technologycapital

SELLRECOMMENDATIONCTCAPITALLLCCornerstoneOnDemandInc.
March26,2014IINVESTMENTRESEARCHCTCAPITAL1SELLRECOMMENDATIONCornerstoneOnDemand(CSOD)Price:$54.
28FairValue:$27.
26MarketValue$2.
8billionFreeCashFlow(FY2013):($1.
0MM)OperatingCashFlow(FY2013):$17.
4MMOperatingCashFlow(FY2013)AdjustedforBalanceSheetItems:$1.
4MMBalanceSheetDebt(FY2013):$220MMTotalDebt:$262MMQ1Release:May1CTCAPITAL2TableofContentsSummary.
3Background4Competition5NeedtoRaiseAdditionalEquity6StockBasedCompensationandBonus'8Geographic.
9CaseforaBuyout.
10Credit.
11CashFlowAnalysis12PopularMethodforComputingDCFAnalysisIsIncorrect12FairValueDCFSensitivityModel17CostofCapital.
18Miscellaneous26401K26Legal.
26Commitments26Auditor26CatalystsandConclusion263SummarySellsidefirmsareunabashedlybullishonCSODresultingfromaglowinglypositivemanagementteamnotshyregardingfutureprospects--infinancialpresentationsandfinancialfilings—supportedbystronggrowthinGAAPrevenuesandprofits,withforecastsofsimilargrowthinupcomingperiods.
Thisviewwasreinforcedbythefirm'slatestreportforitsFY2013inwhichrevenuesandbillingsgrewbyabout50%,andsubsequent10-Kandinvestorcall.
Thebullishsell-sidescenarioisalsocenteredonCSODbeingtoutedasaremainingindependentmid-sizedhigh-growthvendorinalargeuniverseofproviders,withanabilitytoattractagrowingcustomerlist,asevidencedbyabaseofover1600,fromlessthan600threeyearsprior.
Yet,despitetheglamor,thefirmhasnotbeenabletoturnitsgrowthinrevenues,billings,andclientbaseintoafirmthatisevenamodestproduceroffreecashflows.
Whenconsideringmisclassificationerror,amongotheradjustmentswemakeinourcashflowworksheet(Table5)—suchasprincipalpaymentoncapitalleaseobligationsbeingreportedasafinancingactivitywhichwemovetoanoperatingactivity—freecashflowsbecomeevenlessimpressive.
Centraltothecashflowanalysisislargestockbasedcompensation,whichduring2013accountedforover100%ofreportedcashflowfromoperationswhilereducingthetaxbillbyabout$2MM.
Ibelieveitisessentialtoanalyzethefirm'scashflowsofitsbasicbusinessandwithgreaterintrospectionwhen(a)additionallong-termfinancingwillcontinuetobeneededand(b)itisbespokenasapotentialtakeoverwithsuchspeculationactingassupportunderitscurrentvaluation.
Analysts'cashflowworksheetsareincorrect.
TheyarebasingmuchoftheiranalysisonEBITwhichbearslittlerelationtothefirm'sactualfreecashflows.
TheyarealsousinganincorrectWACCbasedona30%taxrate,wheninfacttheshieldiszero.
Althoughtheinterestrateontheconvertibledebtislow,whennegotiated,thiswillnotbethecase,andinanyeventdoesnotreflecttheactualcostofstraightdebt.
Ifanalystsweretouseamoreaccuratedepictionofcostofequitycapitalintheirdiscountratemodels,evenunderhighlyoptimistic(noroomforerror)freecashflowprojections,suchwouldsliceatabout24%offtheircurrentvaluations.
1Astothefirm'sprobabilityofbeingacquiredthattooisquitedoubtful,forsuchanacquisitionwouldbesubstantiallyvalue-destroying(seelatersection,pp.
9,"CaseforaBuyout").
Itwouldthusnotappealtoeitherafinancialorstrategicbuyeriftheformerwasconcernedwithcoveringcostofcapital,assuchbuyersrequirearealfreecashflowtojustifytheafter-taxcostofinvestmentwithleverage,notafreecashcreatedbynavemodelsinpopularusebyanalysts,suchasthatshowninTable10.
Itisfurtherdoubtfulastrategicbuyerwouldspendontheorderof$3.
7billion,aseventhehighestcredits,likeORCLandIBM,haveweightedaveragecostofcapital(assuming80%equityfinance)inthe7%rangewhileCSOD'sfreecashflowbasedreturnoninvestedcapital(forthenewowner)wouldbebelow2%giventhosefirmscashtaxrates.
AsCSODhasa14%costofcapital,basedonitspredictabilityofprospectivefreecashflows,adealwouldbehazardous.
Givenalllargefirmsspeaktohavingastrong1Analystsareusingan11.
9%costofequitycapitalbasedonabetaof1.
2.
TothinkCSODhaslessrisktocashflowsthanDisney,EMC,orEBay,amongmanyothersisinmyopinion,nonsense.
4acquisitionpolicyandhurdlerate,adealbecomesabigunderdogandnotarealprospectourresearchindicatesanysuchfirmsurveyedwouldconsiderforapriceclosetoitsdealvalue,andassimilarlyreflectedbyourvaluationtable.
Thecompany(CSOD)isatanearzerotaxrate,onlypositiveduetomodestfranchiseandforeigntax.
Thistoowouldmitigatethepossibilityofabuyoutastherearenotaxsavingstobehadbyashiftingdomicile.
Sharecountcreepcontinuesasthefirmcannotaffordtorepurchaseshares,yetontheotherhandreportedcashfromoperationsisbenefittingfromverygenerousstockbasedcompensationprograms.
Overthepast2years,theactualsharecounthasincreasedfrom49.
4MMsharesto52.
8MM,withmuchmoresharegrowthtocome.
Thefirmisexpectingasharecountof53.
3MM(weightedaverageduringtheyearunderGAAP)forthecurrentyear,butinrealityitwillbehigher,Ibelieve,byabout2millionshareswhenusingactualsharesasstatedonthecoverofthe10-K.
Stockbasedcompensationhasbeenaneffectualtoolformanyfirms,andCSODisnoexceptionassharesarebeingsolduponvesting.
Over1.
3MMsharesweresoldbyinsidersoverthepastyearwithnoinsiderbuys.
Thecompany'sJuly2018convertible(at$54.
04)notesbearinterestofjust1.
5%.
Obviously,holdersarecurrentlysomewhatdisappointedgiventherecentfallintheshareprice.
Thenotescanalsoconvertifthecommonremainsinexcessof$70.
25,unlikelyatthisstage.
Giventhelackofataxshieldandnormalrisingrates(averagehistorical10yeartreasuryof3.
92%,Table2),interestexpensewouldbegreaterthanthecurrent(2014)projectedfreecashflow,ifcurrentdebtneededtoberepaidatmaturity.
Thechiefconcernisperhapscompetitivepressure.
IfonebelievesthatORCL,SAP,CRM,andmanyotherswithhugemarketcapitalizations(manyover$100billion)whooccupythespacearegoingtositbyandwatchafirmwith$52MMinequitymarchtheirclientsoutthedoor,theyaremistaken.
Thesoftwarebusinessisbyitsnaturefraughtwithvolatility,andeventhoughCSOD'sclientstypicallysignmulti-yearcontracts,theycanleaveinahurry.
Infact,Ihavebeentoldbycompetition,theycouldbe"crushed"ifthelargestfirmssochoose.
Ifnotforconversions,stockissuances,andstockbasedcompensation,thefirmwouldhavesubstantialdeficitequity.
CSODhasdisappointedinvestorsthepasttwoquarters.
