Elliott Vs. Commvault: Low Hanging FruitRupert Hargreaves
Earlier this week, hedge fund Elliott Management Corp on Monday disclosed a 10.3% stake in Commvault Systems Inc, as well as nominating four directors to the company's board.
Commvault, which provides data and information management software applications, saw its shares jump by more than 12% after the announcement that Elliott, which is known for its aggressive nature in shaking up companies to unlock value for investors, had become one of it's largest investors.
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Elliot, which manages around $33 billion for investors, believes Commvault’s troubles include severe margin underperformance, weak financial targets, recurring execution issues and lagging corporate governance, issues it intends to fix by bringing fresh blood into the company. According to initial reports, two of the four board nominees the firm has put forward, have ties to private equity firms, igniting speculation that Elliot could end up pushing for a full sale of the firm.
Elliott said it is looking forward to “constructive engagement” with the company to find a “mutually supported path forward” to create significant shareholder value.
According to equity analysts at Wells Fargo, one of the leading issues of contention for Commvault's shareholders has been the company's operational inefficiencies — something Elliott's letter highlights. Indeed, Commvault spends around 75% of its revenue on operational expenses, something no other companies in its software peer group replicate, even those companies that are growing much faster. Sales and marketing expenses are also much higher than the company's peer group. The sales and marketing expense ratio is in the mid 50% range, compared to other software companies, which average 10% percentage points lower. Elliott believes Commvault should generate a “mid-20% non-GAAP operating margin with a high-single-digit growth rate, which would drive a ~3x increase in profitability by 2020 vs. C2017 levels.”
And not only is Commvault less efficient than its peers, but the company is also pursuing what Elliott has labeled a “sub-optimal” capital return strategy.
The analysts at Wells point out that over the past five years the firm has spent $550 million on share repurchases, although this has done little to reduce the number of shares in issue. Indeed, the actual number of fully diluted shares in issue has increased by 3.8% over the same period. That's not to say that the company lacks the financial firepower to increase its capital returns strategy by a significant amount. Commvault has $446 million on its balance sheet currently in total cash and investments earning only 0.1% in interest every year. There is $133.8 million (estimated) in available share repurchase authorization exiting the December 2017 quarter. Moreover, Commvault's cash generation gives the company plenty of scope to ramp up share repurchases, without taking on debt:
“Commvault currently has $445.5 million in total cash & investments (no debt) and has consistently generated solidly positive FCF in-line or above non-GAAP EBIT (we estimate ~$130-$160 million/annum.; upside potential into $200 million/annum range could be considered at 25%+ operating margin). We believe investors could consider an appropriate capital return strategy of $300 million+; introduction of leverage with attractive rates.”
Elliott calls out Commvault's capital allocation strategy in its letter and also goes on to criticise the firm's new headquarters, which was built a few years ago with a cumulative spend of $131.3 million, which seems an excessive outlay at the expense of investor returns.
However, despite the fact that the company is being run inefficiently and is not using its balance sheet in the most optimal way for investors, both Elliott and Wells believe that the firm does have a robust customer offering; a differentiated underlying technology platform with a robust feature set and ” important scalability advantage.”
It seems this is where Elliott wants to extract value. Commvault already has a robust product offering and customer base, it's just the operational side of the business that needs to be refined to help improve investor returns.
Wells' equity analysts note that the firm's expanding partner ecosystem now includes HP Enterprise, as well as long-standing alignments with Microsoft Azure, as well as Amazon and Google.
More than anything, this is a play on data. Management has informed the market that Commvault manages 200 petabytes of data in the public cloud, which has increased by a factor of three over the past 12 months. Its market advantage should only advance over the coming year as it ramps the exposure of HyperScale product. “During the F3Q18 earnings call Commvault noted that its HyperScale appliances are opening up significant market and distribution opportunities in both the enterprise and mid-market. Commvault’s HyperScale ramp is a focus as the company competes against privately-held, well-funded, start-ups like Rubrik and Cohesity.”
In its letter, Elliott did not give any indication of what it believes is the per share fair value price for Commvault, although based on current metrics (and the scope for the company to significantly improve efficiency and profit margins) the potential upside could be significant. Indeed, Commvault currently commands one of the lowest valuations in the software sector with an EV/2018 Revenue multiple of just 2.8x, at the other end of the spectrum, Workday Inc commands a multiple of nearly 9x EV/2018 Revenue.