Tech Banker

Transaction Alert -- EMC / RSA Security

EMC continues it acquisitive ways with the announcement of the intent to purchase RSA Security today.

Target: RSA Security

RSA, while reasonably modest in size at $322mm in revenues, has an outsized impact on the security industry.  The RSA encryption standard, created by RSA, has become the de-facto standard for authentication to ensure secure access to corporate computers (SecureID Authentication) and is widely used to ensure secure on-line commerce.  RSA also hosts the security industry at it's annual RSA Conference.  RSA, while dominant in its niche, has not really been able to break out of a rather slow revenue growth mode.  Revenues only grew by 1% from 2004 to 2005 although top-line is projected to grow by 20% from 2005 to 2006.

Deal Terms

Total Consideration:                                                 $2.3 billion ($28.00/share)

Premium to market:                                                   45% above pre-rumor price

Valuation Multiples:

     Aggregate Value / 2006E Revenue                           5.7x

     Price/2006E Earnings Per Share                              44x   

Strategic Rationale

EMC is wrapping it's "managing the lifecycle of information strategy" around the transaction.  EMC's spin is that they already manage the information via their suite of storage products and Documentum, the document management application they purchased a couple of years ago.  Now the are simply managing "secure access" to that information via the RSA Security product set.

Architect Partners Assessment

This was a very expensive deal for EMC for, at best, a moderately attractive asset.  The other rumored bidders may have lost the battle but may be better off for it.  EMC will will no doubt rationalize the purchase price by claiming that growth will accelerate substantially under the EMC umbrella but by all measures we believe RSA shareholders are the winners here.  We've pondered EMC's rather unorthodox software strategy many times.  While acquiring RSA, from a very big picture perspective, can be rationalized, we wonder how much real synergy exists with their existing businesses.  We frankly felt the same way about the Documentum acquisition and EMC has apparently made it work, at least financially.  We're still not convinced that was a great strategic fit either unless the strategy is really just a revenue growth strategy.  While the strategy has been rather confusing to us, we do take our hats off to EMC for their excellent execution post-acquisition on their software acquisitions. BusinessWeek did a good article on EMC's acquisition success.  Dave Dewalt also recently posted an interesting piece on this very subject.  Here is a good summary of Wall Street's reaction by Steve Hamm at Business Week.

Thank You Brad Feld!

Brad's post today on board package distribution was music to our ears.  It's perfectly consistent with our "Second Impressions" post recently.  Thank you Brad!

Novell - Bold Move?

Novell.  Not a name that elicits much excitement.  For god sake, it bought, a technology consulting company, Cambridge Associates, in 2001 under the logic that "Cambridge accelerates Novell's adoption of a solutions-selling model that supports customers and partners transforming their businesses"  In other words, they were saying loud and clear that their software requires lots of handholding to sell and implement.  Tough model for a software company!  This was when Eric Schmidt was running the company; boy did he get lucky to find the exit to Google. 

But wait, in 2003, Novell made a bold and impactful move by purchasing SUSE Linux, the #2 provider of a "certified and supported" Linux operating systems, behind Red Hat.  We believe the strategy was, and is, sound.  That strategy being: the world needs an alternative provider to mitigate the threat of Red Hat becoming the new Microsoft.  IBM jumped on board symbolically by investing $50mm in Novell to show their support. 

Okay, good move strategically, but as we all know, strategy is nothing without execution.  So, its been three years, what has execution looked like?  Hmm, the promise hasn't really been realized.  SUSE Linux market share (on the server) has probably stayed flat or declined slightly (from 15% market shore or so) under Novell's stewardship.  With Red Hat at 60% market share, the strategy isn't working if Novell cannot nip away at that dominance.

So why even mention Novell?  We are very interested in the Novell's (and the Borland's, see our previous post) of the world.  The reason is to answer the question: can dinosaur's survive by adapting?  We believe technology companies can make material transitions to their business, with the right leadership and commitment.  Novell announced today a significant leadership transition, we hope this re-energizes Novell and puts them on track to thrive.

Offshore Development - One Man's Experience

Michael Fields, CEO of Kana, highlights his real-life, in the trenches perspective on outsourcing software development work to India.  Sometimes cheaper isn't cheaper at all.  Worth reading.  Thank you Sandhill.com

Symantec Convertible -- Part Two

In our first post, we mentioned that Symantec entered into a form of derivative transaction, widely known as a call spread, which was structured to compensate for the dilution that would occur if convertible bonds holders exercise their right to convert into common stock.

Transaction Structure 

So, what the heck is a call spread?  In this case it was the the purchase of a call option at one exercise price and sale of another call option at a higher exercise price.  Symantec did the following:

1.  Purchased a Call:  Symantec purchased a call option (from one or more of the underwriters) that gives Symantec the right to buy its own shares at a price 22.5% above the current stock price. That is $19.12, the same conversion price as the convertible notes.  The number of shares underlying the call option was likely the same that would be issued if the convertible converts, 104,590,200 shares.  This component is what Symantec refers to as "convertible note hedge transactions" in the press release.