Ibelieveanotherpoorquarterortwothisyearshouldbegintoturnsomeanalysts—allofwhomareverybullish—away.
BackgroundConerstoneOnDemanddeliversSaaS(softwareasaservice),providingemployerswithcloudbasedsolutionsinpersonnelandtraining.
Thefirmbelievesitsproductsenableorganizationsofallsizestobetteroptimizetheirworkforceresultinginimprovedbusinessexecutionandcustomerintegration,includingthesalesforce.
Theyfurtherbelievetheirsoftwareiseasiertodeploy,lessexpensive,andeasytoconfigure.
Giventhegrowthoffirmrevenues,suchpointsaredifficulttoargue.
5TheirIPO,inMarch2011,waspricedat$13withthesaleof10.
5MMshareswithGoldmanandBarclaysasjointbook-runningmanagers.
The$135MMproceedswereprimarilyusedtorepaydebt,sellingshareholdersandworkingcapitaltofinancegrowthandlosses.
TheinitialprivateequityfinancingwasprovidedbyBessemerVenture,MeritechandBayPartnerswhoreceivedpreferredsharesat$1.
60andstockwarrantsat$2.
40.
AtthetimeoftheIPO,thecompanyclaimed580clients.
LoanswerealsoprovidedtoseniormanagerspriortotheIPOwhichwerethanrepaidwiththestocksale.
AllNEO'sandventurefirm5%owners(Bessemer,MeritechCapitalandBay)soldsharesattheIPO.
Subsequently,BessemerandBayhavesoldalltheirsharesandMertiech,whichowned15%priortotheIPOisnowdowntoabout6.
8%,andbeingparedannually.
CompetitionMostlargecompetitorsarerecognizingtheimportanceofSaaSandaresodevotinglargeresources,boththruexpansionofinternalbudgetsandviaacquisitions.
AllarecurrentlyexpandingintoCSOD'sspace.
LastyearSuccessFactorswasboughtoutbySAP($96billionmarketcap)ina$3.
4billiondeal,whileSalesforce.
compurchasedRypple.
OracleboughtTaleofor$1.
9billion.
Whilethelatestroundofacquisitionsbylargerplayershasnothurtthecompanytodate,itcan'thelptheirpositiongoingforwardascompetitorsaresubstantiallystrongerandgearingup.
Recruitingandtrainingsoftwareissimplynotadifficultspacetoenter,remainingsubjecttoenormouspricingpressuresasthefieldheatsup.
Clientswithglobalpresencearegoingtodemandafirmwiththecapabilitiesandinfrastructuretofulfillthoseneeds,andalreadyfirmslikeIBMandothersarepenetratingemergingnationsdownattheuniversitylevel.
2Yet,Ifinditquiteinterestingthatinthefirm'spresentations,managementrarelybringsupthesubjectofcompetition,otherthantobrushitaside.
CSODhastotalR&Dspendingofjust$21MM,comparedtoover$3billionforSAPand$4.
5billionforORCL.
WorkdaySolutions,NetSuite,Accenture(teamswithSalesforce),IBM,andliterallyeverylargeSaaSproviderareenteringthefield,allhavingsubstantiallygreaterresourceshavepricingpowerinaneraofthecostconsciouscustomer.
Duringitslastconferencecall,CSODmanagementboastedtheywerebadlybeatingbothORCLandSAPinlandingnewcustomerson"theirownturf.
"Itakethatasacalltoactionfortheotherplayers,whowerecertainlylistening,eveniftheyneedtotakeonsomelossesthefirstyearsofcontracts,andinfactIexpectCSODtolosebusinessasrivalsbegintocompetemoreonpriceanduseoflessexpensiveoverseasdevelopersandback-officesupportalreadyinplace.
Yetforallthelargeplayersinthespace,manyupstartsarefindingtheirwayin,boostedbyprivateequityfunds.
FirmslikeTakeWorkday($15.
9billion)arebecomingimportantentrantsandahandfulofnewerfirmsarecertainlyboundtohavevariouslevelsofsuccess.
OtherfirmsinthespaceallfindinggoodlevelsofsuccessincludeNetSuite($7billion),ConcurTechnologies($4.
7billion),UltimateSoftware($3.
7billion),andJiveSoftware($1.
2billion).
2Forexample,seehttp://www-01.
ibm.
com/common/ssi/ShowDoc.
wssdocURL=/common/ssi/rep_ca/8/897/ENUS214-068/index.
html&request_locale=en6Rypplewasstartedwithjust$13MM,indicatingtheeaseofpenetratingthespace,luredbythelargepotentialrewardsreflectedinthecurrentmarketvaluesofthesefirms.
CSODisfortunatetohavebeeninatthebeginningofatrend.
Yet,andalmostwithoutexception,investorsbecomefooledbyinitialsuccessstoriesthefirstfewyearsfollowingthebirthofnewindustries.
ThegrowthbeingseenbyCSODneverlastsforfirmsabouttofacestrongerplayershavingsubstantiallygreaterresourceswithlong-termprovenR&D.
ThesuccessesseenwiththelikesofNFLX,AMZN,andPCLNaretiedtoanadvantagethatCSODsimplydoesnothave,andsuchiswhyweareseeingthelargenumberofupstarts.
Competitivepressureisundefeatedinademocracy,aswasshownbyalltoomanyotherfastgrowth,softwareandtechnologyfirmsthatwereboundto"changetheworld"buteventuallyfoundcompetitionwasmorethanimagined:AOL,Napster,Kozmo,AltaVista,SiliconGraphics,Sega,SunMicrosystems,Blockbuster,Dell,andYahoo.
Andthereareplentymoreyouneverheardofthatenjoyedannualgrowthratessimilarto,orgreaterthanCSOD,alsowithanimpressivelistofclientsandcan'tmissattitude.
AndlikeCSOD,theydidnothavethefinancialmuscle(likeGOOG),andscopeoftalentwithheavyR&D(likeGOOG)tomakeitlong-term.
Technologychangesalltoo-quickly.
NeedtoRaiseAdditionalEquityCSODneedstoexpanditsportfolioofproductsandincreaseitsdirectmarketingforce.
ItssparseR&Dbudget,will,soonerratherthanlater,presentamajorobstaclerelativetothecompetition,asitssoftwarebudgetmustincreaseconsistentwithmanagementandthemarket'srequirement.
Table1-BalanceSheet201320122011201020097CSODhasfrequentlymentionedtheneedtoexpanditsofferings,whichwillagainrubsquareagainstthesignificantlylargerplayers,andscoresofsmallerfirms,allofwhomarelearningfromtheFacebookmodelofbuildingtheclientbaseandonlylatermonetizingtheasset.
Developmentworknotonlyentailslargercashoutflows(includingmarketingbudget)buttherisksofdevelopmentdelays,productstandardandclientacceptance.
Anyslipwoulddearlycostafirmhavingaminimalequitybase,likeCSOD,andmustbesorecognizedinthecostofcapital,thatrateofreturndemandedbyshareholders.
Forthisandotherreasons,thecostofequityusedbyanalystsisfaulty,forshareprice,thebasisofbeta,isforCSODmoreafunctionoftheexecutivessuccessinsellingthestory.
Thefirmdoesnotcurrentlyhavesuchneededcapital,norisexpectedtogeneratethecashfromsalestoaccomplishthis,needingtosupportitscurrentsalesgrowthwithnearlybreak-evenfreecashflows.
Asthatproblemlingers,thecompetitivelandscapesteepens.
Admittedly,thefirmlikelyhasafewquartersofimpressivetoplinegrowth,withstillinsufficientfreecashflowscoming,butunderneaththesurfaceishowthisfirmmustbeassessed.
