The rand hedge software phoenix
This month our small cap expert guest writer focuses on FrontRange and Idion, and observes that while a strong rand may not be the greatest of news for South African investors in these two companies, both have engineered enough of a turnaround to warrant some investor attention.Idion and FrontRange both listed in the late nineties boom times (FrontRange as Ixchange) and used expensive stock to acquire operations in the US. Idion went to the board in August 1998 and took full advantage of the IT boom to raise capital to fund a number of acquisitions, initially in the local software market, and ultimately in the US with its purchase of Vision Solutions, which owns globally competitive proprietary clustering and high/managed availability (HA) software and services and support aimed primarily at the IBM iSeries (AS/400) product family.FrontRange listed on the JSE in 1997 as Ixchange and, like Idion, took advantage of the IT boom to explore a roller coaster strategy of acquisitions, followed during the IT meltdown by a reverse process of disposals, to position the group as a focused global player in the mid to small company customer relationship management (CRM) market.After enduring a tough few years, the outlook is now more promising, although both remain risky investments. Idion remains a hold for now, but FrontRange looks a buy.Let`s take a closer look at both companies. IDION TECHNOLOGY HOLDINGSLast year saw Idion successfully fight off a hostile bid for control of the company by major global competitor DataMirror, which acquired some 38 percent of Idion`s shares. Management and other friendly investors have essentially locked up the balance of shares, leading to a fairly unproductive stalemate in terms of share liquidity.Significant reorganisation at Vision Solutions and the sale of non-core operations has seen the company focus all its attention on Vision Solutions, with recent results indicating a strong return to headline profits and positive cash flow.Looking at its competitive position, Vision Solutions addresses a number of markets within the high-availability (HA) space and in September officially released its latest flagship product, Orion, which had been in development for some time.Vision Solutions regards Orion as the first multi-platform-based software solution that enables users to predictably manage the functional availability of servers, data and applications across an enterprise, regardless of platform.Orion supports the OS/400, Windows and Linux platforms and DB2/400, UDB, Oracle, Sybase and SQL Server databases. Vision has invested significantly in Orion`s Java/XML component based architecture, enabling a completely modular and highly scalable solution set.Vision refers to comments by Dan Kusnetzky, author of the IDC Worldwide Clustering and Availability Software Forecast 2002-2006, saying, “we believe vendors that have strong cross-platform offerings, like Vision Solutions` Orion, are likely to be the leaders throughout the period”.Idion faces direct competition across its product range from global competitors – DataMirror and Lakeview in the IBM space, Quest in the Oracle/HP/UX space and from numerous storage-centric competitors, including major players Veritas and Legato.But Vision Solutions should maintain its strong position in the heterogeneous IBM space as well as increasing its ability to address multi-vendor and platform environments.But it will remain a small niche player, albeit a well-positioned one, with revenues still well below the $50 million mark, but starting to attract attention from industry researchers – leading to higher customer sales but also putting it onto the radar screen of bigger players looking for acquisitions.The major inhibitor to growth continues to be the continued soft rate of global spending on infrastructure (typically the sale of HA software is driven by the implementation of multiple new hardware installations).Positive growth factors include the higher visibility HA is enjoying post September 11, new functionality offered by Orion, as well as increased support from IBM. It is estimated that sales of the IBM iSeries platform continue to be in the order of 30 000 to 40 000 per annum.The company is highly focused on cutting costs and achieving profitable margins. Since acquiring Vision Solutions, 26 of the 28 senior managers and over 50 percent of staff have been retrenched or replaced, leaving 170 employees. The development and maturing of the reseller channel is also having a positive effect on margin improvement. The forecastGiven the proprietary nature and minimum of third party product for the bulk of its offering, Vision Solutions enjoys significantly high gross margins on its licence (99 percent) as well as service/maintenance sales (about 64 percent). The company appears to have restructured its cost base appropriately, while still supporting sales and research and development, to return reasonable double-digit earnings before interest, tax, depreciation and amortisation (EBITDA).Despite the long-term potential of Orion, I have maintained a US dollar revenue growth forecast of nine percent for licences and 20 percent for sales and marketing. R&D should stay around 20 percent of sales, and sales, general and admin (SG&A) costs should fall from 50 percent to 45 percent as revenue increases in the 2005 financial year. The EBITA margin should be 17 percent by 2005. The big challengeAs with FrontRange, Idion`s major challenge will be cost control, with the key to profitability over the next three years being its ability to maintain or improve on the above costs of sale, while maintaining revenue growth.Improved operating profit, more stringent control over channel debtors, favourable prepaid maintenance revenues and the deferred tax asset all point to strong headline earnings and, more importantly, positive net cash flow forecasts from the 2003 financial year onwards.Using a terminal cash flow growth of six percent, and a 30 percent discount rate, Idion has a discounted cash flow value of 179 cents out to 2005.There is still high risk in Idion`s profitability prospects, but this is also the case for DataMirror and FrontRange. However, recognising the typical discount for being listed in South Africa, Idion should be placed at the average of the selected peer group rating, or an implied current price of 209 cents – just above its current 200 cents.Idion has demonstrated a sustained return to operational profitability – and that with its right-sized organisation and investment in new product, which should stand it in good stead in the medium term.These forecasts and valuations are conservative, with plenty of upside potential in the medium term, making the stock a hold, albeit in the speculative region of the risk spectrum. FRONTRANGE LIMITEDFrontRange operates in nine countries including South Africa, the