Tech Banker

Technology IPO Market Resurrection?

This past week has been what may be a breakout week for technology IPO.  Three IPO's in particular received an enthusiastic welcome by Wall Street.

CommVault --  CommVault has distinguished itself as a truly viable competitor in the data storage management sector competing head-to-head with giants such as CA, EMC and Symantec's Veritas line of products.  Revenues over the past 12 months were $120.8mm and growth from fiscal year 2005 to 2006 (March year end) was 32%.  CommVault's competitive momentum, emerging scale and growth rate make for an impressive offering.  CommVault has been incredibly patient with its IPO, actually starting the process three years ago and biding their time as their business grew and the technology IPO market began to regain its footing. 

Of particular note in this deal were two rather unusual structural elements; (1) roughly 45% of the shares sold were selling shareholders and (2) a large portion of the proceeds raised by CommVault will be paid to certain preferred stock holders. 

With regard to selling shareholders, it certainly makes a stronger statement (and deal) when existing shareholders are NOT sellers in an IPO.  Given the choppy nature of the IPO market in general, it is a bit surprising that the Company and underwriters were comfortable with such an aggressive structure.  I posit that the answer lies in the fact that the vast majority of selling shareholders were affiliates of CSFB, one of the two book managing underwriters.  Clearly the market looked through this "interesting" set of facts and focused on CommVault's business and prospects.  Generally, underwriters and corporate issues strive to eliminate these types of distractions as they increase the risk of execution.

Another quite unusual "distraction" in this situation was the large cash payment ($101.8mm) being made by CommVault to satisfy obligations under the first five rounds of private financing.  Typically preferred stock issued in private financings converts to common stock upon an IPO.  In this case, in addition to conversion into common stock, the holders of Series A-E preferred stock (again CSFB affiliates) were also due a preferred return and accrued dividends.  This is an extremely unusual occurrence in an IPO.

So, does any of this matter to the new investors purchasing the IPO?  Only if you believe that the selling shareholders see this as an opportunity to liquefy as they have a tempered view of CommVault's prospects.  In this case, the CSFB affiliates have been in this investment for up to 10 years (a VERY long time) and are continuing to hold a substantial equity position in the Company.  Also, very importantly, management is only selling a modest amount, signaling confidence.

Two other IPO's which priced this past week were DivX and Riverbed Technologies.  Both were well received and traded up nicely in the aftermarket.

These transactions are encouraging and suggest that we may be seeing a more receptive marketplace for emerging vendors.  Investment banker IPO activity levels are also reasonably high these days suggesting that with an open market, the technology IPO pipeline may begin to build.  We'll be watching.

Macrovision Convertible Financing -- The Trend Continues

Macrovision is leaping aboard the trend that we have highlighted several times in the past few months -- debt is playing an increasing role in software company capitalization.

Macrovision announced the offering of $175mm of convertible notes today.  Of particular note is that they are also entering into a call spread arrangement (which we highlighted in detail in a previous post on Symantec's recent financing) and using a portion of the proceeds ($50mm) to repurchase common stock.  Just like Symantec and CA, they are doing a leveraged recapitalization.  Instead of turning to the straight debt markets, such as high yield or bank, they have chosen to use a convertible bond as the funding vehicle.  Why?  Lowest cost and execution risk.

CA and Leverage

Today CA announced earnings, a material restructuring intended to reduce ongoing expense levels and the expected initiation of their previously announced $2 billion stock repurchase program.

CA's Capital Structure Philosophy

CA has historically been the most aggressive user of debt within the software sector as a mechanism to finance its business.  While the management team has seen much change in the past five years, the aggressive use of debt remains firmly in place.  As we have seen with the recent Veritas financing as well as the financing of the Secure Computing acquisition of CipherTrust, debt has found its way into the mainstream of the software industry.

CA intends us the Microsoft technique and initiate a tender offer to repurchase $1 billion of its common stock.  The Company expects to financing between 50% -75% of the purchase price with a bank facility and the balance with cash from the balance sheet.  The net effect is that leverage ratio's will rise to the highest levels of the past several years.  Today CA's debt / common stockholder equity ratio is 40%.  Following the buyback that ratio will rise to between 57% - 67%, well above CA's previous debt levels.

IBM / FileNet Update

NY Times DealBook published a short piece on Friday speculating that another bidder may be lurking in the shadows for FileNet.  We place the probability as quite low. 

We believe that FileNet has been receptive to a sale for quite some time and it's been very well shopped informally.  I'm also certain that alternative logical buyers were approached as part of the recent transaction process.  This is wishful thinking on the part of investors who are reacting to the 1% stock price premium offered by IBM.  What they are forgetting is that the stock has moved upward 27% in the past month or so on acquisition rumors.  See our recent assessment of the transaction.

Transaction Alert: IBM Buys FileNet

Well, IBM is getting aggressive.  In it's second large acquisition in a week, IBM announced that it is purchasing FileNet for $1.6 billion.  This comes on the heels of another recent acquisition in the enterprise content management sector, the purchase of Hummingbird by Open Text for roughly $500mm. 