ItisdoubtfulCSODwillbeleaningtowarddebtfinancinggiventhelackofataxshield.
Yet,sharecountwillcontinuetoforgeaheadasstockcompensationgrows,Fornamedexecutives(NEO's),bonustargetsarebasedmainlyongrowthofrevenues,withverylowtargetsforoperatingcashflows,amere15%weightingbytheBoardinthedeterminationofbonuslevels.
CSODwillneedtotapthedebtmarket,especiallysogiventheneedforgreatercompetitive(capex,R&Dandmarketing)resourcesandasits$253MMconvertiblenotescomeclosertoJuly1,2018.
Whileitwillmostlikelyhavethecashtoredeemthenotes,giventhecashitreceivesfromstockvesting,upcomingcashfromoperations,andexistingbalancesheetcash,useofthatsmallcushionwouldnotbewisegiventheneedtostepupthediscretionaryspending.
Idonotbelievethefirmwillbeabletocontinuetosolelyrelyondeferredrevenueandstockbasedcompensationasthemeanstoprovidelong-termfinancing.
Ibelievethefirmwillneedtoissuehigheryielddebtasthattimedrawsnear,andtheratewillbesubstantiallyhigherthanthe1.
5%interestrateduetotheappealoftheconvertiblefeature.
Obviously,holdersaresomewhatcurrentlydisappointedgiventhecurrentstockpriceandmaybereluctanttoagainacceptalowyieldgoingforward.
Thenotescanalsoconvertifthepriceofitssharesisinexcessof$70.
25,unlikelyatthisstage.
Aconversionofpreferredstockseriestookplacein2011,andthefirmwouldliketoseehistoryrepeatwiththenotes,addingtoequitywithouthavingtorecast,althoughIdon'tbelievetheywillgettheirwishthistime,addingpressuretothestockifanadditionalequityraiseisneeded,whichIbelievewillbethecase.
Becausetaxesarenotimposedontheincomeanenterprisepaysasinteresttocreditors,theincometaxsystemcreatesabiasinfavorofdebtfinancing.
ThiswouldnotbenefitOSODduetoitsclosetozerotaxrate.
Infact,itisquitelikelyinterestrateswillberisingtowardthenormalhistorical3.
9%10yearTreasuryrate(Table2).
Givenafirmwitha14%costofcapital,aprobablepre-taxrateofinterestforCSODwouldbeontheorderof6.
5%.
On$253MMthatwouldequateto$16.
4MMorover100%ofthe2013freecashflow,and41%of2015anoptimisticprojectedfreecashflowforecast.
Underour8worksheet,includingnormalizingstockbasedcompensationandotheritems,cashinterestexpensewouldruncloserto85%on2014freecashflows,dependentonnewsignupsasreflectedindeferredrevenuecollections.
Hence,theurgencytocontinueto"promote"thefirmpriortotheonslaughtofcompetition,toraiseadditionalcapital.
Table2-Historic10YearTreasury(Risk-Free)Rate:Mean:4.
64%Median:3.
92%Min:1.
53%(Jul2012)Max:15.
32%(Sep1981)Source:BankAmericaStockBasedCompensationandBonus'Idiscussstockbasedcompensationasithasbeenusedbythefirmasameanstosavecashandraiseequity,whilerewardingemployees.
Executiveshavebeengoodat"talkingthegoodstory"toinvestorsandsoprovidingtheliquidity(584,000sharesaveragevolume)forthesharestobesold,andhavesold,asvested,withover1.
3MMsharesinthepastyear.
Althoughmostawardsdonotresultincashbeingexchangedupongrant,futurecashflowsareclearlyaffected,i.
e.
sharebuybackstooffsetdilution.
Yettodate,CSODhasnot(ofcourse)beenengagedinbuybacks,forcingsharesoutstandingtoriseabout1.
5MMperyear,whichmayriseasmuchas2MMthisyear.
Fromacash-flowstandpoint,companiesgainflexibilitytotheextentthatstock-basedgrantsprovideanalternativetocashcompensation,improvecredit,whiletheirshareholderinterestsarediluted.
TaxcreditsareshownasanoperatingitemonthecashflowstatementunderU.
S.
GAAPonlytotheextenttheyrelatetotheaccountingexpense;ifthetaxdeductionexceedstheamountattributabletotheaccountingexpense,suchexcessisafinancingitem.
Asnecessary,wemakereclassificationadjustmentsinourcashflowworksheet,yetbecauseCSODisinazeroFederalrate,nosuchadjustmentwasrequired.
Theemployergenerallyiseligibleforataxdeductionequaltothefullamountofthestockwhentheemployeevestsintherestrictedstockortheintrinsicvalueofthestockwhentheoptionisexercised.
Firmsthattradeathighervaluationmultipleswillbeaccordedagreatertaxsavings.
UnderFASBStatementNo.
123(R),forbookpurposes,acompanygenerallymeasuresthecostofemployeeservicesreceivedinexchangeforanawardofequityinstrumentsbasedonthegrantdatefairvalueoftheaward.
FairvalueisnormallydeterminedusingaBlack-ScholesoptionvaluationmodelandissorecordedonCSOD'sincomestatement.
Thatcostisamortizedoverthevestingperiod,asshownintheCSODfootnotesregardingbothoutstandingwarrantsandthestockoptions.
9Whenarestrictedstockvestsoranonqualifiedoptionisexercised,theamountoftheemployer'scorporatetaxdeductionisfixed.
Atthattime,itisevidentwhethertheamountdeductibleonthetaxreturnisgreaterorlessthanthecumulativecompensationcostamortizedoverthevestingperiod.
Excesstaxbenefits,ifany,arecreditedtoadditionalpaid-incapital,andofcoursetherearenoneforCSOD.
BonustargetsforCSODareextremelygenerous,withrevenuesassigneda75%weighting.
ForMr.
Miller,CEOandfounder,terminationevenwithoutcausewouldcausea$12.
4MMpayment(healsoowns11.
2%oftheoutstandingshares);Mr.
Wallach,theCFOalmost$7M;Mr.
Seymour,EVPforStrategicAccounts,$5.
5MM.
Othersarealmostasgenerous,butthisshouldpaintthepicture.
Allinsidersremainveryactivesellersofthestock,includingMr.
Miller.
Underitsplansthepotentialforsubstantialdilutionisapparentasreferredtobelow:Our2010PlanprovidesthatonJanuary1stofeachfiscalyearcommencingin2012andendingon(andincluding)January1,2020,thenumberofsharesauthorizedforissuanceunderthe2010Planisautomaticallyincreasedbyanumberequaltothelesserof(i)5,550,000sharesofcommonstock,(ii)fourandonehalfpercent(4.
5%)oftheaggregatenumberofsharesofcommonstockoutstandingonDecember31stoftheprecedingfiscalyear,or(iii)alessernumberofsharesthatmaybedeterminedbytheourboardofdirectors.
Our2010ESPPprovidesthatonJanuary1stofeachfiscalyearcommencingin2012andendingon(andincluding)January1,2020,thenumberofsharesauthorizedforissuanceunderthe2010ESPPisautomaticallyincreasedbyanumberequaltothelesserof(i)1,200,000sharesofcommonstock,(ii)onepercent(1.
0%)oftheaggregatenumberofsharesofcommonstockoutstandingonsuchdate,or(iii)anamountdeterminedbyourboardofdirectorsoradulyauthorizedcommitteeofourboardofdirectors.
Source:2013ProxyGiventhecurrentsharecount,onewouldexpect,undertheEquityIncentivePlan,totalshareseligibleforfuturevestingunderplanscouldgrowby2.
