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Last evening, ActivIdentity (ACTI) reported financial results that demonstrated significant progress in the company´s turnaround. Specifically, the company generated nearly $8 million in free cash-flow during the quarter, it´s first positive cash-flow quarter since the company´s IPO. The company ended the quarter with a hefty cash balance of $136 million (no debt), or nearly $3 per share.

Importantly, unlike another turnaround pick Network Engines (NENG), ActivIdentity (ACTI) generated this cash-flow on the heels of significant revenue growth, with the top-line increasing by 27% year-over-year and gross margins reaching 69%.

The company´s forward guidance, though, for the upcoming quarter was less than stellar. However, our understanding, based on comments made on the conference call was that guidance is somewhat conservative and does not include the potential closing of several significant deals in the pipeline.

Overall, we are not too concerned about the quarterly fluctuations at ActivIdentity, since the software business is, in general, a bit lumpy. More importantly, however, is the fact that ActivIdentity is entering what we believe is a multi-year period of high double-digit growth. Specifically, the company is and should be able to continue to benefit from the increasing adoption of Smart Employee ID badge solutions by both both governments and large businesses.

Interestingly, as we have mentioned in the past, we still do not think ACTI´s shares fully reflect the potential for the company over the next few years. With $136 million in cash, and no debt, the company’s Enterprise Value is about $105 million. Security software still remains one of the hottest areas in software M&A with takeouts going at very high multiples of TTM revenue. With an estimated $60 million in sales in the coming year, we believe that ACTI should be worth about 3X EV/Sales, especially considering that it has now managed to reach profitability amidst strong top-line growth. That would imply a takeout price for ACTI at a price of at least $6.50 to $6.80 per share.

We think that as ACTI continues to demonstrate double-digit top-line growth and increasing cash-flow over the coming quarters, that it’s share price will rise to our target price. At the same time, with a pristine balance sheet and low relative valuation to other security software stocks, there does not seem to be much downside risk in the company´s shares.

Please Note: We first recommended ActivIdentity (ACTI) at $4.37, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are
committed at your own risk, financial or otherwise.

An interesting compensation arrangement with senior executives, an upcoming first ever cash-flow positive quarter, a very low relative valuation to competitors, and a sector teeming with acquisition activity, has us excited more than ever about ActivIdentity (ACTI), and we’re buyers on this recent dip in the stock price.

Compensation Arrangement

First up the recent 8-K filing. In the filing executives were granted a set of restricted stock units based on the price of ACTI stock on January 9, 2007. Interestingly, these shares vest over three years and only if the company’s stock price is at least 130% above the grant date price for at least 60 days. Furthermore, as the filing states:

“The number of shares underlying each award will be increased by 50% if and the Company achieves a specific targeted level of earnings before interest, taxes, depreciation (“EBITDA”) and will be reduced by 25% if the Company’s fiscal 2007 EBITDA is below a specified target.”

If you’re a big follower of executive option grants, like us, the compensation agreement appears to imply a near-term floor on the stock price at near the close on January 9, 2007. The kicker here is the 50% increase in stock awarded if certain EBITDA targets are met, and a reduction in the grant if they are not. Management is obviously very incentivised in the coming year, and clearly must be be forecasting good EBITDA flows going forward to agree to this kind of incentive arrangement.

First Ever Cash-Flow Positive Quarter

And if this doesn’t make you bullish on ACTI, how does the fact that the company will report its first ever cash-flow positive quarter in the coming quarter? How do we know that? At the end of the company’s very impressive fourth quarter 2006 report, management states:

“The company expects first quarter 2007 revenue to be in the range of $13.5 million to $15.0 million with a loss of between $0.08 and $0.11 per basic and diluted share. Cash (including short term investments) are expected to increase to between $128 million and $130 million.“

As you may already know we believe, and think there is solid empirical evidence to support this, that the best time to get into these types turnarounds is when companies start throwing off cash for either the first time ever or the first time in many years of losses. Your odds of investment success, although never gauranteed, are very good under these types of circumstances, especially when the valuation of the company is depressed and there are few Wall Street analysts covering the company.

