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Phoenix Technology (PTEC): A Compelling Software Turnaround

November 29th, 2006 by Yehuda Fruchter | No Comments

Investment Summary
Even though investors may have to suffer thru several more quarters of losses, we think that Phoenix Technologies (PTEC), the leading supplier of BIOS software for PC’s, is an attractive turnaround investment opportunity at current prices. (Note: The price of PTEC’s stock was $4.55 as of this writing).

Over the next two years the shares could begin to rebound sharply as the company starts showing dramatic financial improvements and investors begin to price in new growth opportunities for the business. Specifically, the hiring of a new group of proven technology turnaround executives coupled with the release of Microsoft’s Vista operating system in 2007, have enhanced the company’s future prospects.
At the same time, we also do not see much long-term downside risk for PTEC’s stock at current valuation levels, even assuming that our positive scenarios for the business do not pan out over the next two years. The company’s strong financial position and leadership in the stable BIOS business eliminate any terminal risk for the company and increase the odds of an eventual takeover should current turnaround efforts fail.
The People
In September 2006, Phoenix hired Woody Hobbs as new CEO. Mr. Hobbs was the former CEO of Intellisync which was sold to Nokia in late 2005 for over $400 million. During Mr. Hobbs 5-year tenure, Intellisynch’s revenue more than tripled and the stock rose by over 500%. Prior to Intellisynch, Mr. Hobbs served as the chief information officer of Charles Schwab. He received 900,000 shares of PTEC stock at $5.05 at the time of his hiring. We expect that in mid-2007, Mr. Hobbs will begin to unveil several aggressive growth strategies, which could attract renewed investor attention to the company.
In addition to Mr. Hobbs, PTEC has also recently hired two other well-known technology executives. Dr. Gaurav Banga, the former VP of Product Development of Intellisync and the creator of VeriChat, was hired as the new chief technology officer of PTEC. Richard Arnold, another high-level executive at Intellisync, and the former CFO of Charles Schwab, was hired as the VP of Strategy at PTEC. Mr. Arnold received options on 600,000 Shares at $4.45. Mr. Banga received options on 275,000 shares at $4.51 per share.
Finally, aside for these executives PTEC has a highly active base of institutional investors who have been pressing for corporate change for quite some time and have bought into the stock at much higher prices. Chief among the activist investors is Ramius Capital, which recently actually offered to buy 90% of Phoenix for $5.05 per share. We encourage you to read thru Ramius’s initial 13-D filing for a decent summary of the investment thesis for PTEC’s shares. You can access the filing here:

http://www.sec.gov/Archives/edgar/data/832767/000092189506001435/sc13d06297pho_06052006.htm

The Business
Basic Statistics
As of 9/30/2006 Phoenix has about 26 million shares outstanding, $60 million in cash, and no debt. We estimate that, in a worst case scenario, the company could burn thru $20 million in more cash before returning to profitability in late 2007. We also estimate a core, sales run rate of about $40 million per year with gross margins approaching 80%.
Background
Phoenix was founded in 1979. The company is the leading provider of BIOS software for digital devices based on the x.86 microprocessor architecture.
What is BIOS? From Webopida: “BIOS is Acronym for basic input/output system, the built-in software that determines what a computer can do without accessing programs from a disk. On PCs, the BIOS contains all the code required to control the keyboard, display screen, disk drives, serial communications, and a number of miscellaneous functions. The PC BIOS is fairly standardized, so all PCs are similar at this level.”
In plain English, the BIOS makes software that loads a computer’s operating system when it is turned on. It provides a critical link between hardware platforms and operating systems. In case you may not have noticed, when you turn on your PC, you will see something related to the BIOS flash across your screen before Windows is loaded. In most cases, the BIOS software that is loaded on your PC comes from PTEC.
PTEC’s customers include major computer manufacturers such as Dell, Matsushita Electric Industrial Co. Ltd., Lenovo Group Ltd. (which acquired IBM Corp.’s personal computer division last year), Sony Corp., and Hewlett-Packard Co.
Comments
We like PTEC’s business for three primary reasons:
• Solid Brand, Operating History, and Customer Base
While not a well-known consumer brand, Phoenix Technology is one of the best known software brands in the PC industry. The company’s software has been a core component of computing systems for over 20 years. The company’s customer base is a who’s who of the consumer computer world.
• Stable Business Outlook that is Defensible
Though the company has failed in the past to build additional growth businesses upon its dominant BIOS position, it is clear that the company has a solid business foundation that cannot be easily replicated and which should provide stable revenues for quite a long time, i.e. as long as x86 computing devices are used. In addition, it is highly unlikely that the technology surrounding BIOS will change much in the company years, preventing any technological obsolescence for PTEC’s core product. This highly defensible core BIOS business provides solid downside business protection for investors in PTEC’s stock.
• High Gross Margins
PTEC, like Microsoft, essentially licenses its core BIOS software to PC manufacturers for a share of revenue on every PC that is sold. This is a business with 80%+ gross margin potential. Without much in R&D or marketing expenses, the BIOS software business is essentially a cash cow, if managed properly.