2.  Sold a Call:  Symantec also sold a call option ( again, to one or more of the underwriters) that gives the purchasing underwriter(s) the right to purchase Symantec shares at a price 75% ($27.32) above the current stock price.  Again the number of shares would have likely been something close to 104,590,200 shares.  This component is what is referred to as "separate warrant transactions" in the press release.

Transaction Impact on Potential Equity Dilution

So what does all that accomplish?  It allows Symantec to eliminate all equity dilution resulting from the conversion of the convertible up to a stock price 75% above the current price (again $27.32).  Even if Symantec's stock price is above $27.32, it still protects against equity dilution somewhat as the proceeds paid to Symantec from the exercise of the sold call option (#2 above) could be used to repurchase common stock in the market.

Let's illustrate equity dilution with several scenarios:

Scenario One, Stock Price $18.00:  Convertible bond holders elect to get repaid as bond value ($2 billion) in more valuable than value as converted into common stock ($18.00/share x 104,590,200 shares = $1.9 billion).  Result: No equity dilution.

Scenario Two, Stock Price $25.00:  Convertible bond holders are incented to convert to common stock ($25.00/share x 104,590,200 shares = $2.6 billion as converted value vs. $2 billion bond value) and receive 104,590,200 shares.  Symantec exercises purchased call (#1 above), purchasing 104,590,200 shares.  Result: Purchased call exercise offset convertible bond conversion 1:1.

Scenario Three, Stock Price $35.00:  Convertible bond holders are incented to convert to common stock ($35.00/share x 104,590,200 shares = $3.7 billion as converted value vs. $2 billion bond value) and receive 104,590,200 shares.  Symantec exercises purchased call (#1 above), purchasing 104,590,200 shares.  As in Scenario #2 above, the purchased call exercise offsets the convertible bond conversion 1:1.  But, in this case, the purchaser(s) of the sold call (#2 above) are now incented to exercise their right to purchase 104,590,200 new treasury shares at $27.32.  Symantec receives $2.9 billion in cash from the sold call exercise which is then used to repurchase 81,640,122 ($2.9 billion sold call exercise proceeds / $35.00 stock price) shares in the open market.  Result: Net 22,950,078 shares issued instead of 104,590,200 without the call spread in place.

So in conclusion, the call spread works to either eliminate or mitigate the equity dilution resulting from the conversion of the convertible notes.

Economic Cost

Symantec had to pay $ for the "convertible note hedge transactions" and got paid $ for the "separate warrant transactions".  So what are the numbers?  According the the 8K, Symantec paid $592 million for the purchased call (#1 above) and received $326 million from the sale of the call (#2 above). 

So, the net cost to Symantec was $266 million to create the call spread.  $266 million amortized over the average life of the bonds (6 years) is $44 million per year.  That equates to a 2.2% annual cost.  Tack this imputed cost to the coupon on the convertible (.75% and 1.0% depending on the maturity) and you have an imputed annual cost of roughly 3%.  So, simplisticly, Symantec is borrowing $2 billion and paying a 3% annual pre-tax cost.  Not bad terms.

The 80% - 20% Rule

Andy Hayler, a software entrepreneur and generally thoughtful guy, reminds us of one of life's Ironic truisms, 20% means more than 80%.

Andy points out that Microsoft is methodically making inroad into the business intelligence application category.  Andy's core thesis is as follows:  Microsoft may never field a product offering that offers the depth of features and functionality as do Cognos and Business Objects, but it really doesn't matter as "most users only take advantage of a fraction of the features of a BI tool anyway."

This is the exact same dynamic that is occurring all over the software sector.  Think Salesforce.com vs. Seibel (Oracle), Google spreadsheets vs. Excel, MySQL vs. Oracle, Linux vs. Unix, Writely vs. Word, ...  The fact is that 20% of the functionality provides 80% of the value.   Put another way, 80% of the market only needs/wants 20% of the functionality.  The irony is that software vendors are notorious for adding features over time. As a rule, it's function that most users don't want, need or care about.  Further, the additional features are not typically monetizable!  If anything, its a strategy to keep pricing from eroding, not pull more $ from the client.

Perhaps all software entrepreneurs, VCs and big company corporate executives should consider their strategy within the 80/20 rule.  Is the software industry product/business model all wrong?

Symantec's Striking $2B Convertible Financing

Nobody gets it.  Symantec issued $2 billion of convertible notes on Monday.  That in itself is notable news but there are a couple much more interesting elements to this transaction.