Transaction Terms

Purchase Price:                                                                        $35.00/share

Premium to Pre-Announcement Price:                                        1%

Enterprise Value:                                                                      $1.2 billion

Enterprise Value / 2006E Revenues:                                           2.5x

Price / 2006E EPS:                                                                    30x

Target:  FileNet

FileNet is an enterprise content management platform vendor.  In other words, customers use FileNet's suite of products to build content management applications suited to their own needs. 
Web pages, word processing documents, spreadsheets, HTML, XML, PDF, email messages and other digital content are all examples of the types of content that FileNet is capable of cataloging, organizing and making available as needed.

FileNet has been in a bit of the doldrums over the last several years, with stock performance being essentially flat since the beginning of 1994 and revenue growth sub-10% annually.  While net income has increased nicely over the past several years, operating margins remain rather lackluster at 10% over the past 12 months.  Many believe that FileNet, as an independent entity, was not particularly well positioned with tough competition on the high end from EMC/Documentum and Microsoft showing early success at the low-end with Sharepoint.

Strategic Rationale

IBM, showing a bit of a "me too" mindset with EMC, is justifying this transaction under its "Information on Demand" initiative.  No doubt, managing information assets within an enterprise is a challenging and high value effort which equals expensive projects with lots of services work to make right.  Perfect for IBM's capabilities and strategy.

Architect Partners Assessment

IBM has shown it's smarts again with this acquisition.  FileNet's products fit well within IBM's overall product set, albeit with some overlap, and importantly to IBM's strategy, FileNet products drive considerable service revenue as well.  Although as we mention above, FileNet's software should be considered a platform, it does continue to move IBM up closer to the application category and as we speculated in our post on IBM's acquisition of MRO Software, we believe this add further validity to the notion that IBM's strategy around owning applications has shifted.  Time will tell if our premise holds true.

One interesting dynamic worth mentioning is the lack of premium offered.  Historically, on average, public company control premia have been on the order of 35%-40%.  Clearly a 1% premium to pre-announcement stock price doesn't incent shareholders to act.  The markets immediate reaction was to bid the price above the offer price by IBM, believing an alternative suitor will emerge.  While it's possible, we believe that all logical purchasers had more than adequate time to consider this purchase and have likely chosen to pass on the opportunity.  One also need to consider that FileNet's stock price rose over 27% in the preceding month or so, suggesting takeover rumors were rampant.  We bet that shareholders will be disappointed when other bidders fail to emerge.  We'll be watching closely.

Transaction Alert: IBM purchases MRO Software

Last week IBM announced the purchase of MRO Software, for an equity value of approximately $740mm.  This is the largest software acquisition for IBM since the Ascential Software deal in April 2005.

Transaction Terms

Purchase Price:                                                             $25.80/share

Premium to Pre-Announcement Price:                             19%

Enterprise Value:                                                           $586 million

Enterprise Value / FY 2006E Revenue:                             2.6x

Price / FY 2006E EPS:                                                     24x

Target: MRO Software                         

MRO Software provides software and services that allow corporations to manage the lifecycle of assets such as plant, equipment and IT systems.  The vast majority of MRO's business is managing the lifecycle of non-technology assets which clearly complements IBM's Tivoli business focused on managing IT assets.  The core IT management centric product inherent within MRO is their service desk offering (Product: Maximo ITSM), although the Maximo ITSM product set was released in 2005 and remains a very small business within MRO.  MRO's business is service and support heavy with 69% of total MRO revenues coming from those two categories. 

Architect Partners Assessment

MRO is a somewhat surprising acquisition for IBM.  Historically IBM has focused on being a non-competitive partner to application vendors. MRO competes directly against the SAP and Oracle's of the world, albeit in a rather obscure category.  This may signal a significant shift in strategy within IBM.

MRO does fill an obvious hole in IBM's IT management product set, an IT service desk product.    Some have speculated that this was IBM's primary motivation for the acquisition.  While this is a nice benefit, it makes for an expensive way to achieve the result.   

Transaction Alert: HP buys Mercury Interactive

Well, HP finally did it!  After years of showing at best tepid support for its software business, HP finally showed some conviction.  HP's purchase of Mercury interactive is a blindingly obvious strategic move with the only question being, what took them so long.

Target: Mercury Interactive

Mercury Interactive was founded as a software quality testing vendor.  In simple language, Mercury created software that tested software.  Mercury's software stress tested newly developed software products to catch bugs and performance issues before the software was released to the market or installed.  Mercury dominated this niche, and still does, but as growth became harder to achieve Mercury was compelled to extend its product scope.  Several years ago, Mercury began selling software to manage the performance of applications which were already deployed and running.  Today Mercury Interactive competes quite effectively with companies such as IBM, CA, BMC, Symantec, Quest and even to a limited degree HP.   

Transaction Terms

Enterprise Value:                                                 $4.5 billion ($52.00/share)

Premium to market:                                             33% above pre-announcement price

Valuation Multiples:

     Aggregate Value / 2006E Revenue                       4.8x

     Price/2006E Earnings Per Share                         34.0x   

Strategic Rationale

Strategically,this has been one of the most obvious transactions to not get done for years.  HP has long had a strong reputation around its Openview product set but it's been perceived as strong at managing the network layer, alright but emerging at managing the systems layer and weak at managing the application layer.  Mercury is the leading player at the application layer providing a perfect complement to HP's product weaknesses.  Very importantly for HP, they are also acquiring an industry leading team of professionals which we are sure will be an important catalyst to reinvigorate HP software business.