What Went Wrong Here?
Despite establishing a dominant position in one of the most important software components in the PC market, management incompetence prevented PTEC from ever fully capitalizing on this unique position. Specifically, management attempted to diversify into enterprise software application businesses that leveraged next to nothing from the company’s dominant BIOS business. As is usually the case in business, this diversification outside of their core business was unsuccessful and led to bloated corporate overhead and significant losses.
In addition to a failed diversification strategy, management also severely damaged the attractiveness of the BIOS business by implementing fully paid-up license pricing policies for the BIOS software, instead of using the royalty-based license model, wherein the company gets paid for the use of BIOS on every single PC. The paid-up licensing model severely undermined the perceived value of the company’s products, limited revenue predictability, and put pressure on average selling prices.

What Has Changed?
Under the leadership of new CEO, Woody Hobbs, PTEC has quickly exited from several of the unprofitable enterprise software businesses and thereby reduced headcount by over 15%. In addition, the company has decided to fully eliminate the use of fully paid up licenses in the BIOS business in favor of royalty-based pricing model. Finally, Microsoft’s delayed launch of the Vista operating system has caused a slow down with PC makers which has negatively impacted PTEC’s top line. However, with the launch of Vista expected in early 2007, PTEC should see a significant increase in revenues as PC makers are forced to order new BIOS software to be installed on the new Vista systems. These new BIOS “upgrades” will also allow PTEC to renegotiate unfavorable terms of past license deals and move towards a complete royalty-based model.
Risk Analysis
Phoenix faces several major risks on a go-forward basis:
• Continued Losses
The company will report significant losses for at least the next two quarters before revenues can increase enough to cover fixed overhead costs. In addition, though Mr. Hobbs was quite successful in fixing up Intellisync for a sale to Nokia, our research suggests that he never really steered the company to profitability. So it is conceivable that he has no intention of driving PTEC to profitability either. It’s possible he just wants to significantly increase the top-line without worrying much about profits. This is a risky strategy which will only pay out for investors in the event the company is sold and/or is hyped to other investors. Mr. Hobbs clearly has the skills to accomplish these two objectives, but betting on the “greater fool” is at times a risky proposition.
• Acquisition Activity Could Backfire
A key component of Mr. Hobbs strategy at Intellisync was aggressive acquisition activity. We expect he will pursue the same strategy for Phoenix. Acquisitions are always a risky endeavor.
• Dependence on Slow Growth PC Industry
Phoenix’s core BIOS revenue is primarily dependent on sales of PC’s. As is well-known, the PC market is no longer the growth industry it once was. As such, despite the fact that the BIOS business is stable and very profitable as a standalone operation, one cannot expect major growth from BIOS software going forward.
• New BIOS Licensing Model Could Backfire
As Phoenix moves towards the new royalty-based licensing model for BIOS software and seeks to renegotiate deals with customers, it’s possible that customers will balk at the new pricing model. In such a case, it is conceivable that Phoenix will lose business to competitors, who may offer more favorable pricing for BIOS software.