37MM(the4.
5%rule)thisyear.
AndfortheESPP,totalsharestogrowbyanadditional1%or528,000shares.
These,ofcourseareBoarddecisions.
ItwasannouncedinJanuary,subsequenttothefilingoftheFY201310-K,sharesissuedundertheESPPincreasedby524,699.
Therearecurrentlyover7.
4MMsharesallowedtobeissuedunderexistingplansandRSU's.
GeographicThefirmoperatesinmanyoverseascountries(using3rdpartymarketers),yetasshown,significantgrowthisresultingbasicallytheUS.
Yet,itishere,wherethecompetition,bothnewfirmsfundedbyprivateequity,andoldestablishedplayers,arediggingin,andtheselatterfirmsarenotabouttogivewayintheirmostimportantmarketatatimegrowthishardtocomeby.
10Table3SalesvsGeographyGeography201320122011US128,98381,83750,874UK19,44812,9308,612Other36,69823,14713,536Total185,129117,91473,022Source:201310-KCaseforaBuyoutEverybuysideanalystmakesacaseincorporatingthebeliefCSODisripeforabuyertocomealongandmakeabidforthecompany.
Yet,thisisnotthe1990's.
Simply,givenotherdealsthathavetakenplace,whywasn'tCSODamongthemTheanswerissimple.
Today'sCEOneedstomakeafundamentalcaseforanacquisitionofthissize,asthefirmhasa$2.
8billionmarketcapnotincludingdilutionfromthewarrants,restrictedstock,andotheroptionsandincentivesthatwouldbecomedueandvestedshouldabuyercomeintoplay,letalonethepremium(convertdilutionishedgedbutnotwarrants)mostlargerownerswoulddemandgiventhecurrentshareprice.
Itappears,atpresent,CSODisdrawingnopresentinterestfromobviousplayerseagertoexpandtheirpresenceinSaaSandcloud-basedsoftware.
CSODpaid$49.
5MMtohedgetheconvertiblenotesandinturnreceived$23.
3MMforthesaleoftheconcurrentwarrants(forwhichitmustissue4.
7MMsharesabove$80.
063).
Abuyerwouldneedconsider,includingadditionalwarrantstopurchasewarrantsof133,000sharesheldbyADPat$.
53andwithwhomithadapriordispute,ifthetotalcostofcloseto$3.
7billionmadesense,tobuyafirmthatunderstretchedcircumstances,evenwiththepowerofalargepartnerwhocouldtakeadvantageofalargeclientbase,producenomorethan$40MM,ifthat,inannualfreecashflowsyearsdowntheroad.
Suchpotentialacquirermustconsiderthemanynewplayerscomingintothefield,manyofwhomhavebeenfundedby"moversandshakers"inprivateequitywhohavedonethisbeforeandarefamiliarwithtechnologystart-ups,aswellasthelargedilutiveeffectonfinancialmetricssuchadealwouldentail.
Allfirmswereviewedthatcouldconceivablymakeabidspeaktoanacquisitionpolicyofacandidate(target)earningitscostofcapital.
Clearly,CSODwouldnotmeetthatrequirement.
AndgivenCSOD'sminimalequity,itwouldneedtodrawadditionalcapitalfromtheparent,furtherincreasinganacquirer'scost.
Thiswouldbeneeded,asoutlined,asthefirmdoesnotcurrentlyhaveapositivecashbasedreturnoncapital.
Undertheoptimisticassumptionfreecashflowsweretoriseto$50MM,anunlikelyscenarioformanyyearsatleast(ifever),whilereturnoninvestedcapitalwouldbeimpressive,likelyinthemid30%range,suchwouldbeduetothelowcapitalrequirementsofthefirm,notareflectiontocovercostofpurchasebasedonalogicalcostofcapital.
Whenviewedunderthemicroscopeofafreecashyieldonmarketvalueorfreecashyieldonenterprisevalue,conclusionsarevastlydifferentfromROIC.
Forinstanceatafreecashflowof$50MM(minusinterestincome),freecashflowyieldona$3.
7billiontakeoutisjust1.
4%(atzerotax),waybelowanordinarycostofcapital,letalonecostofequityforasmalltechfirminanindustrybrewingwith3Thesewarrantsissuedaspartoftheconvertiblenotefinancingareincludedinshareholders'equity.
11potentialcompetitors.
Thusevenforanacquirerwithsurpluscash,thedealdoesnotmakecashsense(value-destroying).
Iffinancedwithover$1billionindebt,freecashflowswouldremainnegative,evenattheassumed($50MMpre-interest)rate.
Itwouldthusneedtobeanall-cash/stockdeal,andthattoo,ofcoursewouldbevalue-destroying,giventhecashreturnandexistingvaluationmultiplesforconceivablepublicentitieswhicharepotentialsuitors.
GivenCSOD'szero"cash"taxrate,freecashflowwouldfurtherbemitigatedasupstreampaymentsweremadeattheacquirer'staxratewhencalculatingthedivision'sROIC.
ForexampleORCLisina22%cashrate,IBMabout20%,SAPandACNbothabout24%.
MostoftheNOL'swouldbelostinabuyout,andalllargecountriesarecurrentlyexaminingtheuseoftransferpaymentsintaxavoidance.
Ibelievetherearechangescominginthisareawhichwillboostthecashtaxrateforinternationals.
Insiders,includingthefounderMiller,continueasheavysellersofstock.
AlthoughMr.
Millerreportedownershipof11.
2%lastApril,itisdownfrom13.
3%ayearago,andgivenreportedsales,lowersince.
Onewouldpresumegiventhecontinuingsales,hewouldhavepreferredasaleofthecompanyatahigherpricethanwasrealizedinunrelentingopenmarkettransactions.
Outstandingdilutionscouldconceivablyadd$500hundredmilliondollarstoanysuchdeal,givenexistingoptionsandpotentialdilution,dependentonwhatcontractswereworkedoutwithexecutiveswishingtostayonascontinuingconsultantswiththenewfirm.
Non-employeedirectors(5)ownoptionstobuyalmost600,000sharesofstock.
TheBoardisstaggeredwitheachclassserving3yearterms.
ClassIIuntil2016;Class1until2015,ClassIIwhichincludesthePresidentandLeaddirectorwhoareupthisyear.
CreditTotalobligationsarestraightforward,consistingof$271MMinlong-termdebt(includinginterest)ofwhichmostaretheconvertiblenotes,$1.
1MMincapitalleasesand$26.
8MMinoperatingleases.
Theyreportde-minimusoff-balancesheetobligationsandcommitments(laterclarified).
Idonotviewthefirmashavingacreditissueasaresultoftheequityconversions(whichhadbeenrunningabout1.
5MMsharesperyear,andmayriseabout2MMormoregoingforward);anacquisitionmadeprimarilywithstock,andlackofsharerepurchases.
AsseeninFigure1,interestexpenseiscurrentlyoflittleconsequence,yetcouldeasilyconsumeasubstantialportionofcashflowsifsalesgrowthdoesnotmaterializeandtheBoardadmitstheneedforsteppedupdiscretionaryspending.
Afterall,whilespending60%ofsalesonmarketingisimpressive,$21MMinR&Disnot,giventhelikesofSalesforcespending$624MM.
Goldman,whichrantheIPO,shouldbeinapositiontoraiseadditionalequity,ifneeded.
Asseen,CSODfanciesconvertsincapitalraisingalternatives,whichhastodate,allowedthefirmtoavoidhavingnegativeshareholders'equityatacheaprate.
In2010,$133MMwasconvertedtocommon.