Valuation is Low

Which brings us to the valuation of ACTI. With $130 million in cash, and no debt, the company’s Enterprise Value is about $95 million. Security software still remains one of the hottest areas in software M&A with takeouts going at very high multiples of TTM revenue. We believe that on average, takeovers in the software industry as a whole are done at 2.5X EV/Sales. With an estimated $60 million in sales in the coming year, that would imply a takeout price for ACTI at a price of at least $6.10 per share or about 25% above the current stock price. This number may prove conservative given that sales estimates may come in well above expectations, as they did last quarter, and given the valuation of key competitor VASCO Data Security International Inc. (VDSI), which currently trades at over 7X EV/TTM Sales. We think that as ACTI begins to deliver consistent cash-flow over the coming quarters it’s share price will rise so as to eliminate this valuation gap.

Our only problem with ACTI: What’s the company doing sitting on all that cash now that the business is cash-flow positive? They need to either give some of that cash back to shareholders via some sort dividend or stock buyback. Another option is to look for some small add-on acquisitions to accelerate growth. Management needs to address the cash position in upcoming conference calls.

Please Note: We first recommended ActivIdentity (ACTI) at $4.37, and still hold a position in the stock.

Special thanks to Toby Shute for contributing content to this post.

Congrats to subscribers who have held on to ActivIdentity (ACTI). We recommended the stock on CasinoCapitalism.com, back in March 2006, at $4.37, and after alot of volatility were finally rewarded today with the announcement of a huge HSPD-12 government contract. Specifically, the company announced
a major contract win with the U.S. Department of Defense (DoD), U.S. Army and
U.S. Air Force for ACTI’s smart card desktop client software to enable their move to next-
generation HSPD-12 certified Common Access Cards for 3.5 million military personnel and
contractors around the world. 

We just had a chance to listen to ActivIdentity´s latest conference call. All in all, we are impressed with the company´s focus on minimizing cash burn, and driving the business to profitability via continued costs cuts and new revenue generating initiatives. Management is forecasting decent revenue growth next quarter and expects to reach cash-flow positive by early next year. The company seemingly has excellent opportunities in the government sector as Federal Government departments and agencies look to achieve HSPD-12 compliance later this year.

If ActivIdentity can execute on its revenue growth and cost-cutting initatives, the company will, as per management´s guidance, turn a profit in 2007. We think, as noted in the past, that if these forecasts prove accurate, that the stock can trade at 2.5X to 3X revenue, a still substantial discount to the valuation accorded to RSA (a competitor to ACTI) in the recent EMC acquisition. Assuming a $60 million revenue run rate in 2007, and $135 million in cash (no debt), that implies a price target for ACTI of between $6.25 and and $7 per share over the next 12 months.

Please Note: We first recommended ActivIdentity (ACTI) at $4.37, and still hold a position in the
stock. All ideas, opinions, and/or forecasts, expressed or implied
herein, are for informational purposes only and should not be construed
as a recommendation to invest, trade, and/or speculate in the markets.
Any investments, trades, and/or speculations made in light of the
ideas, opinions, and/or forecasts, expressed or implied herein, are
committed at your own risk, financial or otherwise.

Last night EMC announced the acquisition of RSA Security (RSAS) for $28 per share in cash or about $2.1 billion. After stripping out RSA´s cash position, it appears that the price paid for RSA was approximately 5X 2006 revenue estimates. This acquisition of RSA Security is very positive for all the players in the identity assurance and authentication market, and is specifically bullish for my pick in the sector: ActivIdentity (ACTI).

Yesterday, ActivIdentity (ACTI) released earnings results for the March Quarter. As expected the company burned thru more of its cash hoard, but on a more positive note signaled that the cash losses would begin to decline steadily with cash breakeven expected later this year. In addition, the company is guiding towards modest revenue growth next quarter. Finally, we should hear sometime this year what the company plans to do with its $140 million cash balance (down to $135 million by the end of the year). As mentioned in the first write-up, I think the company is way overcapitalized and I hope for a special one-time dividend to be announced.

Investment Summary:
We believe that ActivIdentity (Nasdaq: ACTI), at its current price of about $4.37, represents a low-risk investment, with substantial upside price potential in the next two to three years, as the company capitalizes on new growth opportunities in the digital identity assurance market, under the guidance of the new CEO, Jason Hart.