Importantly, even though the above risks seem daunting, the truth is that they mainly relate to execution risk going forward and are already reflected in the company’s current valuation. We do not think any of these risks would cause a major problem for the company as we still think the company would in the worst case have a stable base of $40 million in revenue for quite some time from the BIOS business. With 80% gross margins, this business would be very profitable.
Return Analysis
Since we are more focused on risk than return, we’ll keep the upside/hype scenario short. Basically, the company has just started implementing a major restructuring effort that will significantly reduce overhead costs on a go-forward basis. At the same time, the company’s top-line prospects appear to have improved given the move towards royalty-based licensing and the upcoming release of Microsoft’s Vista operating system in 2007. Plus there is a new management team that has proven experience in growing the top-line for small technology companies.
All in all, management is assuming a $15 million expense base here, and is therefore implying the potential for at minimum a $60 million+ revenue base over the coming few years. That would be about 50% higher than current base revenue levels suggest, implying pretty significant top-line growth. Notably, Hobbs tripled Intellisync’s revenue, and so it seems that he can do the same with Phoenix, especially considering that Phoenix actually had $80 million+ in annual revenue for much of the late 90’s and into 2000.
Valuation: Downside and Upside Scenarios
We think that in a worst case, a company with a dominant position in BIOS, selling software at 80% gross margins should be worth 2X base revenue + cash (2X Enterprise Value/Revenue). In the case of PTEC, assuming $40 million in cash, and $40 million in base revenue, that implies a worst case value of $120 million or about $4.60 per share, right about where the stock is currently trading.
On the upside, if new management can reinvigorate the company and get it back to more normalized revenue levels of $60 million, it’s conceivable that the company would be valued at 3X Enterprise Value. That would imply a valuation of $220 million or about $8.50 per share.
Giving each scenario 50% odds implies an expected value of about $6.50 per share, implying 45% appreciation potential in the shares.

Stratos International (STLW): Expect Some Fireworks Soon

November 22nd, 2006 by Envoy Global Research | 1 Comment

Last evening we noticed that Riley Investment Management LLC) filed a 13G on Stratos International (STLW), reporting an over 8% stake in the company. As you may already now, Stratos remains our top turnaround pick in the fiber optic sector. Our investment case was spelled out some time ago in this post and updated here. The stock still remains ridiculously undervalued, especially considering the recent rise in other larger, and yet paradoxically more "junky", fiber-related stocks.

FiberNet (FTGX) and Investing in Volatile Stocks

November 21st, 2006 by Yehuda Fruchter | No Comments

Guy, a subscriber, comments:

I highly respect the job you did of analyzing Interap and showing how undervalued it was. FTGX also appears way undervalued and yet it has dropped over 10% since what I think is a pretty strong report showing the company is on the verge of turning things around financially.

However, there is a big difference between INAP and FTGX, in that Internap has very valuable IP. INAP holds numerous patents on finding and using the best possible route across the internet, which it uses for its unique performance IP offering as well as its FCP box. I don’t see anything equivalent with FTGX. Furthermore, Internap is a company with global scope, with PNAPs in England and Asia and Canada, as well as throughout the US. FTGX is a small company with presence in just two (admittedly important) markets.

Finally, what is the gross profit margin at FTGX and will this increase? And to what extent are they gaining new colo customers? The market certainly seems very skeptical of FTGX – for reasons I don’t quite understand. I know that you like to find company’s that represent little downside risk to capital but it looks like an investor in FTGX, even now, will have to stomach downswings of 10-20%. This is something that will keep my investment very small for the time being.

Envoy Global Research Responds:

We agree with Guy’s analysis. INAP is a different company than FTGX in certain ways, and it is not a perfect comp for valuation purposes. But, INAP and FTGX share one very important similarity: the colocation business. In our view, it is the colocation business that is driving profits at all these IP Services companies, including INAP (before the VitalStream acquisition), and therefore there does not seem to be a reason why FTGX should be trading at such a discount to its peers given the high valuations afforded by Wall Street to all of the colocation companies. At the same time, we are well aware that colo is still a small part of FTGX’s revenues (20%), and therefore one needs to apply a discount to industry multiples when valuing FTGX as a whole.