Thesameyear,$87MMofstockwasissued,alsohelpingfundthelosses.
Stockbasedcompensationandtheequitycomponentoftheconvertsadded$46.
4MMtoshareholdersequityinFY122013,almostequaltothatofcurrenttotalequity.
Clearly,theyhaveacontinuingneedtoraiselong-termcapital.
Figure1-InterestExpenseSmallNow,butProjectedtoRiseCashFlowAnalysisItisdifficulttoconceiveasoftwarefirmwith1600clients,$185MMinrevenues,andmodestcapitalspendingandresearch,cannotgeneratemorethannearbreak-evenfreecashflows.
Yetthatremainsthecircumstancegiventhelargecontinuingmarketingspend.
Thoughourfreecashflowanalysisandworksheetindicatesthereislittlereasonforsuchoptimism,sell-sideanalystsneverthelesscontinuetoplayupthecashflowgeneratingpowerbasedonadecadeouttimehorizon.
PopularMethodforComputingDCFAnalysisIsIncorrectGoldmanSachshasa$68pricetargetbasedona10yearDCFmodel.
WhileIgivekudustoanyanalystwhoevenattemptstoforecastatechnologyfirm's(letaloneonewhichhasbeeninbusiness12yearswithamere$53MMequityhavingnot"eaten"equityviabuybacks,dividendsorexcessivecapex)freecashflowsadecadeaway,todosowhencurrentfreecashflowsarebreak-evenislittlemorethanapartygamewithnosolidbasis.
Sell-sideanalysts,liketheonementioned,donotmaketheimportantadjustmentstothestatementofcashflows,includingover-andunder-spendingandreclassificationerror.
Evenifaninvestorfeltsuchanalystsfreecashflowmodelwasaccurate,theprojectedrisefrom6centspershareto60centsisstilljusta1%yieldgivenprobabledilution.
Thisanalyst—andImerelyillustratehisworkasheseemstorepresentconsensus"Street"thinking,illustratedbyahightolowrevenuesestimaterangeoflessthan$3MM--isforecasting,for2014,ariseinreportedGAAPcashfromoperationsfrom$17.
4MMto$33MMwithcapitalspendingof$19.
4MM,stillmakingthefirmnearfreecashneutral,duetoadjustments.
Asthefirmmustcontinuebeinggenerouswithexpensesrelatedtomarketing,itisdifficulttoseeadjustedfreecashflowsover$25MM0.
001.
002.
003.
004.
005.
006.
007.
00Y04Y05Y06Y07Y08Y09Y10Y11Y12Y13Q4Y13132yearshence4given(a)therealneedforstepped-upspendingonR&Dand(2)otherissuessuchastaxes,additionalmarketing,capex,comp.
benefits,etc.
Bearinmindthatover100%ofFY2013cashfromoperationsresultedfromstockbasedcompensationalone.
Afallinthesharepricewillputacrimpinthisfinancingtool.
TheGSanalysisusesa30%taxrateinhiscalculation,providingforalowercostofdebtthanisreallythecase,giventheactual"cash"taxrate(Table4)andsmalllikelihoodsuchwillchangeinthecoming4yearsgiventhelargeandstillgrowingNOL.
TheuseofEBITinsteadofactualfreecashflow,asshowninTable5,isincorrect,beingbasedoffGAAPincomestatementcomponentsandwithoutregardtocapitalspending(intensity)andotherinvestment(softwareandothervendor)requirements,workingcapitalrequirements,taxes,paymentstominorityowners,amongotherdeficiencies,andshouldnotbeusedasabaseinthecalculationofreturnoninvestedcapital.
EBITorEBITAoftenbearslittlerelationtofreecashflowsandisevidentagainhere5.
Forthefirminquestion,returnoncapitaliszerotonegativeduetothelackoffreecashflows.
Ourmodelsalsonetoutcashinterestincomeandcashonthebalancesheetinthecalculationofreturnoninvestedcapital.
Foranewbuyer,theproperpricewouldbethecostoftheinvestedcapital,notthecurrentreportedGAAPassetvalues.
Whatstrikesmemostregardingourcashflowworksheetisthesimplicityofthisfirm.
Typically,wemakemanyadjustmentsforafirmthissize,includingcostofsalescomponents,andanyunusualitemscontainedtherein(supplychain,pension,insurance),aswellasfactoringoutdepreciationandmovingothercomponentstoSG&Aorelsewhere;SG&Aitself,totaxesandhealthcareandlitigation.
BecausethefirmisinazeroFederaltaxrate,nosubstantialtaxorotherrelatedre-classificationwasnecessaryregardingthelargestockbasedcompensation,excessbenefitsshownasafinancingactivity.
Normaladjustments,includingreclassificationaswellasover-andunder-spendingnormallywouldbeinthe$15-20MMrangeforafirmthissizeandsimilargrowthrateinacompetitivesector.
Thesizeofthenumbersinthestatementofcashflowsarequitesmallindeedwiththeexceptionofstockbasedcompanddeferredrevenue;financialactivitiesrelatetocapitalraises.
ThecurrentsmallfirmdiscretionaryspendmanagementhasearmarkedtosupportfuturegrowthagainstmajorplayersishighlyunusualgivenCSOD'sgrowthstage.
Salesandmarketingrunsover500%ofR&D.
Asidefromthetaxaccount,thereislittlegoingonthatisdifficulttoanalyze.
Derivativesarenotutilized.
Capitalspendingislowforthefirmandmaybearesultofadecisiontopreservecash.
WhileSaaSistypicallyassociatedwithalowlevelofcapex,inordertogrowsales,the$21MMR&Dbudgetmustsubstantiallyincreaseifthefirmistoeffectivelycompetewiththeexistingplayersandcertaincomingonslaughtofnewcompetition.
AsseenwithSalesforce.
com,capexbudget(Figure3)andits$624MMresearchbudgetdwarfssuchexpendituresforCSOD.
Forthisreason,ourcashflowworksheetpicksupnoexcesscapitalspendingorresearch—everydollarisneeded—andinfactshouldmostlikelybe4Thatsaid,weallowforsuchinourDCFmodelwithsmallerthanexpectedincreaseintheactualsharecount.
5SeeSecurityValuationandRiskAnalysis,pp.
250-26714consideredasunderexpenditures.
Thisunderspendingisafactorinthefirm'shighcostofcapitalasfutureabilitytocompetemustbequestioned,andataminimumwillbeaconsiderablylargeruseofcashgoingforward.
Theproblemis,ofcourse,thefirmequityhasbeenessentiallydepletedasaresultoftheoperatinglosses.
Accrualsamountedtojust$22MMforFYE2013andisimmaterialtothecashflowanalysis.
AOCIissmallandrequiresnoadjustmentstothecashflowworksheet.
Capitalleaseprincipalpaymentsaremovedtooperatingcashflowsforaccuracyandcomparability.
Capitalleasessignedduringtheyearwereforcapitalequipmentandfurniturefortheworkforce.
Operatingleasestotaled$26.
7MM,notanimportantfactorintheanalysis.
Taxexpense("Cash"RateTable4)wouldhavebeenevenlowerifabletorecognizeotherbenefits,notpossiblegiventheexistingrate.
AsofFY2013,totalNOL'samountedto$146MM,withFederalnotbeginningexpiryuntil2019.
AtakeoverwouldnegatemostoftheNOLbenefit,andforeigncreditsareotherwisesmall.
Table4-CashTaxesand"Cash"RateThecashflowworksheetmakesnomajortaxadjustments(somebenefitisinfactrecognized)orreclassificationasaresultofthezerotaxrateandlargeNOLwithmanyyearstorun.
