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Author Disclosure: I (Frank) did not write the following, and have no position in EDGW.
Edgewater Technology (“EDGW”) is a misunderstood IT consulting firm that trades at 3.5x EV/LTM free cash flow, 5.0x Equity cap/LTM free cash flow, and 3.0x EV/LTM Adj. EBITDA with Adj. EBITDA and free cash flow expected to increase next year. The company has successfully transformed into a leading product-based consulting firm with significant market shares with its strategic partners including Oracle, SAP, and Microsoft. EDGW generates significant free cash flow as a result of its flexible business model, large NOL and minimal capex requirements. Cash represents 30 % of its equity cap. Major shareholders and their approximate ownership include: Gabelli (20%), Dimensional (9%), Bricoleur (7%), Ariel, Teton & Kennedy (each ~5%). We believe there may be a large shareholder who, as result of some liquidity issues, has stock for sale, which creates an entry opportunity for this illiquid stock. Finally, as discussed below, we believe there are several catalysts that will lead to an appreciation in the stock price.
Previously EDGW had focused on the customized building of software for its clients. However, over the past few years EDGW has refocused its business to product-based consulting services whereby EDGW implements Oracle, SAP, Microsoft, and other software. We believe EDGW is an important partner for these major software vendors, who often provide sales leads to EDGW and rely on EDGW to implement their software and interact with end-user customers.
For a company so small, some may be surprised to learn that (we believe) EDGW is one of Oracle’s top five IT service provider partners in the U.S.; one of SAP’s top service partners in the Northeast U.S.; and a leading service provider for Microsoft’s Dynamic CRM software in the U.S. We view the successful strategic relationships EDGW has with these major software companies to be a strong validation of EDGW’s work product.
EDGW targets upper-middle global 2000 companies. EDGW’s revenues are well-diversified with its top 10 customers representing less than 25% of total revenues and no single customer representing more than 5% of total revenues. EDGW customers are primarily in North America and the company has very little exposure to Europe.
EDGW has a diversified and established customer base including many well-known firms in the following sectors: Manufacturing (Bausch & Lomb, Lojack), Healthcare (Penn Medicine, Miami Childrens hospital), Insurance (Trustmark, Delta Dental), Hospitality (Extended Stay America, Hilton, Carnival), Retail (Motorcoach Industries, Autonation), and Financial Services (Marsh, Discover, Mastercard). As mentioned during the recent earnings call, EDGW continues to sign up new customers.
Approximately 80% of EDGW’s revenues are channel-related with Oracle, SAP, and Microsoft. EDGW provides services under the following brands: (1) Edgewater Technology provides business advisory and technical consulting services to clients implementing transformational products that provide a high rate of return; (2) Edgewater Ranzal is a recognized expert in EPM product-based consulting in the Oracle Hyperion channel; (3) Edgewater Fullscope is an award winning Microsoft Dynamics AX partner that provides product-based ERP services for manufacturers; and (4) Edgewater SAP provides EPM product-based consulting in the SAP channel, working with tools such as BPC and BusinessObjects.
Equity Cap $34.6
Earn out (2.6)
Ent. Value $23.9
LTM FCF calculation
Adj EBITDA 8.0 (excl stock comp)
Cash tax (0.5)
We expect EBITDA and FCF to be higher in 2012 due to continued growth in the business (last quarter the company generated double digit organic growth). In addition, EDGW recently announced a facility restructuring that will result in an EBITDA increase of $0.6 million annually.
Management has not yet given guidance for 2012. We believe CJS Securities is projecting $9.4 million of EBITDA (excluding stock comp) for 2012.
Not all databases, research reports or press releases back out the non-recurring items and add back stock comp as we have done here.
1) Over the LTM, the company incurred $1.1 million of non-cash stock compensation, a big number relative to its GAAP profits.
2) Maintenance capex of approximately $600k annually is significantly less than D&A of $3.0 million annually.
3) An approximate $24 mm NOL (equivalent to the company’s Enterprise value) significantly reduces cash taxes. Management has guided to an approximate cash tax rate of ~17%.
For the above reasons, we believe ebitda and eps valuations can be deceiving. Thus, we believe a free cash flow analysis (Adj. EBITDA +stock comp-int-cash tax-maintenance capex) is a better valuation methodology.
Equity Cap/LTM FCF ($6.9 mm) 5.0x
EV/ LTM FCF ($6.9 mm) 3.5x
EV/LTM Adj EBITDA ($8.0 mm) 3.0x
We believe the best way to value EDGW is to apply a multiple to fcf then add back net cash. Assuming a 7.5x multiple for hypothetical purposes, this implies:
LTM FCF per share $0.61
Implied Value/share $4.59
Plus Cash/share $0.94
Total Value/share $5.53
Implied Premium 81%
The above analysis is for illustrative purposes only. It does not in any way reflect our thoughts on the appropriate valuation of the company. As a reminder, the above analysis uses LTM figures, which we expect to increase over time.
EDGW has incurred some legal costs relating to a lawsuit which is detailed in the SEC filings. The key issue is that EDGW is the party suing, so in the worst case scenario the company will receive nothing. If they win, EDGW could receive over $1 million. It is unclear exactly how much additional money EDGW will need to spend on this suit, but we do not believe it will be material.
WHY IS STOCK MISPRICED
1) Microcap stock with limited float
2) Investors do not appreciate turnaround/change in underlying business
3) Analysts and data bases not always using “correct” financials
4) NOL, D&A>capex, non-cash stock comp and large cash balance often not reflected in some valuations
5) Non-recurring items (legal, etc.) obscure actual results
6) Management’s IR not optimal
CATALYSTS THAT CAN LEAD TO SHARE PRICE APPRECIATION
(1) Continued stock buybacks – last quarter EDGW repurchased 1.2 million shares (~10% of shares outstanding) and still has authorization to repurchase lots more shares.
(2) Improved investor relations – management is eager to improve its IR and to do more of it. They are presenting at Sidoti’s conference tomorrow and are very eager to communicate with potential investors. We believe once more investors learn about EDGW and the strength of their business, the stock should appreciate.
(3) Continued strong results – we expect EDGW to continue generating strong results over the next several quarters which could result in a higher multiple. Although the company will record a large non-cash charge this quarter due to the facility restructuring, once it starts reporting “clean” results, it may get on more investors’ radar screen and obtain a higher multiple. Continued organic growth may also attract new investors.
(4) Accretive acquisitions – management has done 2 acquisitions in recent years, both of which were successful. Management is conservative and we do not believe any acquisitions are imminent.
(5) EDGW is acquired – we believe EDGW may be an attractive buyout target for other traditional consulting firms or accounting firms who are seeking to expand their presence. We believe a buyer could generate significant cost saving. Furthermore, considering the disparity in multiples, an acquirer could likely pay a very large premium and still have the transaction be accretive. We do not believe a takeover is imminent nor do we know how management would respond to a takeover offer…but we would not be surprised if a buyer ultimately emerged.
Talk to Frank about Edgewater Technology