In addition, even though INAP may have valuable IP assets, we think that FTGX’s metro fiber assets are potentially more valuable than IP, given the always questionable legal status of IP. However, metro fiber, given its status as a real estate asset, is almost always beyond doubt. We doubt they are going to build any more major carrier hotels in NYC/NJ any time soon, so FTGX’s fiber and positioning is significantly more valuable than the current market price implies.
In any case, the best way to value FTGX is by comparison to other carrier’s carrier companies, such as Looking Glass and Telecove, both of which were recently acquired by industry giant, LVLT. While it is difficult to get exact EBITDA figures for these companies, since they were private and LVLT somewhat obscures the cash-flow data, the valuations based on revenues are more transparent. From what we gather, Looking Glass with $75 million in revenue was acquired for 2.2X Enterprise Value to Revenue (EV/R). Telcove, with $390 million in revenue, was acquired for over 3X EV/R. We believe that Looking Glass is the best comp for FTGX given its size and the almost exact same business makeup (IP Transport + Colocation).

Therefore, assuming $40 million in revenue for FTGX, and using the Looking Glass multiple, one is forced to conclude that in the event of an acquisition, FTGX would be worth about $9 per share. Even at a significant discount to Looking Glass, FTGX should be worth $6 or a slight premium to tangible book value. These prices also appear quite reasonable, as paying 2X revenue for a recurring revenue stream with a stable base of customers is certainly justifiable.

So why is FTGX trading down? Well, we plead ignorance when it comes to understanding the stock market’s short-term price swings. But, it is important to mention that in the micro-cap stocks that we follow, such major price swings are quite common. This is why we always only invest a small amount of our entire portfolio in each individual small cap opportunity and why we stay extremely diversified in these types of investments.

Some money managers insist that you need a concentrated portfolio of stocks to outperform the market, and while that may be true if you actually have a say in the business, such concentration will surely lead to ruin when investing in small caps as a passive investor. The stocks are just too unpredictable and at some point you will take a 50% haircut.

Furthermore, the notion that concentration leads to outperformance is simply wrong when it comes to investing in small cap, turnaround stocks. Our real-life experience, and that of other successful investors, is exactly the opposite. Extreme diversification will lead to significant outperformance when the right types of stocks are chosen and one pays careful attention to valuation. The bottom line is that one needs to stay very diversified in turnaround and restructuring investments, if one intends to profit from the huge returns that a portion of these investments will ultimately provide.

Chatting with Jon A. DeLuca, CEO of Fibernet Telecom

November 16th, 2006 by Envoy Global Research | No Comments

We continue to believe that companies with high-replacement cost fiber
in metro areas are best positioned to benefit from the consolidation
wave sweeping the IP Transport and Colocation services market. As such
we were pleased to have recently had the opportunity to chat with Jon
A. DeLuca, President and Chief Executive Officer of FiberNet Telecom
Group (FTGX), a company that owns strategic metro fiber assets in key
US cities. While FiberNet’s cash profits are on the upswing, Fibernet’s
stock (FTGX) still trades at a significant discount to fully-diluted
tangible book value, and therefore appears to offer a low-risk way to
invest in the growth of the metro fiber and IP Services markets.

Web.com Making Progress

November 14th, 2006 by Envoy Global Research | No Comments

Even though we’ve been critical of Web.com’s (WWWW) management in the
past, we think the stock is an interesting value at current prices,
following the stock’s significant drop from its yearly high. Recent
M&A activity in the company’s sector and improved financial results at the company, appear to suggest that the stock has decent upside and low downside at recent quotes.

Crown Crafts (CRWS.OB): Betting on Babies

November 9th, 2006 by Yehuda Fruchter | No Comments

Betting on Babies

Introduction

At first glance, Crown Crafts, Inc. (CRWS.ob, Current Price: $3.30), an infant products company that just recently finished a major recapitalization, seems like a ludicrous stock to feature on our value-oriented site. The company’s shares are up more than 500% already this year, with most of the rise starting just a mere four months ago. However, when you dig a bit deeper, we think you may reach the conclusion, much as we have, that despite the already extraordinary rise, the stock still has significant upside left, with minimal downside.

