This article is authored by MOI Global instructor Michael Morosi, Equity Portfolio Manager at MAPFRE AM, based in Madrid, Spain.
When most people think of the technology sector, often the first thoughts that come to mind are of the select few mega-cap companies that have impacted nearly every aspect of modern life. Or perhaps they think of the precursors of these giants, conjuring the image of two computer science geeks developing an innovative gadget in their parents’ garage. Alternatively, they may envision the modern incarnation of would-be CEOs pitching their hot startup idea to any venture capital investor who will listen. Underlying each of these examples is the assumption that technology and disruption are synonymous with exponential growth and sky-high valuations. However, often overlooked is the fact that the core technologies upon which today´s innovations are built have been around for over half of a century. Further, there are many segments of the technology sector that are in a decidedly more mature phase of their lifecycle. Often, the stable, cash-flowing companies that inhabit this part of the market are cast aside by investors in constant pursuit of the next Amazon. This dynamic can create very compelling investment opportunities for value-oriented investors.
MAPFRE AM’s Behavioral Fund, which seeks to generate long-term outperformance by exploiting persistent investor biases, recently invested in one such technology company. QAD, Inc. is a software firm that embodies both the qualities of an established company with a sizeable installed base of largely recurring customers and a nimble, fast-growing organization that is gaining share from larger, less responsive competitors.
QAD, Inc. is a Santa Barbara, California-based provider of enterprise resource planning (ERP) software to clients in six focused industry verticals – automotive, customer products, food and beverage, high-tech, industrial products and life sciences. ERP software is mission-critical technology that integrates all of a company’s business processes, including product planning, development, manufacturing, sales, and marketing, into a single database, application, and user interface.
QAD is a niche player in the $40 billion global market for ERP software, which is dominated by industry-agnostic players like SAP and Oracle. QAD targets global small- and medium-cap companies that have complex operations spanning multiple geographies and that value high-touch service and a flexible, industry-specific offering that SAP and Oracle cannot deliver. 70% of its customers are headquartered in the United States, but less than 50% of the company’s revenues come from the US because of the global nature of the operations of its 2,000 customers worldwide. Reference clients include automotive suppliers like Lear Corp and Adient plc, industrial concerns like Illinois Tool Works and Watts Water Technologies, and specialty chemical companies like Saft Groupe and Solvay SA.
QAD targets $330 million revenue in 2018 (+9% y/y), with a 30% contribution from subscription revenue, 25% from professional services, and 45% from legacy maintenance and license revenue. The company’s revenue growth is primarily driven by subscription revenue, which increased 36% y/y through the first three quarters of 2018. QAD generates low-50s gross margins, mid-single digit net income margins, and $20 million in annual free cash flow. The company’s market capitalization is approximately $800 million.
There are three pillars to MAPFRE AM’s investment thesis for QAD, Inc.: the company’s relentless focus on serving customers in its attractive niche market, ongoing subscription model transition, and long-term management orientation.
QAD has carved out an attractive niche within the massive global ERP software market. It competes head-to-head with SAP and Oracle, as well as a host of smaller competitors, and wins based on industry fit and product features, speed-to-benefit, and cost. QAD’s industry vertical – even sub-vertical – orientation allows it to design and deliver products that are highly specified for the needs of its customers. The company is responsive to customer needs and invests continually in new functionality to stay ahead of slower moving competition.
Consistent with its nimble size – the company has 1,850 employees compared to SAP’s 95,000 – QAD also offers its customers attractive speed-to-benefit, with flexible deployments that avoid many of the pitfalls of the dreaded “ERP migration” that have caused the premature departure of many CIOs. The company’s purpose-built application architecture is structurally lower cost than the legacy ERP providers, allowing QAD to pass along the savings to their customers.
Further, the company continues to build on its unique customer offer through the next generation of its platform, Channel Islands, which was made generally available to all of its customers in September. Channel Islands increases the flexibility of QAD’s architecture and improves the user experience through a new interface built on HTML5, allowing customers to access the application from any device at anytime.
Subscription Model Transition
One of the biggest trends in technology over the past decade has been the movement from on-premise data infrastructure to cloud data infrastructure. Under the on-premise model, companies incurred significant costs for purchasing and maintaining large capacity of data servers and storage. When adopting a cloud model, companies are able to move from hosting and managing all of their data internally to outsourcing both the capex and maintenance to a third-party. Cloud service providers are able to capitalize on economies of scale to deliver better service at a lower cost, while guaranteeing effectively 100% uptime through redundancies and backup.
The business model of cloud service is entirely different, as well. The on-premise model involved selling enterprise software on a perpetual license basis, including a large one-time payment to purchase and deploy the software along with a much smaller ongoing maintenance package. On the other hand, cloud service is provided strictly on a recurring subscription basis. Customers typically sign contracts for a 3-5 year term, resulting in as much as a 4x increase in annual recurring revenue. This model results in a higher value, more predictable revenue stream, especially for companies offering products with very low churn rates, like QAD.
Software-as-a-Subscription (“SaaS”) transition stories have been a highly profitable investment thesis throughout this shift in the industry, as companies often saw their valuation re-rate from 2-3x to 6-10x revenue. Given the mission-critical nature of ERP software, this segment is the last of the major software categories to migrate to the cloud. However, now that companies have experienced the cost savings, reliability, and security in migrating lower-risk functions to the cloud like customer relationship management (CRM) and human resources management (HRM), Chief Information Officers at large- and mid-sized companies are ready to make the switch with ERP.
QAD’s subscription revenues have grown at a 37% five-year CAGR and are responsible for the re-acceleration of the company’s overall revenue growth. At the same time, after initially suffering from under-absorption of data center capacity, the company is just now achieving the scale necessary to deliver profitability in-line with other SaaS companies. Subscription gross margins have expanded over 20 points in the past five years, including eight points in the most recent quarter, increasing from 56% in 3Q17 to 64% in 3Q18.
Despite the material contribution of the subscription business to recent results, only 15% of customers have transitioned to the cloud model. We believe subscription revenues can maintain a 20-30% annual growth rate, and eventually the vast majority of the company’s revenue will come from its subscription business. While QAD’s revenue multiple has expanded from 1x to 2x over the past four years, when compared with SaaS peers in the 5-10x range, this re-rating trend has a way to go.
Long-Term Management Orientation
QAD was founded in 1979 and has been led by Karl and Pam Lopker, a husband and wife team of business and technology leaders. Sadly, Mr. Lopker, who was also a co-founder of highly successful consumer brand Deckers Outdoor Corporation, passed away earlier this year, though his outstanding leadership and impact on the company’s culture and the broader ERP industry endures. Mrs. Lopker, who has been instrumental in leading the company’s cloud transition and Channel Islands initiative, has assumed the sole CEO role. QAD’s founder-managed ethos has played a key role in the company’s go-to-market success and unified company culture. Attending a QAD user conference provides one insight into the strong community and devotion to the product of both QAD and its loyal customer base.
Additionally, Mrs. Lopker holds 5.6 million Class A shares and 2.4 million Class B shares, representing over 40% of the economic interest and 65% of the voting rights in QAD. While the long-term interests of shareholders are clearly aligned with management, the dual-class shareholding structure does imply management retains the voting rights to block any potential acquisition offer.
QAD’s ongoing transition to a cloud company remains under-appreciated by investors. The relatively limited float and sell-side coverage contribute to the exceptional value opportunity. Our approach to valuing QAD is comprised of four components: high-growth subscription business, net present value of high-margin legacy license software cash flow, net cash, and hidden asset value.
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