' valuation of RMNI in cash flow generation mode. I discuss scenarios below outlining how spending 12-15% of revenues on sales and marketing in a 'steady state' to focus on generating cash flow can be illustrative of the future economics of the business. Management has guided for FY 2018 spend of 37% of revenues.
This appears to be a conservative and discounted multiple should RMNI be able to reach a steady state margin profile and given their growth runway. Attempting to normalize the income statement moving forward is difficult, and any attempts to do so will most likely be wrong given the cap structure (dilution potential) and unknown legal outcomes.
With that said, it's possible that RMNI could generate anywhere from $500mm to $700mm in revenues over the next 3-4 years, with EBIT margins in the range of 15-25%, depending on the company's legal situation, their primary emphasis (growth, generating cash), and how competitive the market becomes. The company still boasts 92% customer retention, indicating no severe losses in their customer base due to the lawsuit, and my conversations with customers point to satisfaction with RMNI, their prices, and the level of service. With restrictions on sales and marketing spend now lifted, and new sales hires ramping to their expected run rate over the next 6-12 months, it wouldn't be difficult to imagine RMNI spending 30-40% of revenues on sales and marketing (managements preferred number) up to 2022, while growing their top line by 25-30% within the same time frame. The company then has options to dial back the growth spend and begin to generate cash flow.
Per the latest conference call:
"Sales and marketing expenses increased as a percentage of revenue to 36% of revenue in the quarter, up from 31% in all of fiscal 2017. We currently expect to spend up to 37% of revenue on sales and marketing for all of fiscal 2018."
Source: Author Data
There is an incredible amount of assumptions baked into these numbers, but back of the napkin math shows a wide range of possible scenarios. Even in the 'poor legal outcome' scenario where revenues don't grow as much as the two alternative cases, and RMNI has difficulty acquiring new customers, low multiples of EBIT produce a share price nearly double where the stock currently trades. If Rimini can continue to grow its customer base and revenues amidst legal issues, there is a path to 50%+ upside. If they are awarded a favorable legal settlement in 2021-2022... we have Mr. Market to thank for today's share price.
- Increased customer wins - RMNI still boasts a 90%+ customer retention rate, and has recent customer wins in Australia and South Korea, demonstrating their global reach. The market will have to take notice if they keep growing the customer base at high teens % or above through 2022
- Favorable legal settlement/outcome - if we hear positive developments regarding the case, or the suit is dismissed by Oracle (to be fair, very unlikely), the market could have a positive reaction
- Reduced interest costs - RMNI showed a large net loss in Q3 due to a non-recurring large finance fee ($48mm). This activity is not expected to continue, and interest costs will decline from here
- Potential reduced legal costs - RMNI has estimated and budgeted for a percentage of pre-tax earnings to go toward legal expenses. This estimate may prove to be lower than expected, providing a boost to earnings
- Gross margins lowered due to additional costs to fix process and refusal to raise prices
- Softening of LTV/CAC - 7.7x in Q1 2017 versus 4.0x as of Q3 2018
- Adverse legal outcome >$100mm settlement and impairing processes completely
- Litigated to death
- Low liquidity - any large exit or sale by PE funds looking to exit may trigger large share price drop
- Positive legal outcomes cause a flood of new competition resulting in the industry becoming a cost-cutting race to the bottom - Spinnaker boasts saving customers 62% on maintenance costs
- Dilution - the cap structure allows for the possibility for dilution, and a recent S-3 filing indicates a potential secondary offering down the line
- Can't significantly address customer concerns that 3PM is right for them
- Market for 3PM never grows
- Companies develop self-support capabilities using internal resources
- Debt - there is the potential for RMNI to have to issue more debt to pay for any adverse legal outcomes or unfavorable rulings
Disclosure: I am/we are long RMNI. 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: I own RMNI common and RMNIW warrants.