Of course we wish we had discovered CRWS in early July, but as Bernard Baruch famously noted, “I never made money by buying at the bottom, nor by selling at the top.” Moreover, in the case of CRWS, it would have been next to impossible for any intelligent “outside” investor to have considered buying the stock near its low, given the fact that the company teetered on the edge of bankruptcy and massive shareholder dilution prior to recent unforeseen events.

For all intents and purposes, therefore, we think it is best to view CRWS as a post-bankruptcy company or IPO, notwithstanding the fact that the company’s shares were publicly-traded prior to its recapitalization this past July. When seen in this regard it is easier to eliminate that “fear of heights” which normally, and quite correctly, accompanies the purchase of stocks that have already risen substantially.

The Business

Crown Crafts, Inc. designs, markets and distributes infant and juvenile consumer products, including bedding, blankets, bibs, bath items and accessories, and luxury hand-woven home décor under licensed and branded collections. Major licenses include Disney, Baby Einstein, Scooby-Doo, and many other well-known entertainment and retail properties. A full listing of licensed categories can be found at one of the company’s websites at: http://www.ccipinc.com/

Sales of the Company’s products are generally made directly to retailers, which are primarily mass merchants, large chain stores and gift stores. The Company’s products are manufactured primarily in China. Major customers include: WalMart (35% of sales), Toys R Us (30% of sales), and Target (14% of sales).

Crown Crafts currently has about 10 million shares outstanding, and about $13 million in debt. Sales in the last fiscal year were approximately $73 million, with income from operations (EBIT or Earnings Before Interest) of about $7 million or nearly $0.70 per share (the company has substantial tax loss carryforwards).

The Problems: China and Major Leverage

Crown Crafts, Inc., was founded in 1957. The company operated for a long time as a domestic textile manufacturer, an industry, which due to the China phenomenon, has been in a major decline for decades.

However, instead of rationalizing the business as outsourcing to China gained momentum, management at Crown Crafts leveraged up the company in 1998 and acquired three other US-based textile manufacturers.

The attempt at consolidation though did not work and as business conditions in the textile industry continued to deteriorate Crown Crafts proceeded to lose over $100 million in a three-year period. In 2001, the company was forced to begin a major restructuring in order to avert bankruptcy. Since that time, the company has been engaged in significant asset sales and operational realignments, which included the outsourcing of virtually all of its manufacturing to foreign contract manufacturers.

Recent Changes and Their Significance:

Debt Refinancing and Warrant Extinguishment Lead To A New Lease On Life

After over five years of corporate restructuring, by year-end 2006, Crown Crafts had succeeded in reducing debt from over $100 million to nearly $48 million, and the profitability of the company was restored. However, the company was still hampered financially by significant lender warrants, high leverage, and hefty interest rates.

Then in July 2006, after convincing bankers that CRWS was on sound footing, the company announced a new financing package, which substantially reduced total debt, cost of funds and, most importantly, extinguished all of the warrants that were exercisable by its lenders. Specifically, prior to the refinancing the Company had approximately 36 million shares issued and $48 million in debt. Following the refinancing, the company now has only 10 million shares and merely $12.6 million in debt. Notably, of that $12.6 million in debt, only $9.7 million is interest-bearing, down from $16 million in 12% debt prior to the refinancing.

Following the announcement of the above refinancing, CRWS’s stock understandably zoomed upwards by over 300%, primarily because equity which was previously essentially worthless, suddenly had the possibility of retaining some value. However, despite the rise in the company’s stock, the shares still do reflect the potential growth that Crown Crafts can achieve now that the company is finally operating under a normalized capital and financial structure.

More specifically, now that the company’s management can cease worrying about day-to-day corporate survival, they can concentrate on growing the company via the leveraging of extensive overseas sourcing relationships, the development of new license opportunities, and the consideration of strategic acquisitions. The company’s recent announcement of the licensing of the “Baby Mink” brand for sale into the fast growing Hispanic market, is but one example of the numerous growth opportunities that have opened up for the company now that financing is no longer an issue for management.

