Small Cap Stocks

Disclosure Note: The price of S1 Corp. (SONE) as of this report was: $5.60. Neither Envoy Global, Inc. nor any of its affiliates currently own shares in SONE. We, or our affiliates, may purchase shares at any time. Please be sure to read our disclaimer at the top of this post.

Introduction
For those of you following the torrid pace of M&A in the past year, you may be aware that software has been a hot sector, especially for those very busy private equity shops. In fact, Bill Burnham over at Burnham’s Beat, counted 32 software acquisitions in 2006, with Private Equity firms accounting for 25% of them. This is up strongly from 11% of the deals in 2005. In this post, we’ll cover S1 Corporation (Nasdaq: SONE), a company that operates within a software sub-sector experiencing intense M&A activity: banking and payment software solutions.

There have been a lot of deals in the financial software space, which provide some convenient comps for evaluating the potential upside and downside in this sector laggard. In addition, the company’s underperformance relative to its peers, in conjunction with some attractive business features, has drawn in an activist hedge fund, Ramius Capital, which has been exerting significant pressure to unlock shareholder value. Some of you may already be familiar with Ramius via one of our top member picks, Phoenix Technologies (PTEC).

Interestingly, Ramius’s pressure has already yielded some positive results, such as a modified Dutch auction and some shake-ups in management and in the structure of the organization. So let’s dig into S1 Corporation (SONE) and see if there’s more value here that has yet to be realized.

Business Summary
What does S1 do? The business description in the company’s SEC filings is now somewhat obsolete, because as of last week, the organization has been reorganized into three distinct operating units. A high-level summary of the business is available right here on the company’s new website.

Basically, the company’s Postilion unit offers software for self-service banking to financial service providers. The Postilion division also includes offerings based on payment processing, which include gift-card processing.

Meanwhile, the S1 Enterprise division (about $110 million in revenue), is focused on providing front-end banking solutions to larger banks. Products include treasury management tools for larger corporate clients of banks, cash management tools for smaller corporate clients of banks, online personal banking tools, teller systems, and call center platforms. The division will also try to sell to insurance companies. State Farm is the only insurance client of S1 at this time, but management feels it can build upon its success with State Farm to attract smaller insurance clients.

Finally, FSB Solutions, a newer unit, is focused on teller and branch solutions and possibly lending software aimed at the branch.

In all, S1 has over 3,000 financial institution customers, the majority of which are located in the United States.

Basic Capitalization Statistics
Following a recent Dutch auction in which SONE bought back nearly 15% of its float for $55M (at $5.25 per share), there are about 60.6M shares outstanding. The balance sheet is clean with adjusted cash of approximately $85 million and zero outstanding debt. At current prices, SONE’s enterprise value is about $260 million.

Financial and Comp Summary
Historically, SONE has not been a profitable company on an accounting basis, primarily due to large depreciation and amortization charges. However, the company has generated positive operating cash flow in the past. Notably in 2002 and 2003, the company reported about $20 million in operating cash flow. Offsetting this cash flow is about $7 million in cap-ex. So overall, the company is currently trading at about 20X EV/Depressed Cash Flow levels.

To really understand the value of this company, though, one needs to recognize that at the core lies a large base of recurring maintenance and service revenue at decent margins. Managed correctly, this type of revenue stream, as opposed to lumpy license revenue, can throw off a large amount of cash on a predictable basis. In fact, it is this mostly stable, and potentially very profitable, revenue stream that attracts private equity to software companies. In the case of S1, the company had about $160 million of this type of revenue in 2005 and for 2006 the numbers look basically the same. Total revenue in fiscal 2006 is expected to come in at about $190 million. So the stock is currently trading at about 1.3X EV/Revenue.

To put these numbers into context, there are two recent deals that occurred in this competitive space. First, The Carlyle Group and Providence Equity Partners bought Open Solutions for $38/share in October 2006. Factoring in the ability of bondholders to convert to stock puts the valuation at about 3x EV/TTM revenue and 10x EV/2007E EBITDA. Then, on Nov. 30, Intuit bought Digital Insight for $1.35B, valuing the company at about 5x EV/TTM revenue and over 15X EV/EBITDA.

These companies had been great performers, and were assigned generous multiples accordingly. Therefore, aside from the fact that the businesses are somewhat different, one can’t immediately apply these multiples to SONE to arrive at a fair value estimate. However, as you can see, growing and profitable companies in the space command a significantly higher multiple than S1 currently sports, leading us to believe there is a lot of room for multiple expansion for SONE in the case of a sale or turnaround of the company.

The People: New Top Entrepreneurial Executive
It has been a bit of a revolving door at S1. James “Chip” Mahan served as Chairman for the better part of the last 8 years, and as CEO from 1995 to 2000. Jaime Ellertson took the helm until his termination in July 2005. Chairman Mahan reassumed the CEO role until his retirement from the company in October 2006. Ramius had been pressing hard for a separation of the CEO and Chairman roles, and they got it: John Spiegel is now Chairman and Johann Dreyer has been appointed CEO as of November 2006. We are enthusiastic about the appointment of Mr. Dreyer as CEO. Mr. Dreyer is a proven entrepreneur and co-founded Mosaic, a company SONE acquired in 2004 for nearly $40m.

Here is Mr. Dreyer’s bio as listed on the IR section of the S1 website:

Johann has 19 years’ experience in the banking technology and electronic funds transfer field and is a founding Director of Mosaic Software, an ATM/POS company that S1 acquired in 2004. Prior to joining S1, Johann started his own company, Software Collage, in 1992, specializing in EFT systems for banking. In 1994, Software Collage merged with Jigsaw Software to form Mosaic Software. In 1999, Johann was appointed Executive Chairman of the Board of Mosaic Software and moved to the U.S. to take up the challenge of establishing the company in the global market. In early 2002, Johann became Group CEO of Mosaic Software. He completed a BCom Honours (cum laude) in Computer Science at the University of Stellenbosch, South Africa.

