Monday, September 10, 2012

Nice Systems Equity Research

Another day and another technology company lowers guidance. This time the market seems to have been caught unaware by Nice Systems (NASDAQ: NICE) lowering full year revenue and EPS guidance below its previous guidance and notably lower than the market consensus. In a sense, I’m surprised that the market was surprised. Despite Nice and its rival Verint Systems (NASDAQ: VRNT) reporting upbeat results and guidance in the last quarter, since then a number of technology companies have waned. Moreover, many stocks in the data sector such as Informatica (NASDAQ: INFA) haven’t had many positive things to say recently. That said, the question now is to decide whether Nice is worth investing in right now, so I decided to look at the bull and bear case.

What do Nice Systems do and Why Might it be Relatively Recession Resistant?

Nice and Verint’s end demand is driven by regulatory and compliance drivers, as well as the need for companies to analyze customer interactions. Essentially, they sell enterprise intelligence solutions, which help corporations monitor customer interactions and optimize workflow. Verint is seeing its deal size increase over time, as customers are taking advantage of its increasingly broader product offerings. For example, previously a customer might have bought a data capture solution (video or voice recording), but now they are also buying data analytical solutions as well. Nice is doing well out of offering an integrated range of offerings across financial crime and compliance to customer interaction and analytical applications.

Turning to the financial sector, both benefit from increasing security and regulatory compliance within financial services. They make the kind of surveillance and monitoring systems that banks need to monitor money laundering, cyber crime and illegal trading activity. At that is just within their own staff’s activities! As such, their primary profit drivers are increasing regulation and, the growth of ever more complex needs to gather information from multiple sources, both internally and externally.

With the implementation of Dodd-Frank and the increasing needs for firms to manage security and work flow optimization, these firms look set to grow. They help companies to extract insight from interactions, transactions, and surveillance. The information is gathered from a wide range of different sources, from emails and phone calls to video surveillance.

Furthermore, financial firms and Governments are under increasing pressure to protect themselves and the company from internal and external security threats as well as to  ensure that work flow is being properly managed. These words sound abstract, but consider criminals like Nick Leeson and Jerome Kerviel, both of whom benefited from lax monitoring and compliance controls. It strikes me as being an area of spending that Governments will be highly reticent to cut.

In addition, Work Flow Optimization gives a tangible return on investment and much of Nice's end demand is regulatory and compliance led. Another cause of worry could be an increase in the demand from organizations for their WFO solutions to be sold by their contact center infrastructure provider. Although, Nice is focused on the high end so this trend is unlikely to have a great affect.

What is the Sector Saying?

I mentioned Informatica earlier, but to be fair it did not specify weakness in Government or Financial but rather a broad based spending slowdown. This may be company specific. However, Tibco (NASDAQ: TIBX) said that business optimization growth moderated, but what it didn’t say was that orders were falling off a cliff thanks to Europe. In fact, when asked about it, management said that it had not seen any change in European conditions from a quarter ago. Again, neither Government nor Financials were singled out.

What is clear is that data sector growth is slowing.

Why Weren’t These Results so Nice?

The Q2 results were pretty much in line on EPS but revenue was light by $4.6m from consensus. However, the real problem was the guidance:

  • Full Year Revenue Guidance of $890-910m vs. previous guidance (May) of $930-950m and market consensus of $940m
  • Full Year Non-GAAP EPS Guidance of $2.28-2.38 vs. previous guidance (May) of $2.32-2.50 and market consensus of $2.44
  • Q3 Revenue Guidance of $217-225m vs. consensus of $239m
  • Q3 Non-GAAP EPS Guidance of 56-60c vs. consensus of 61c

It’s not hard to see why the stock is getting slammed.

Management made the usual noises about delays in getting deals signed off and customers implementing tighter controls on budgets. This sort of thing is de rigueur for an industry embarking on a protracted slowdown, but it is also symptomatic of what could be a bit of temporary weakness caused by enterprises displaying caution over euro zone difficulties. Investors will need to decide which is which.

Some color was given in the conference call where management was at pains to point out that they didn’t think it was from competitive tensions. Deals were slipping rather than being lost. In particular an ‘extraordinary’ amount of deals were not being completed towards the end of the quarter.

Here is a chart to demonstrate how Nice now forecasts revenues to develop for the rest of the year.

It’s clear that this appears to be a case of the company lowering guidance from previously expected strong growth rather than one of a dramatic fall off in revenues and earnings.

The Bullish Case for Nice Systems

The Bullish case has it that now the temporary slowdown is priced into the stock, and it can appreciate from here. Enterprises’ always act in a cautionary manner when faced with large macroeconomic risks but when they get accustomed to them, they gradually start to spend again. This is particularly relevant with Nice because its solutions are mission critical in many cases. The situation is nowhere near as bad as in 2008 and the company is still growing.

Moreover, the company’s new guidance is based on projecting forward the deal conversion rates that it is seeing now and, this is likely to be the low point. In other words, if deal conversion improves then guidance will have to be raised and the stock will shoot higher. In addition, in Q3 of last year Nice reported a weak quarter but told the market that it felt it would recover in the next quarter. It did. Investors would have been rewarded then as they will be now. The book to bill is still forecast to be above one for the full year. Nice is still growing.

This is a buying opportunity.

And Now the Bear Case

The bear case points out the weakness in the macro environment and points out that it doesn’t appear to be going away anytime soon. Government and Financial are both key sectors, and they are both going to be hit hard by austerity measures and by ongoing uncertainties in Europe. Also, if you look at the guidance for Q4 –despite it being lowered- it is questionable whether Nice can hit these numbers. For example, the Q4 target requires Nice to hit a record quarter and a huge pick up in sequential growth. Even the revised guidance is too optimistic.

The company has little visibility and is ultimately set to disappoint.

Where Next for Nice Systems?

On balance, I would be more positive than negative here. The lowered guidance still represents yearly double digit growth rates in revenues and EPS. In addition, the company generates a lot of cash flow. By my estimates around $129m on a trailing basis, which makes up around 6.8% of its enterprise value. If you believe in the lowered guidance, the stock looks cheap and I like the fact that the management is projecting ahead based on current conversion rates.

Make no mistake, if we are headed towards Armageddon in the euro zone then its end customers will be hit hard and so will Nice Systems. Then again, investing is about balancing risk with reward, and on that basis I think the stock is attractive at these levels.

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