As you’ll see from the figures below, even not assuming any growth above and beyond what the company already has, CRWS’s stock, at current price levels, remains extremely cheap by almost any standard of measurement.

The Price, Downside Risk, Upside Reward

Financial Condition is Solid

Before getting to some basic valuation considerations, it is important to note that there is little financial risk for Crown Crafts at this juncture. As noted above, the company now has minimal debt and interest expense is more than manageable based on conservative EBITDA estimates. The company does not have a substantial cash balance, but that is quite normal in this type of business and of no cause for concern.

Main Business Risk

The primary risk that the company faces now that it is no longer a manufacturer, is that major retail clients, such as Walmart, can go around CRWS and source products directly from manufacturers in China and thereby bypass CRWS, which is for all intents and purposes a middleman between China and Walmart. This is of course a risk that cannot be minimized, but it is something that almost every single retail product company currently faces in the US with ascension of China manufacturing and the dominance of big retailers, such as Walmart.

The major way to mitigate this risk is by gaining rights to valuable license properties, which lend a brand “aura” to your products, and/or by designing your own branded products. CRWS is pursuing both of these strategies, and recent financial results seem to indicate that the company is succeeding in these endeavors. At the same time, we think that now that the company can concentrate on strategic business goals, as opposed to financial restructuring initiatives, this drive to secure valuable license properties will accelerate. With time, and with some good negotiation, CRWS should be able to solidify its competitive position, to the extent that retail product companies can do this in China/WalMart world.

Valuations:

In valuing Crown Crafts, we would note that there is only one publicly-traded comparable. That company is Russ Berrie, which trades under the symbol RUS. The stock currently goes for a little over 1.2X Enterprise Value (EV) to Sales. However, a significant chunk of RUS’s sales are unrelated to the business line shared with CRWS. As such we think that the best way to get a valuation for CRWS is took look at RUS’s subsidiary, Kids Line, which was acquired by RUS in December 2004. Kids Line was a direct competitor of CRWS. RUS purchased Kids Line for $130 million, plus additional earnout considerations of over $10 million based on an EBITDA multiple of Kids Line EBITDA. The EBITDA multiple ranged from a low of 5 to as high as 8. We estimate Kids Line sales at the time of the acquisition at $74 million, implying a valuation of 1.75X EV/Sales.

Downside Price Risk: $2.50

Based on the above valuations for Kids Line, we estimate that CRWS is worth in the worst case scenario, 5X Average EBITDA over the last several years or $2.50 per share.

Upside Price Potential: $12

On the upside, assuming no top-line or EBITDA growth, which is very conservative, given the company’s recent earnings results, we think CRWS is worth at least 1.5X EV/sales or about $12. This would still be at a discount to Kids Line valuation, but the discount is warranted until CRWS proves several quarters of growth.

Conclusion

With at most 30% downside, and the potential of over 200% upside, we think CRWS is an excellent investment “gamble” at current prices.

Network Engines Reaches An Inflection Point

November 9th, 2006 by Envoy Global Research | 1 Comment

This morning Network Engines reported its first cash-flow positive quarter in quite some time, generating $1.5 million in cash on increased sales and improved gross margins. Notably, the company is reporting these results ahead of any potential sales increase from several partnerships which will kick into high gear in 2007. At current prices, we still think that NENG has one of the best risk/reward investment ratios we have seen in quite some time, and as we have mentioned in the past, this will be an exciting stock to watch in 2007.

Motive, Inc. (MOTV.PK): A Play On SupportSoft’s Resurgence

November 7th, 2006 by Yehuda Fruchter | No Comments

Introduction
Despite an ongoing accounting investigation and a lack of current financial statements, we think that Motive (MOTV.PK) is an interesting enterprise software stock to keep an eye on. As the company files updated financials in the coming months, investors may begin to feel more comfortable assigning the company a higher valuation, especially considering the recent increased value in MOTV’s chief competitor, SupportSoft (SPRT), and our belief that enterprise software shares will outperform the market in 2007.

