We recently acquired a sizable stake and initiated coverage of SeaChange (SEAC).
Date: March 27, 2020. Current share price: $3.60. Market cap: 130M.
There’s been some good write ups, so I won’t repeat what’s already written. Those interested can read the initial write ups on Sumzero or ValueInvestorsClub. Below we outline our opinion of SEAC’s key opportunity set.
First some background
SEAC is an enabler of streaming services. Meaning as a content owner, you can use SEAC’s technology to launch your own streaming service like Disney+ or Hulu. The company originally productized this service via a form of professional services. SEAC would help setup, configure and sometimes manage these streaming services for their content producer clients. This resulted in low margin revenue because even though their product is technology, they’ve essentially turned it into a professional services org. This also meant SEAC’s clients needed large engineering teams to manage these systems, resulting in higher operating cost.
2 years ago Tar Holdings (Karen Singer’s activist firm) took a significant position in SEAC and replaced the entire board and installed her own management team. The new management team is mostly comprised of the sales leadership team from Brightcove (BCOVE), a competitor. I will add my own editorial here and say that this was an excellent move, as when you poach the sales people in enterprise sales, you effectively poach the client relationships as well.
The new management team at SEAC led by Yossi joined in early 2019 and have primarily focused on two things, re-introducing their technology as an enterprise software product, and signing deals.
First they reproductized SEAC’s technology into a technology license play, called Framework. Framework deals are high margin (80%+) because SEAC now primarily licenses out their technology on a 3-5 year contract, as opposed to generating revenue from offering PS/MS engagements. This effectively returns their business into a enterprise technology provider like ServiceNow. This also allows SEAC’s customers to host Framework via the cloud or hybrid solutions, as opposed to having to manage this on-prem, resulting in much lower operating costs.
Second, Yossi’s team have focused on demonstrating the value of their Framework product and closing deals, having signed an impressive 15 deals in the first three quarters they began offering this new product. Q1: 1 deal, Q2: 6 deals, Q3: 8 deals, Q4 to be released on April 6, 2020.
So to recap, in the last two years: 1) we have a more aligned shareholder base with Tar Holding and several other funds taking large positions. 2) A new highly capable management team with existing sales relationships. 3) A newly introduced high margin enterprise software product. 4) And most importantly, growing sales.
Key Opportunity Set:
- SEAC generates high margins
- Building sales momentum
- Sales likely enjoy tailwind from higher streaming demand amid COVID-19
- Re-rating of multiples and forced share purchases once included in Russell 2000
Generating high margin deals
SEAC’s Framework product is very similar to ServiceNow’s (a platform, with modules you can pay for). Under Framework are modules like analytics, media management and back office. These Framework deals are sold in two parts. The first part are licenses for whatever module SEAC’s clients want, this gets paid and recognized at the beginning of the deal. The second part is maintenance and support (upgrades, system patches, support, etc), that gets added to SEAC’s backlog and recognized through their contractual period, typically 3-5 years. Licenses account for 60-65% of each Framework deal and has a 95% profit margin. Maintenance and support accounts for the remaining 35-40% of each Framework deal, and has a margin of around 35-40%. Deals are on average around $2.6M for the first 15 they’ve signed so far. This means on contract signing, SEAC books $1.6M for the current quarter, and books $0.07M ($1.2M / 4 years / 4 quarters) for each subsequent quarter until contract end. This model re-positions SEAC as a enterprise application provider, like IBM’s Redhat, or ServiceNow. We expect the market will begin to re-rate SEAC at an appropriate multiple within 12 months, as detailed below.
Building sales momentum
While building a sales funnel and closing sales is an obvious thing for any new management teams to do, it should be noted that there is an element of career risk for decision makers when choosing ‘new’ products (not unlike the hedge fund industry when it comes to investing in unknown companies). Nobody wants to choose something that may or may not work and people tends to follow the crowd in selecting the vendor everyone else is using, indeed there is an element of momentum for companies that’s proved themselves. It’s in this light, that their first three reported quarterly earnings are so impressive. Not only did they sign a significant amount of deals, but they did this on a new product. In our calls with management recently and last year’s conference calls, management have reiterated several times that this is important and is an early sign that their product is highly competitive with existing solutions.