US, Singapore, France, Germany and Italy, employing some 450 people, down from 540 a year ago. The user base is in excess of one million people or over 120 000 companies worldwide.The listed entity recently increased its stake to 100 percent of the US-based subsidiary, which focuses on two separate markets within the broader CRM space, namely business contact management and sales and marketing automation software (GoldMine); and customer service and support software (HEAT).Both GoldMine and HEAT are acknowledged as serious industry players in their markets by global IT research organisations such as Aberdeen Group and Gartner (which rated HEAT as a “Challenger” in the IT service desk vendor Magic Quadrant in 2002) and both have won significant customer and industry awards for functionality and ease of use.Aberdeen observes in an executive white paper that the company has created a solid strategy that is finding support from the market and “if the company can continue to drive its message out to the broader market, it will be able to secure a leadership position in the growing CRM middle market”.However, FrontRange has recently abandoned its vertical CRM strategy, because of the costs of further segmenting its customer base, and the costs of implementing vertical applications.The company has consequently refocused its CRM strategy on its core product offering and in further refining and developing a distribution channel that has seen some attrition over the past year as many smaller IT businesses have closed shop.HEAT, representing some 65 percent of revenue, continues to be well supported and the product strategy remains, with continued feature enhancement and development.R&D efforts are further being focused on developing and integrating Goldmine and HEAT on the latest technology platforms of the XML, SOAP and web services standards. The Microsoft factorCompetition remains from Microsoft, as well as major software vendors like SAP and PeopleSoft as they add integrated CRM functionality to their product suites.FrontRange indicates that while Microsoft could become a serious competitor in the long term, in the medium term it competes with only about 25 percent of FrontRange`s current product offering; and faces similar challenges in bringing new product to market.Barriers to entry in the CRM market space have increased dramatically and FrontRange`s competitive position is consequently enhanced as Microsoft increasingly demonstrates its intentions to carve out a niche, capital for new entrants remains scarce and competitors continue to show depressed revenue growth and performance.But much depends on which way the market for CRM solutions moves in two main respects:1. Integration into packages versus best of breed. This is difficult to call, but with the ease of integration through web services architecture, it may become less of an issue and functionality may become the differentiator instead;2. The dominance of a standard (such as Excel in spreadsheets or Word in word processing). Here it is likely that a certain functional subset will be standardised (within Outlook for example), but that workflow and integration associated complexities will probably leave room in a market for more complex products.FrontRange continues to demonstrate relatively stronger performance than its closest competitors in the CRM space over the past year: overall revenues dropped by some four percent in US dollars, compared with 20 percent to 30 percent for Siebel, Pivotal and Onyx, with licence sales showing even higher declines.Forecasts for global spend on software and services are still soft to cautiously optimistic for the balance of this year.With prospects for licence and accompanying services revenue growth still looking slim, and a move to channel rather than direct sales, licence growth forecasts in US dollars falls from three percent to minus 10 percent for next year, and minus five percent in 2005, before stabilising at zero. Putting plans in placeServices should show zero growth and maintenance should grow at 10 percent, returning flat to low US dollar revenue growth for 2004 and beyond, in line with management`s expectation.The company is putting programmes in place to reduce its product cost of sales (such as no longer bundling certain database components) and increase the product margin through a more efficient channel strategy, so product gross margin should rise from 78 percent currently to 80 percent by 2005.Management is targeting a reduction in sales and marketing costs to 45 percent of sales in 2004, with an ultimate target of 35 percent, but based on a conservative 45 percent to 2006, and unchanged costs of general and administration and research and development, the EBITA margin for 2006 should be close to 10 percent.Improved operating profit through more stringent control over costs and savings from implementation of the channel strategy should ensure strong headline earnings and positive net cash flow forecasts.On a similar discount cash flow model to Idion (six percent terminal cash flow growth and a discount rate of 30 percent), FrontRange has a DCF value of 162 cents.While there is still high risk in FrontRange returning to strong profitability, its global and local competitors in the CRM space face similar market challenges and FrontRange should trade on par with them. Using the same logic as with Idion, FrontRange has an implied current price of 325 cents, well above its current price of 170 cents.Trading at a significant discount to its US peers, FrontRange is bound to start attracting more offshore corporate and investment banking interest and a medium-term investment must be underpinned by a US-based exit. This makes the stock a buy.Brian Rainier, a former rated analyst, is MD of Brainier Capital & Consulting, which provides detailed stock market research in a joint venture with Legae Securities. This analysis is subject to a disclaimer which can be found at www.brainstorm.itweb.co.za.
29 September 2003
This month our small cap expert guest writer focuses on FrontRange and Idion, and observes that while a strong rand may not be the greatest of news for South African investors in these two companies, both have engineered enough of a turnaround to warrant some investor attention.
Idion and FrontRange both listed in the late nineties boom times (FrontRange as Ixchange) and used expensive stock to acquire operations in the US. Idion went to the board in August 1998 and took full advantage of the IT boom to raise capital to fund a number of acquisitions, initially in the local software market, and ultimately in the US with its purchase of Vision Solutions, which owns globally competitive proprietary clustering and high/managed availability (HA) software and services and support aimed primarily at the IBM iSeries (AS/400) product family.
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