Important Note: If you plan to trade in MOTV’s stock, please use limits. We do not recommend purchases above $3 and if you are extremely risk averse, you can wait till the company completes its restatements before considering this issue.

The Business
Motive, like SupportSoft, provides software that enables broadband providers to automatically deploy, maintain and support advanced voice, video and data services. Customers include: RCN, AOL, British Telecom, and many additional telecom and broadband companies. The company was founded in 1997, and went public in June 2004 at $10 per share. Their website is at www.motive.com.

Due to the fact that the company is still undergoing an accounting investigation, there are no updated financial figures for Motive, but based on our estimates the company probably has between $32 million and $60 million in annual sales (Note that the company reported over $90 million in sales in 2004, but this number is definitely going to be restated downward significantly). We believe the company will end 2006 with about $40 million in cash, and no debt. There are close to 28 million shares outstanding on a fully diluted basis.

For some recent PR from the company which gives some indication as to financial results thus far in 2006, please see the link below:

http://www.motive.com/newsevents/pressreleases/pr.asp?id=5902

The Problems: Revenue Recognition Issues and Lumpy Sales from Large Contracts

The following are the two major problems that Motive has faced and may continue to confront:

• Past Accounting Issues Cloud the Core Business
In late 2005 and early 2006, Motive announced that it was investigating its past accounting practices and that it would need to restate its financial statements dating back to 2001. As a result of the expanded restatement, the company has failed to file updated financial reports with the SEC and its stock has been delisted from The Nasdaq National Market.

According to the company the restatements primarily involve software revenue recognition practices. Our feeling, based on our experience with other software accounting shenanigans, is that what probably happened here is that company simply recognized revenue upfront for contracts that were supposed to be delivered over time. In addition, it is possible that the company allocated maintenance revenue to license sales, in effort to prop up the more highly-valued license revenue line. The net result is that Motive’s past financial statements have significantly inflated revenue results. Without past financials, investors do not necessarily have the means to accurately value Motive’s core software business. It is important to note, however, that the revised results will have no effect on the company’s reported cash position, nor are they a reflection on the company’s current business prospects.

• Lumpy Sales
Like other small enterprise software players, including SupportSoft, the principal operational challenge facing Motive, is that quarterly revenue results are very difficult to predict. The company typically derives a significant portion of revenue each quarter from a number of license agreements closed in the last month of a quarter. At the same time, operating expenses are, to a large extent, fixed in the short term. So if revenue falls below expectations in a quarter the company can lose a significant amount of money.

For instance, the company’s cash and short-term investments totaled approximately $59 million as of December 31, 2005, and are expected to be approximately $45 million as of the close of the third quarter. So Motive has burned thru nearly $14 million in cash thus far in 2006. The company, though, has stated that intends to breakeven in the third quarter of 2006.

The basic way the company can prevent losses because of lumpy sales is to increase its reliance on maintenance sales and reduce overhead to ensure breakeven even on disappointing license sales. Motive could also begin to experiment with different subscription business models, much as SupportSoft is doing.

Recent Changes and Their Significance:
New Management and Increased Value for SupportSoft

Despite the above challenges two recent changes augur well for Motive on a go-forward basis:

• An Entirely New Management Team Has Been Installed

Throughout 2006, Motive has completely revamped its entire executive management team. Notably, in February 2006, the company hired Alfred Mockett as the new Chairman and CEO.

Mr. Mockett previously worked at British Telecom (BT), where he served as chief executive of BT Ignite, the company’s $6 billion broadband and Internet services business unit. More recently, Mr. Mockett was the chairman and chief executive officer of American Management Systems (AMSY), the $1 billion revenue IT consulting and professional services company. AMS was acquired in mid-2004 by the CGI Group.