GAAPlossescontinueandshouldagainthisyear;it(therate)doesrequireaboostincostofequitycapitalasseeninthatworksheet.
SuchadjustmentstocostofcapitalareatoddswithtraditionalequityanalysteducationwhichcontinuestorelyontheCAPM(asverifiedbyEDGARfilings).
Analystsalsogravitatetowardtheeffectivetaxrateinsteadofthetrueshieldofthecashtaxrateintheircomputationofcostofdebtcapital.
Theeffectiverateforthefirmwas32%forFYE2013.
Wecouldhave,infact,penalizedthecashflowsasanunder-expenditureofR&D,yetchosenottoasaresultoftheheretoforelargepercentagerevenueincreases.
Ourcostofcapitalqualitativeadjustmentattemptstolook"overthemountain"anddoesslightlypenalizethecapexspend.
Costofcapitalshouldbelookedatasabarometerofrisktofuturefreecashflows,thepossiblereturntoshareholdersforsupplyingequitybasedcapital.
Stockbasedcompensationreducedtaxableincomebyapproximately$2MMforFY2013.
15Figure2-CapitalSpending-CornerStoneFigure3-CapitalExpendituresSalesforce.
com0.
001.
002.
003.
004.
005.
006.
007.
008.
009.
0010.
00@NA@NADec06Dec07Dec08Dec09Dec10Dec11Dec12Dec13Dec130.
0050.
00100.
00150.
00200.
00250.
00300.
00350.
00400.
00Jan05Jan06Jan07Jan08Jan09Jan10Jan11Jan12Jan13Jan14Jan1416Table5CashFlowWorksheet-CSDO17Table6-AdjustmentSummaryAdjustmentstoReportedOperatingCashFlowFYE2013CFO17Non-recurring:0B/S-1Adjustments-2Other0incomestatement0.
4Footnote0Financingact.
0Inv.
Act.
-16TotalAdjustments-18TotalAdjustmentsas%ofFCFn/aFairValueDCFSensitivityModelInrecognitionofthedelineatedrisksshownnextasTables8and9,associatedwithholdingtheequitysharesofCSOD,itscostofequitycapital,wearriveatafairvaluewerethefirmtogenerateabout$11MMinfreecashflowfor2014(just$2MMlowerthan"street,"duetoadjustments)andthenallowfor50%growththru2018,20%growththru2023,15%growththru2030,then3%.
Weallowfornodownorevendisappointingyears.
Itallowsfornolargestockdilution,orothernegativeevents,suchasincreasedcompetition,marketingissues,lossofkeypersonnel,clientretention,legal,developmentandsoftwaredevelopmentissues,recession,orotherissuesthefirmissuretoface.
DisplayedinTable7aresensitivityfairvalueestimatesbasedonvariouscostofequitycapitaldiscountratesbasedonthegrowthinfreecashflowscitedinthepriorparagraphanddiscountratesaslowas8.
5%,whichisonlyslightlyabovethe8.
1%currentcostofcapitalfortheS&P500,andnohigher(althoughaccordedahigherweighting)than14%,theactualestimatedcostofcapitalourmodelindicatesascorrect.
Theresultisablendedfairvalueof$27.
70,veryclosetoourtargetprice.
Atanunfairlylow8.
5%discountrate,fairvalueisstillsome26%belowthesharepricecurrentvalue.
18Table7FairValueAsfootnotedearlier,analystsarebasingtheirDCFcostofequityona1.
2betaundertheCAPM.
Useofthepropervalue,14%,basedonallknownthreatstofuturefreecashflowshasprovenamorereliableandcommonsensemetric.
Thedifferencebetweenusinga"street"costofequityof11.
9%,andthe14%ourmodelbelievesisfair,isa24%lowerfairvaluetarget,of$24.
31vs.
$18.
43.
Thetargetgivesnocredencetoatakeover.
Itpurelyvaluesthefirmasa"goingconcern.
"CostofCapitalThefollowingtwoworksheets(quantitativeandqualitativefactors)areessentialinarrivingatareasonableestimateofour14%costofequitycapital.
Althoughweareevaluatingcostofequity,thecostofdebtisametricsinsuchanalysis.
ForCSOD,costofdebtislow,theweightingofthecompositiongearedtowardlowinterestrateconvertibles.
Thisdebtwillneedtobenegotiatedin3-4yearsasmypremisewillnotallowforthe$54conversionpriceatthattime.
Ourcostofequitycapitalmodelsarebasedonestimatingthepredictability(withrelatedstrength)ofprospectivefreecashflows.
CSOD'sfreecashflowshavethusfarnotbeensufficientforthefirm'sneeds,andhavesoofferedshareholdersnocapitalreturn.
Atthispointitremainsariskybetagainstcompetitorswithnearlyunlimitedbudgetstoforecastlargefreecashflowsbeginninginseveralyears,justifyingthecurrentpriceoftheshares,andsoforecastedbyanalysts.
Management,toitscredit,havebeenstrongmarketers(bothtonewclientsandinvestors),yet,asespousedearlier,thefinancialhistoryDiscRte.
ProbabilityFV8.
50%5%$39.
698.
75%5%$38.
219.
00%5%$36.
819.
25%10%$35.
4610.
50%25%$29.
5611.
50%25%$25.
6914.
00%25%$18.
43FairValueCashFlow100%$27.
70NetCash/Debt*0FairValuePerShare$27.
70*Excludesanytaxonrepatriation19booksarefulloflargeGAAPgrowthprojectionsthatnevermaterializedintheultra-competitivesoftwareandtechspace.
Thisfirmhaslittlefixedassetsandsoftwarethatcontinuallyneedtobehard-pushedagainstthosecompetitorsover100timestheirsize.
Wesee,underthe"CashFlowheading:severalflagsforpoweroperatingcashflowswhicharesimplyreportedcashflowsfromoperationsadjustedforbalancesheetitemsbasedonrevenuechanges.
Hereweseealargebenefitfromstockbasedcompensationandless,butstillaflagforaccountspayable,recognizingthecashflowbenefit.
Theflagforvariabilityofsalesandcostofsalesisgivenduetoitslargegrowthrate,asistruefordeferredrevenue,animportantsourceoffinancingandrisktovaluationmultiple.
Whilethismaysoundatoddswithlogic(isn'tgrowthgood),themodeladdstocostofcapitalashighgrowthcontinues,especiallyrunningconcurrentlywithprogressivelylargerdollarvolumes.
WemadethesameadjustmentwithAppletwoyearsago,aswithmanysmalltomid-sizedfirmswhichultimatelyranupagainstthebetterheeledorsuperiorfastmovingtechnology.
Theflagsfordebtarenotseriousatthisstageandresultinalowmarktocostofcapital;itresultsfromdebtfinancing(nottotaldebtincludingleases)risingfrom$5.
6MMto$220MM.
Still,thefirmcouldnotatpresentrepaysuchdebtwithin5yearsfromthecurrentlevelsofcashflows,notthatsuchaneventisarealissue.
Taxesadd60basispointstocostofcapital.
Overtime,the"cash"andeffectiverates,andrelatedstabilityindexesofbothhaveproventobeareliableindicatorofriskduetolikelyunpredictablechanges,therebyeffectingfuturefreecashflows.
Theworksheetsshownbelow,withappropriateflags,eachaddingtocostofcapital,formthebasisofourcostofequity.
Severalitems,duetolevelofdifficulty,addanegligiblemarkupovertheriskfreerate.
Otherflags,ofcourse,wouldresultextremelyinseveremark-ups,aswouldbethecase(thoughnothere)iftheauditorresigned,thefirmlostalargeclient,orwasimpactedbysovereignrisk(Venezuela).