For those who are concerned that they’ve depleted the low hanging fruits brought over by their sales team from BCOV, I would argue that it’s the opposite. Now that major content owners/licensees have signed with SEAC, more will follow. Management have also stated this several times in earnings calls and 1 on 1s.
Sales likely enjoy tailwind from COVID-19
SEAC’s opportunity set in light of the current pandemic is two fold: 1) it allows content owners to monetize their content via their own streaming service as opposed to licensing the content to existing streaming services like Netflix, and 2) it allows existing streaming service owners to reduce their cost structure by using SEAC’s more cost effective solution.
SEAC repeated this point in recent PRs here, here, and here. In a recent call with SEAC IR, I asked for color around these PRs, as SEAC has historically not PR’d new deals, nor do they typically release any PRs in between earnings at all. SEAC IR advised that Yossi wanted to get across the point that there’s some strong opportunity set in the current stay-at-home environment and the competitiveness of their product.
I suspect investors will get more color around the size of the COVID-19 opportunity set in the upcoming earnings call on April 6th.
Re-rating of multiples following Russell 2000 inclusion
While we primarily prefer growth driven catalysts in companies, once in a while we get a perfect timing. In the case of SEAC, we estimate that as long as SEAC can maintain a rough market cap equal to Russell 2000’s current price, it would result a forced buying of around 1.1M – 1.5M shares by the indices. This means if Russell 2000’s current price is 1,000, then SEAC’s market cap must be at least 100M to qualify for inclusion. If Russell’s current price is 1,300, then SEAC’s market cap must be at least 130M.
Currently Russell 2000’s price is 1,100 while SEAC’s market cap is 130M, so we have a bit of a buffer. I also expect SEAC’s share price will continue to grow following the up coming earnings report. This catalyst should be fairly significant as I expect current share float is even smaller than what’s reported as we and several others have accumulated shares during the recent market decline.
Aside from forced share purchases, we expect the inclusion of SEAC into major indices to also act as a catalyst of SEAC being re-rated closer to industry peers.
Valuation
We spoke with CFO Mike Prinn as part of our pre-earnings touch point and he reaffirmed they plan to provide an upgraded guidance for calendar year 2020 (their fiscal ’21). He reaffirmed the guidance is “double digit” growth compared to their previous ’19 guidance of 70-80M. Here we need to keep in mind that they only began selling Framework in Q1 ’19 where SEAC only had 1 deal, however Q2 and Q3 had 6 and 8 deals respectively. Per their 70-80M guidance, this would mean in Q4 they would need to close around 9-10 deals:
- Q1: 1 deal
- Q2: 6 deals
- Q3: 8 deals
- Q4: 9-10 deals (est)
(Assumes an average deal sizes of around 2.6M, calculated as an avg of their past 15 deals.)
For 2020, if they simply maintained the same deal rate of 8-10 with no further growth, they would already do 90M of revenue in 2020.
Mike also reaffirmed he expects OPEX to have a run rate of 11M per quarter. We know license revenue has a 95% GM, support has 35% GM, put this all together and we’re looking at approx. 90M in revenue, back out COGS, back out 11M of OPEX, to arrive at around 20M in net profit. See my model attached for details. Tweak my assumptions however you’d like but either way, this is a lot of profit for a 130M market cap software business that’s still growing! Apply your preferred multiple or discount rate to arrive at your PT.
However, we believe management’s language is on the conservative side, and in our model (attached), we have a more aggressive estimate (we assume 11-12 deals/quarter). This gives us an estimated earnings of $35M or $0.92/share for 2020. Our price target is $12/share based on the organic growth enjoyed by the company, as well as immediate catalysts identified above.
Our model is attached as a reference.
Summary and guidance
Overall, we believe SEAC is an excellent opportunity to not only invest in a growing software business with an aligned shareholder base, but also one that is likely to benefit from immediate catalysts in the form of 1) April 6th earning and full year guidance for 2020, 2) Russell 2000 inclusion by early June. In the mid to long term, I expect there is a likelihood of a sale once share price has re-rated to more attractive levels for current major holders.
I will provide updates to SEAC for those interested.