In looking at the share performance of AMSY, it appears that the company was sold at approximately the same price of the stock as when Mr. Mockett took over in late 2001. This of course is somewhat of a negative for MOTV, but we would note that AMSY was a different business than that of MOTV with nearly 40% of the revenue coming from the US Government. In addition, several of AMSY’s large customers were in the telecom industry, which had a major downturn during the time when Mr. Mockett was CEO of AMSY. Finally, it is important to note that AMSY had nearly $1 billion in revenue, as compared to MOTV’s $40 million or so. It is much more difficult to turnaround and grow a $1 billion company than it is to stabilize and grow a company with less than $50 million in sales.

Overall, it would appear that Mr. Mockett managed AMSY well, given the difficult economic backdrop, and in the end shareholders did not lose any money. In our opinion, Mr. Mockett is an executive with enough experience to manage MOTV at this juncture. His background in telecom, particularly with BT, a large customer of MOTV, will surely be of benefit to MOTV. Mr. Mockett was granted 200,000 shares of restricted Motive stock and a non-qualified stock option to purchase up to 750,000 shares of Motive’s common stock at an exercise price of $3.40 per share

In addition to Mr. Mockett, the company recently hired 3 other high level executives, including a new CFO. You can read about these executives by clicking on this link:

http://www.motive.com/newsevents/pressreleases/pr.asp?id=5903

From our perspective, the hiring of a new CFO seems to imply that the company’s restatement is near completion. Mr. Fitzpatrick, the new CFO, was granted a non-qualified stock option to purchase up to 100,000 shares of Motive’s common stock at an exercise price of $2.15 per share.

• Motive’s Main Competitor, SupportSoft, is Gaining Traction on Wall Street

Long time subscribers to our research, have probably already benefited from our astute call on SupportSoft (SPRT) earlier this year. The company has been undergoing an impressive turnaround under its new management team and the stock currently trades at $5.50, sporting an Enterprise Value (EV) to revenue multiple of nearly 2.5. SupportSoft is a direct, and somewhat smaller competitor to Motive. As such, it is our opinion that resurgence of SupportSoft and its renewed Wall Street coverage must at some point filter down to Motive’s shares, especially considering the wide valuation gap between the two companies.

The Price: Risk/Reward – Upside/Downside

Financial Condition is Solid and Business Risk is Limited
Before getting to some basic valuation considerations, it is important to note that there is little financial risk for Motive. The company has nearly $40 million in cash and no debt. In addition, despite the accounting troubles, the company still has a strong base of satisfied customers and generates in our estimation nearly $30 million a year in maintenance revenue. We do not think the company’s financial restatements have had any effect on the company’s ability to maintain the current customer base.

Main Risks
Despite the solid balance sheet, Motive still faces significant risks, chief of which is the company’s reliance on lumpy sales and high fixed costs. Furthermore, if customers do not renew their licenses for the company’s products (licenses usually run for three years) the company may begin to lose money at fast pace. Overall, it is still not entirely clear if Motive will be able to operate its business profitably, following the closure of the company’s accounting restatements. There is also no guarantee that the company will be able to sign new customers and ignite growth, given that the company’s image may have been tarnished by the accounting scandal and given that the company’s main competitor, SupportSoft, is quickly gaining a foothold in key international markets.

Downside Price Risk: $2.50
Notwithstanding the above risks, we think that following MOTV’s financial restatements, the company could become a takeover target. This view is supported by Mr. Mockett’s, Motive’s current CEO, operational steps at his last software company, AMSY. Assuming an M&A transaction, we have calculated that MOTV’s stock is worth at least $2.50 in a worst case scenario. We arrive at that value by assuming a minimum of $30 million in revenue and applying a 1X revenue multiple to that value and then adding back cash of $40 million.

Upside Price Potential: $5.50
In arriving at our upside target, we assume that following the company’s restatements, Motive, like SupportSoft, becomes successful in signing new licenses, growing its customer base, and generating cash. We think that it is definitely conceivable that Motive could do $50 million in annual revenue in such a scenario, as this was the company’s run-rate in the last “true” quarter prior to restatements. Applying a multiple of 2 (lower than SupportSoft’s current EV/R multiple) and adding back cash results in an upside of $5.00.

Conclusion
With at most 10% downside, and the potential for 90% upside, we think Motive is an excellent investment “gamble” at current prices.

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