Firmsthatlosttheabilitytoraisefundsinthecommercialpapermarketcouldalsoresultinalargepenaltyduetothatcheapsourceoffunds.
Lackoffreecashflow,bothlastyearandhistorically,aswellasthecontinuingneedtoraiseequitycapital,asshowninthe"credit"section,addedover350basispointsovertheriskfreerate.
Table8-CostofCapital-QuantitativeASpecialReportbyCTCapitalLLCCORNERSTONEONDEMANDINCFlagsCashFlows:20OperatingcashflowOperatingcashflowOperatingCashFlowsover10yearsGrowingoperatingcashflows-recent5yearsOperatingCashFlowinthemostrecentquarterPowerOperatingcashflowXPowerOperatingCashFlowsover10yearsXGrowingPowerOperatingCashFlows-recent5yearsXPowerOperatingCashFlowinthemostrecentquarterXFreeCashflowFreeCashflow4-YearaverageFreecashFlowFreecashflowmultiple(P/4-yearaverageFCF)XDeferredRevenueXGrowingfreecashflows-recent5yearsFreeCashFlow-mostrecentquarterAccountsreceivableflagXAccountsreceivableflag-basedonthemostrecentquarterInventoryflagInventoryflag-basedonthemostrecentquarterNAAccountspayableflagXAccountspayableflag-basedonthemostrecentquarterDiscretionarycapitalexpendituresXDiscretionaryR&DXDiscretionarycostofgoodssoldDiscretionaryselling,general&administrativeDiscretionaryadvertisingCashburnrate-lastfiscalyearCashburnrate-mostrecentquarterUndergoingSigsharerepurch.
withdecliningOCFCapitalspendingXDebt:Growthintotaldebt-Recent10yearsGrowthintotaldebt-Recent5yearsXGrowthintotaldebt-mostrecentquarterXDebt/(4-yearaverageFCF)multipleXDebt/(4-yearaverageOCF)multipleXAbletorepaytotaldebtfrom4-yearaverageof(OCF-2/3capitalexpenditures)XAbletocovercurrentdebtbyfreecashflow21Abletocovercurrentandnextyear'sdebtfromFCFAbletocovertotaldebtfromFCFinthelast12monthsXAbletocovercurrentdebtfromnetworkingcapitalAbletocovercurrentandnextyear'sdebtfromnetworkingcapitalAbletocovercurrentdebtfrom4-yearaverageOCFAbletocovercurrentandnextyear'sdebtfrom4-yearaverageOCFAbletocovertotaldebtfromOCFinthelast12monthsXAbletocovercurrentdebtfrom4-yearaverageOCF+networkingcapitalAbletocovercurrentandnextyear'sdebtfrom4-yearaverageOCF+networkingcapitalDeteriorationinnetworkingcapitaltototaldebtXDeteriorationinnetworkingcapitaltototaldebtcurrentquarterXInterestcoveragefromworkingcapitalandFCFInterestcoveragefromworkingcapitalandFCFcurrentquarterOperatingleases/totaldebtPensionunderfunding/totaldebtS&PCommercialpaperratingS&PseniordebtratingIncreaseinpostretirementbenefit(healthcare)expenseIncreaseinpostretirementbenefit(healthcare)liabilityAbletocovercurrentandnextyear'sdebtfromcommonequityNACreditSpreadsTax:Taxexpense/pretaxincomeTaxpayment/PretaxincomeXStabilityoftaxratexTaxexpense/pretaxincome.
Mostrecentquarter.
XProspectivetaxrate(holiday,expirationofcredits,etc)xMiscellaneous:Countrycode(nonUS>0),flaggedifnon-U.
S.
QualifiedauditopinionAuditorchangeGrowthinF.
GInventory>GrowthinSalesNAGrowthintotalInventory>GrowthinSalesExtraordinaryitemsPensiongainInterestincomeSignificantacquisitionsDecreaseinorderbacklog22ReinvestmentindicatorXReinvestmentindicator-mostrecentquarterAbilitytopaydividendsfromoperatingcashflowPensionFund-AssumedReturnonAssetsincreasedfromtheprioryearPensionFund-AssumedRateofSalaryIncreasesdeccreasedfromtheprioryearIncreaseinthespreadbetweentheassumedreturnonpensionassetsandsalaryincreasesNACreditSpreads-MacroInflationExpectations-StLouisFedRelianceonMajorCustomerLitigation,LegalVariabilityofSalesandCOGSXProductivity:Sales/EmployeeGrowth-Recent5yearsSales/NetPPEGrowth-Recent5yearsXDisclaimerCopyright2014CTCapital,Inc.
Thisreportisforgeneralinformationalpurposesonly.
Itdoesnothaveregardtothespecificinvestmentobjectives,financialsituationorrisktoleranceofthereader.
Investorsshouldconsultwithperformtheirownduediligenceorconsultwithacompetentfinancialprofessionalpriortomakinginvestmentdecisions.
Thereport'sdataisgatheredfromsourcesitbelievescorrectbutweassumenoliabilityforitsaccuracy.
NeitherCTCapitalnoritsprincipalsoremployeesguaranteesuchaccuracyormakewarrantiesregardingresultsfromitsusage.
Noportionofthispublicationshallbereproducedinanyformatorbyanymeansincludingelectronicallyormechanically,byphotocopying,recordingorbyinformationretrievalstorageorretrievalsystemorbyanyotherformormannerwithoutthepriorwrittenconsentofCTCapitalInc.
AsidefromthequantitativefactorsseeninTable8,wealsolooktoqualitativefactors(Table9)whicharenotcapturedbythereportedfinancialstatementsorotherstatisticaldatabases.
Suchincludesasseen,thoserisksrelatedtoself-insurance,patents,relianceonkeycustomersorsuppliers,creditspreads,etc.
Theseareitemizedbelow,andasseen,thefirmisfairlyclean,yettherearemostpressingissuesconcerningsize,competition,industry,shareholdersequity,andmattersrelatedtotheresearchandcapitalbudgets.
Whensummingtherespectivepenalties(quantitativeandqualitative)forCSOD,wearriveat11.
35%addedtothe2.
62%riskfreerateoratotalcostofequitycapitalof14%.
Thatistheannualreturn23shareholdersshould,onaverage,demandforaninvestmentinthisfirmgivenitsprospectiverisks,asdelineated.
Wethereforebelievetheequitysharestobesubstantiallyovervalued,giventheuseofourcostofequityastheproperdiscountrate.