Architect Partners Assessment

Timing is everything.  Several events transpired to make this transaction achievable.  First, the departure of Mercury Interactive founder, Amnon Landon, last year as fallout from the well described option dating scandal.  Amnon was a fighter, not a seller.  Second, HP's change in leadership has clearly resulted in a new level of respect for its software business, resulting in corporate resources now being allocated to building what had been an oxygen starved business under Carly's watch.  Third, the loss of credibility  and uncertainty caused by the senior leadership changes and accounting issues at Mercury Interactive brought its valuation down to earth, making it a relatively affordable acquisition for HP.

This is one of those deals where both sides win.  The takeout valuation of Mercury is actually quite good at 4.8x revenues, particularly when one considers that revenue growth was expected to be only on the order of 12.3% from calendar 2006 to 2007 based on Wall Street analyst consensus.  Assuming solid execution, not a given, we believe the business will thrive under the HP umbrella making the relatively hefty purchase price quite reasonable. 

Here is a take from Vinnie Mirchandani and James Governor and Tony Baer.

EMC / RSA Follow Up

A follow up to our original post.  Network World published a decent assessment of EMC's recently announced intent to acquire RSA.  It's a positive perspective on the transaction, a position in the minority.

Underwriter Profits

Recently we commented on a post by Tom Evslin regarding how underwriters profit from an IPO.  We felt that Tom's post was an unfair assessment of underwriter motivations and incentives.  Let us try to explain simply how and where underwriters make money on an IPO.

Gross Spread -- The Easy Part

First the easy part, underwriters earn a commission (known as a gross spread) calculated as a percentage of the capital raised for the issuing company.  As a rule this is 7%.  When all is said and done, on average about 70% of the gross spread is actually kept by the underwriters and split amongst themselves in a very disproportionate manner.  Where does the balance of roughly 30% go? To pay the salespersons' (employees of the underwriters) commissions who sold the shares and the underwriters' expenses of the deal (legal and travel mostly).  These fees are quite lucrative, for example a $75mm IPO will net roughly $3.7mm in fees to the underwriters as a group.  If your a lead, book running underwriter (managing the deal) you get a big chunk of these fees.  If your a co-manager, not quite so interesting, but crumbs are better than no crumbs.  If the deal is large enough, those crumbs tend to be large also.

Aftermarket Trading -- A Bit More Tricky

Okay, now lets get to the part that is a bit more complex, the aftermarket.  This is the area there there seems to be some misconception that underwriters stand to profit handsomely.  Let's look at exactly where and how underwriters make money in the aftermarket.  There are two ways that underwriters can profit in aftermarket trading of an IPO, (1) trading and (2) inventory profits.

Trading: First underwriters act as a market maker and essentially match buyers to sellers.  In doing so, the underwriter is buying shares from willing sellers at the "bid" price and reselling them to willing buyers at the "ask" price.  There is a small difference between these prices and the underwriter pockets that "spread" for every share which is purchased then resold.  So, how much do these profits represent in a typical IPO?  Well in the first 10 days following an IPO (a rough approximation of the stabilization period following an IPO) these profits average only about 9% of the gross spread that we described in the paragraph above.  This equates to about $473,000, again assuming a $75mm IPO.  This statistic is according to the research paper, When the Underwriter is the Market Maker: An Examination of Trading in the IPO Aftermarket published in June 1999 which studies 306 IPO's completed between September 1996 to July 1997. 

So trading can be a decent business but is hardly a gold mine.  This business has actually become far less attractive with the advent of decimalization in 2001 as spreads used to be at minimum increments of 1/16 ($.625/share) because that was the smallest fraction available.  Now average spreads are more on the order of $.01-$.02/share as decimal-based quotation has enabled competition to drive spreads down.

Inventory Profits: The second way for underwriters to profit in aftermarket trading is to actually make a bet on the direction of the stock by either owning the stock (holding inventory and being long) and speculating that the stock goes up or being short the stock (naked short) and speculating that the stock price will decline.  In my direct experience, holding material inventory positions, either long or naked short, in an IPO during its stabilization period (again lets assume the first 10 days) is NOT a position underwriters intend to be in.  Any inventory held is usually the result of the underwriters' attempt to stabilize the issue following pricing, not an attempt to make a bet on direction.  In fact, the same research paper as referred to above, also evaluated profits generated from inventory positions following the IPO.  Their findings were that on average underwriters generated NO net profits from inventory positions during this stabilization period.

Conclusion

So, IPO underwriting is a lucrative business but the vast majority of profits are generated via the gross spread that is paid by the issuer to the underwriters.  The aftermarket activities of the underwriters are certainly generally additive to profits but do not represent a mother lode.

Secure Computing / CipherTrust Follow-Up

A good article by Sara Lacy at Business Week published today on the Secure Computing / CipherTrust transaction.