Rethinking Leverage

This financing is really in essence a recapitalization of Symantec.  $1.5 Billion of the proceeds are being used to finance the purchase of Symantec common stock.  In other words, Symantec sold bonds to pay the cash to shareholders.  Why are they doing this?  Well, finance theory states that the cost of debt is less expensive than the cost of equity (up to a certain point).  The direct manifestation of this is that following this deal, Symantec will have fewer shares of common stock outstanding, which will increase their EPS, even when factoring in the carrying cost (interest cost) of the debt.  Higher EPS = higher stock price, excluding other factors that impact stock price.  So simply put, this is Symantec management working to enhance shareholder returns by placing prudent amounts of debt on the balance sheet.  This is the continuation of a fairly nascent trend toward optimizing capital structure within large software vendors (and frankly has implications across the entire technology sector).  Computer Associates was a pioneer in the use of debt and Oracle, Veritas, RedHat, Mercury Interactive and Symantec among others have begun to rethink their historical aversion to debt.  MANY more technology companies are considering this move now.

Why a Convertible Bond?

The second extremely interesting element of this transaction is that they issued a convertible bond instead of high-yield debt.  In other words Symantec actually issued a security that gives a right to buy Symantec stock at a higher price in the future.  Well, that certainly isn't consistent with the recapitalization argument stated above.  But wait, Symantec also entered into a derivative transaction, know as a call spread, which was structured in a way to compensate for the dilution that would occur if holders of the convertible bonds wanted to exercise their right to buy the common stock.  Its sort of a complicated way to get to the same place but what Symantec and their underwriters did was create synthetic high-yield debt.  Why would they do that when the high-yield market would have voraciously snapped up Symantec high-yield bonds?  Well, the convertible bond market, combined with a complicated derivatives trade were a better deal.  Us outsiders will never know the real data, but I can assure you that Symantec was thrilled with the outcome. 

Underwriters LOVE these deals because the fees are very high.  Bankers and issuing company executives also feel good because effort put into structuring a rather complicated deal (satisfying in its own right) results in superior terms for their shareholders.  Believe me, every technology company over $2 billion in market capitalization is getting bombarded by bankers selling this same technique.  Investment bankers get giddy sometimes.

So lets get back to our opening statement, nobody gets it.  The real story here is what I outlined above.  In my check of press reporting and blogging, their is no mention of the real significance of the deal or the rationale which motivated it.  Striking.  Here is the take from Stock Market Beat.  All the bonafide press just regurgitated the press release.

Jerry Weissman -- Presentation Coach

Jerry Weissman is a legend.  During the 1990s he was a required stop for all aspiring technology IPO management teams.  That is if they were smart (and could get a slot in his schedule).  Jerry is a presentation coach.  He's a bit formalistic, but when your formula works, it means its a good formula.  His formula works.  One great example of his technique that I remember well is he advised that when asked a question, rephrase it back to the questioner before answering.  It's a wonderfully effective technique to show that you understand the question, get clarification if required and gives you time to formulate a crisp answer.

Well, yesterday Guy Kawasaki's blog brought Jerry back into our minds.  It turns out that he is prolific blogger!  That made me smile as apparently an old dog (take that as an respectful term in this case) can learn new tricks (technologies).  His post on being a great panel moderator is terrific.

The Challenge of Focus

We believe venture capitalist Seth Levine of Mobius is right on in his post entitled "What DON'T You Do?"  As he points out, most effort is made to define a company's focus, which is essential, but turning the question inside out helps to define the line between okay and not.  Isn't this subject the essence of probably 70% of the conversations that go on within an organization, particularly a young organization which is still defining itself?  Whether it's sales, product, marketing or management, the same question is always being considered; where do we spend our money and more importantly our time.  Seth's approach is a good tool to keep in mind.

Google's a Software Company

We realize this may not be the "politically correct" thing to say but let's not forget what Google really is, a software company.  Search is software; period.   

In fact, Google is the most software of all major "Internet" companies.  Let's compare: (be nice, we are quite cognizant that we are being ridiculously simplistic with the following analysis)

Amazon sells stuff via its virtual store and manages the entire customer and supplier process with software.  Makes money by buying stuff cheaper than it sells it.

EBay created a virtual flea market with software that allows buyers and sellers to communicate on all pertinent issues associated with a purchase/sale.  Makes money by charging a fee for the right to use the marketplace.

Yahoo of course started with search (pure software) and has become one of the great aggregators of content on the Internet; a new media company.  Makes money by selling advertising.

Microsoft's real business today is selling software that sits on PCs and servers.  We all know that their feeling pretty vulnerable right now, rightly so, and are trying to become the next Google, Yahoo, Amazon, EBay.  Oh yeah, let's not forget their burning desire to be the next Oracle, SAP, EA, Nintendo, Sony, Disney, ...  (Is this a focus issue or is it okay not to have focus when your huge?)

Google is search, search and more search.  Or in other words software, software and more software.  Of course, their revenue model is strikingly different, they sell highly targeted advertising.  It's the traditional media revenue model applied to the software business.

What's next for Google?  Well, more software.  We laughed out loud when we heard that Google announced its spreadsheet product today.  We laughed even louder when we see some interpreting this as Excel light, implying its not a threat to Microsoft's core business.  Wrong!  Google's out to lay waste to Microsoft and while their at it, taking on the entire traditional software business model.  They, not Software.com, are the masters of the software as a service (SAAS) model.