Table9-CostofCapitalQualitativeFactorsQualitativeFactorsNotproperlyAccountedForInQuantModelAllrightsreservedCompanyTickerCSODCountryRiskCountryriskexposure-USreliancexCurrencySupplyChainGovernmentTerrorismEducationHungerPovertyNaturalDisastersElectionsUnionsWar%ImportedOilNationalizationTaxRateInflationhistoryCommitmenttoMarketsandBizCorruptionMaplecroftCIAFactbookTotalScore-SoverignCDSpricerisk24ChangetoCostofEquityCapitalHeritageFoundationindexonbusinessfreedomDemocracyIndexInsuranceSelf-insurance,inclpotentialimpactRiseinPremiumsEffectonCashFlowClaimsSettlementsImportanceofUnderwritingrisk(insuranceco's)ChangetoCostofEquityKeyEmployee(s)SuccessionPlanImpactwithlossofInsiderOwnershipxBoardofDirectors,inclchangetoBoardStructure-independenceOtherX(notreflectedinmodel)Moralobligations8-KOtherFilingsSignificantSale(alsohaveconsequences)sectorxLitigationlifecyclexAnnouncementsxLargeAcquisition(incl.
announcement)NoncurrentdebtsfromM&A-commitments,deferredobligationsChangestoCapitalExpxTaxes-holidays,othertaxriskxManagementChangesDelaysinFiling25StateIssuesDerivativerisk(counterpartyrisk)CreditFacilities-Next2yearsCustomers-size,other-ifnotmodeledImpactofChangeinGDPRestatementsAuditorIssuesNotCoveredElswwhereRefinancingxReliabilityofSuppliesSusceptibilitytoCompetition(consumertechnologyeffect)xPatents,taxbenefits,otherexposuresLast5Years-ROIC/CostcapxPurchaseAgreementsOtherContractsorObligationsCommitments/ContingenciesChangetoCostofEquityLIFOBenefit/Reserve%CashHeldOutsideUS-ImpactWorkersCompIssuesB/SAssets-QualityinclmarketablesecuritiesCovenantsandchangestoNon-recurringitemsOtherpost-retirementandotherbenefitsPensionContributions-ImpactonOCFPBGC-ERISARisk(4062(e))ProxyReviewregulatoryriskstrategicriskxreputationalriskinventoryrisk(excess)Communication-toshareholders,employees,etcInternalcontrolsbusinessstrategyxriskculturePruneportfolioaswellasaddRiskManagerTowhomreportsBoardinvolvmentStockHighlyshortedorlargeincreaseinshortpositionSharebuybackProgramStrengthofcreditfacilitylendersCommercialPaperriskCDSswapspread=highweighting26ConcurrencewithCRA's(creditratingagencies)Operatinglease-termsand%upforrenewalHybridSecurities,shownasequitybuts/bdebt,orreversexSecuritizationsOtherretirementplans-SERP,etcoperatingleases.
%reclassifiedasinterest1/3Miscellaneous401KThefirm's401K,startingin2012,withmatchingcontributionsupto50%,$2,400maximum,and4yearvesting.
Cashcontributionsnormal;noimpacttocostofcapitalorcashflows.
Thecompanyreportsnopensionorpost-retirementobligations.
LegalAsidefromonesmallsettledsuit($2.
3MM),withnoapparentfearofspreading,therearenootherapparentissuesimpactingcostofcapital.
CommitmentsNoadjustmentswererequiredduetosuch,mostlyregardinglessorsanddirectors,andcommitmentrelatedtovariousthirdpartyvendorstotaling$15.
3MM.
AsnotedPVofoperatingleasesare$26.
7MM,althoughthereisapositivedrift.
AuditorFairopinion.
Accountingconsistentwithindustry.
PricewaterhouseCoopersLLP.
CatalystsandConclusionTherecomesatimethatevenfirmswithastrongtoplinemustproducefreecashflowsandGAAPprofits.
Todate,thathasnotoccurredforCSOD,andevenifsuchtakesplaceduringnexttwoyears,freecashflowswouldmostlikelybesmallinrelationtoitscurrentmarketvalue,givenneededexpenditures.
Now,stronger,largerplayersareenteringinforce,aswellasmanyworldwideemergentupstarts.
Thehoardofanalystswhorecommendpurchaseare,inourestimation,usingantiquatedcashflowmodelswhich,inreality,donotmeasuretherealabilityofafirmtoreturncashtothesuppliersofequity.
Thesepopularmodelsdonotaccountforunusualchangesinthebalancesheet,makeclassificationerroradjustments,accountforoverandunder-spending,oradjustformarketrates,extraordinaryactivities/events,orotherfactorswhichcouldbereliablyusedinemploymentofreturnoncapitalorothervaluationmodels,aswellascomparisonstocostofcapital.
Suchatypical27worksheetforCSODisshownbelow(Table10),materiallydifferingfromourTable5,despitethesimplicityofthisfirm'saccounting.
Table10-CSOD-NaiveAnalystCashFlowWorksheetUnfortunatelyforCSOD,thecompetitioncouldbeexpectedtonarrowitspositiveproductgap.
Asanalystsseesuchcompetingandimprovedproductscomingon-streamalongsidegrossmarginpressureaspricecompetitionentersthepicture,thecombinationshouldspookatleastafewofthemanybuysideanalystswhoarecurrently,withoutexception,verybullishonthestock.
Ifonesuchanalystweretoturn,whichIbelievewillhappeninthecoming12months,thesharesinCSOD,givenitsultra-richvaluation,wouldbebroughtdownclosertoourfairvaluation.
RecalltheimpacttosharesinApplewhenjustonewell-knowninvestorturnedaway.
Insofarasapotentialtakeoverisconcerned,andthatsentimentissharedineverybuysidereport,Idoubtthattobearealisticscenarioasthenumbersarenotsensibletoapotentialinvestormakinglargescaledecisionsonthebasisofcostof,andreturnon,capital,especiallyconsideringlikelylargedilution.
CSODjustdoesnotpassthereturnhurdles.
Itisalwayspossible,ofcourse,forafirmwithconsiderableexcesscash,byvirtueofoptimisticprojections,aggressiveinvestmentbankers,orantsyshareholderslookingtodeploysaidcashcurrentlyearninglessthan1%,couldattempttomakeabuyoutcasebylookingatablue-skycrystalball10yearsintothefuture,astheanalystfromGoldmanattempted.
Ourdiscussionsleadustobelievethisisnotinthecurrentthinkingofseveralplayersbasedontheirattitudetowardcapitalefficiency.
SharesinCSOD,likeallfirmswithhighcostofequity,arevolatileinstruments.
Smallperceptionsregardingfutureprospects,realorperceived,canbeexpectedtoresultinlargeswingsintheshareprice.
Thisisnotreflectedbyits1.
2beta,whichisaflawedmeasure.
Witha14%costofequity,asmalleventwithquiteminimalimpactoncashflowscouldconsequentlypropelthestockineitherdirection.
Withthatcaveat,aswellasthe"greaterfool"caveat,havingseenlotsofvalue-destroyingacquisitionsmadeforavarietyofreasonsatthetimeofannouncement,itishardtoplaceavalueonthesharesofCSODinexcessof$27.
26.
Andsuchvaluation,Ibelieveastretch,asshownunderourvaluationTable7.
Idonotbelieveintheuseof"comps"forafirmnogreaterthancashneutral,orperhapsthisyear,veryslightlyfreecashpositive,anda14%costofequity.
Intensecompetitionisexpectedintheyearandyearsaheadwhich,Ibelieve,theyarenotadequatelypreparedtocontest.
28KennethS.
Hackel,CFA***Thisreportisforgeneralinformationalpurposesonly.
Itdoesnothaveregardtothespecificinvestmentobjectives,financialsituationorrisktoleranceofthereader.
InvestorsshouldperformtheirownduediligencepriortomakinganinvestmentintheCTCapitalLLCrecommendation.
Thereport'sdataisgatheredfromsourcesitbelievescorrectbutweassumenoliabilityforitsaccuracy.
NeitherCTCapitalLLCnoritsprincipalsoremployeesguaranteesuchaccuracyormakewarrantiesregardingresultsfromitsusage.
Noportionofthispublicationshallbereproducedinanyformatorbyanymeansincludingelectronicallyormechanically,byphotocopying,recordingorbyinformationretrievalstorageorretrievalsystemorbyanyotherformormannerwithoutthepriorwrittenconsentofCTCapitalLLC.
TherearenorefundssubsequenttothereportbeingissuedforanyreasonasitrepresentsthesoleopinionofCTCapitalLLC.
andbasedonproprietarymodelsandanalysisnotemployedbyothersecurityanalysts.
***