Upon his appointment as CEO of S1, Mr. Dreyer was offered options for about 450,000 shares at $4.86 per share.

We generally like to invest alongside entrepreneurs who are working with a clean balance sheet and strong options incentives. We are therefore optimistic that Mr. Dreyer can turn things around at S1, or sell the company.

What Went Wrong?
Acquisitions and Bad Execution amidst a Strong Industry Environment
S1 is basically a software acquisition story gone wrong. A good summary of the company’s additional problems was provided by Ramius in various SEC filings, so there is not much reason for us to rehash it.

Let us quote from their proxy:

The Ramius Group believes the Company is substantially underperforming its peers due to a series of operational missteps, poor capital allocation decisions and a failure to capitalize on a range of growth opportunities in the Company’s legacy and Enterprise product suites.

Despite its large installed customer base and the high margin recurring revenue stream that such a customer base provides, the Company has faced significant challenges operating as a stand-alone entity. S1′s share price has declined by approximately 77% from January 2, 2002 to March 20, 2006 (decreasing from $18.00 to $4.10) and S1′s revenues have declined approximately 13.8% from January 1, 2002 to December 31, 2005 (decreasing from approximately $236.7 million to approximately $204.1 million).

The Ramius Group believes management did not allocate appropriate research and development resources necessary to support legacy products, and as a result missed out on growth opportunities in the core community banking sector. In addition, the Ramius Group believes that repeated execution issues on the Enterprise side of the business have resulted in missed growth opportunities in the large financial institution sector, a cost structure that we feel may not be appropriate for the potential revenue opportunity of the Enterprise product family and damage to the Company’s credibility with customers, stockholders and the research analyst community.

What Has Changed?
New Management Initiates a Corporate Reorganization

With its ugly performance in 2005, S1 drew the attention of Ramius Capital, a hedge fund that initiated a position in December of that year but really started loading up in March 2006, around the time that it met with management to discuss the company.
Ramius has been publicly urging S1 to put itself up for sale since that time. The company replied that it would not be prudent to sell the company, and a proxy battle immediately began to take shape as Ramius announced that it would be seeking board representation, board expansion, and reinstatement of the ability for any 10% shareholder to call a special meeting.

The two parties settled in advance of the annual meeting, with the result being one Ramius member gaining a board seat and reinstatement of the 10% rule. Additionally, the company agreed to hire investment bank Friedman Billings Ramsey to explore strategic alternatives. That latter move led to the tender offer, and apparently the retirement of “Chip” Mahan and the hiring of Johann Dreyer as CEO.

In Mr. Dreyer’s short time as CEO he has already consolidated and reorganized the company into three distinctly branded units: Enterprise, Postillion, and FSB Solutions. In addition to helping focus the business, this reorg could certainly facilitate a piecemeal sale of the company’s remaining operations. Investors should get a sense as to the financial impact of this reorganization in coming quarters. We suspect that recent moves will allow the company to both improve profitability and position it for increased sales.

Risk Analysis: Strong Balance Sheet, but Customer Concentration
We view the long-term risk in SONE shares as extremely limited because of the attractiveness of the company’s stable revenue base and clean balance sheet. Specifically, the company has no need to raise money and could operate quite profitably under the right scenario. In addition, the stock is currently trading at a significant discount to M&A multiples in the industry, suggesting that a fair amount of pessimism is already reflected in the shares.

It is also important to note, though, that SONE does have some degree of customer concentration risk. Currently, State Farm Mutual Automobile Insurance, in the Enterprise segment, contributed 25% of total revenues (or about $35m) during the nine months ended September 30, 2006. One clearly needs to take this large revenue stream into consideration when valuing the company.

Return Analysis: Successful Turnaround or Sale

If the company’s efforts to bring down operating costs, rebrand its units and roll out the new Enterprise offering are moderately successful, we believe that S1 will achieve profitability and renewed top-line growth. In this scenario, the shares will trade up to an expanded multiple, more in line with its profitable peers. Short of this success, we view a near term buyout as quite likely, and this would value the company at a premium to the market price.

Conclusion: Downside and Upside Scenarios and Our Position

We note that Ramius bought most of their shares in the low-$4 range, and new CEO Dreyer’s options are at $4.86 per share. Therefore, on the downside we don’t see much risk of the shares going for less than 1x EV/Sales, or about $4.50 per share. In addition, the prospects of a near-term buyout should help to keep a strong floor on the stock price.

On the upside we have two scenarios: a near-term buyout or a turnaround under present management. A buyout in the near term, assuming mediocre results from present initiatives, would likely value the company at a little over 2x EV/Sales, or around $8 per share. The turnaround, for which we will assume zero revenue growth, could bring the company into the 2.5-3x multiple range of its profitable peers; that works out to roughly $10/share.

Assigning each of the three scenarios equal weight gives us an expected value of about $7.50/share, a 30%+ premium over the present share price.

Overall, while we don’t expect any fireworks here, we seem to have a reasonable investment gamble at present prices and a very attractive play at sub-$5 prices. This is surely one stock to keep on your watch list. Our reason for our not aggressively purchasing shares at current levels reflects our desire to buy stocks at near or below key executive option prices. In addition, in situations where there is a re-focusing with a prospect of a sale, one needs to be extremely careful to purchase shares at a substantial discount to worst-case M&A values in order to reap the maximum upside.

Special thanks to Toby Shute for contributing to this post.