Friday, April 5, 2013

Verint Systems Guidance Looks Conservative

Verint Systems $VRNT is one of those stocks that you buy because you think it’s good value and then get bored with as the market ignores it for ages. Then one day you look again and realize that suddenly somebody noticed it and it's up sharply. The buzzwords of big data, cyber security, customer relationship management (CRM) and data analytics all seem to trigger market interest, and it looks like the market has finally woken up to this stock. So after the sharp rise, is it still good value?

Verint Reports Solid Results

Verint’s recent results were good and came accompanied with more bullish commentary on current performance, although the usual conservative looking guidance was issued. For those not familiar with the company I have some background on Verint and its chief rival Nice Systems $NICE in an article linked here. Not only is Nice a rival, but it is also potentially an acquirer or merger partner of Verint. A deal between the two makes a lot of sense because they are complementary with their end markets and geographies.

The idea behind investing in these companies is that as companies increasingly see the value in analyzing customer interactions and making actionable decisions from structuring data then they will also invest in monitoring it. Similarly security issues require governments to increasingly engage in intelligence gathering from monitoring and surveillance. Indeed, Verint is more of a government (25% of revenues) and security play, while Nice is more focused on enterprises.

A breakdown of revenues for the full year.

Enterprise intelligence revenues have been growing strongly, and Verint described the pipeline as being stronger than in recent years. Furthermore, this segment contains more software and analytics sales, so as it increases we should expect gross margins to improve. The one weak area has been video intelligence, but that is more about declining hardware sales and the forecast is for this segment to be flat this year.

From Hardware to Software

Investors will note that both Verint and Nice analysts estimate high single digit revenue growth for the next few years, but the bottom line is only forecast to grow at a similar rate. Why is this, especially as gross margins are rising and software and analytics become a larger part of the mix? In addition, is the PE ratio the best way to value this business?

I’m going to answer these questions by looking at Verint, although Nice is seeing the same kind of dynamics.

Firstly, let's look at the relationship between product share of revenues, gross margins and free cash flow generation. Free cash flow and margins go up as product revenue share of total revenues declines.

While generating more free cash flow is a good thing it is partly because Verint (and Nice) are generating more sales from higher margin software/analytics revenues. This can be seen as bad by investors because it can cause earnings to grow slower in the short term.

However, if you think about it software revenues tend to be recognized over time while hardware revenues tend to be booked upfront. The best way to gauge the underlying trend is to look at deferred revenues as well as product sales.

Note how current deferred revenues are growing in the last three years even while product revenue growth is slowing.

I have included product revenue growth as a useful benchmark, but Verint (or Nice for that matter) doesn’t, strictly speaking, have a razor/blade model. An industry company to compare them with is Check Point Software $CHKP This IT security company does have a razor/blade model, and even though it is growing its software revenues, its product and license growth is now negative. This implies that growth going forward will be difficult to come by. I’ve covered Check Point in more detail in this article. The difference between CHKP is that the hardware is the first foot in the door while Verint and Nice sell their solutions as part of an overall mix.

Overall the underlying trend is good for Verint.

Where Next for Verint?

This is a difficult question to answer because its future may well lie in a merger with Nice. In addition, it has simplified its corporate structure with the acquisition of Comverse Technology (which formerly owned a large chunk of Verint) so the extra liquidity will appeal to investors.

There are a few drivers here. A key competitor of both Nice and Verint is Hewlett-Packard’s $HPQ Autonomy. This company is allegedly under investigation by the Serious Fraud Office (SFO) in the UK and the US Department of Justice. Ironically, the SFO is a customer of Autonomy. I think it is reasonable to expect Verint and Nice to be favored in competition with Autonomy as a consequence of the cloud hanging over Autonomy.

In conclusion, Verint is getting close to that 5% free cash flow yield that I find attractive, and in the future it can grow cash flows in excess of its revenue growth. I prefer (and hold Nice), but I don’t think investors will go far wrong with Verint either.

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