In early November, Needham analyst John Lynch, wrote an updated research report on PTEC, which we think provides an excellent summary of what went wrong with the company and what may go right in the coming year. We have reproduced the commentary below and added our analysis at the end.
Needham comments:

“As the PC industry has matured and prices have dramatically declined, the component pricing environment has been fierce. Phoenix, the world’s leading supplier of the BIOS firmware, which is essentially a PC component, has felt the effects of this pricing pressure acutely. Their ASPs, especially in desktop systems, have eroded under the pressures of their highly cost conscious PC OEM customers. Inferentially, despite their gaudy market share, the company lacked an IP or engineering advantage that would enable them to maintain sufficiently favorable pricing. Other viable competitors exist, and some potential customers have opted simply to design their own BIOS in house.

Because they foresaw anemic growth in their BIOS business, the previous management team at Phoenix decided to seek growth through a new business segment that would produce applications to meet the burgeoning demand for security and disaster recovery. Citing the swelling number of threats and nuisances caused by malware and other malicious attacks, the company felt they could sell these applications to valueadded- reseller (VAR) customers, a new sales channel for Phoenix, which would in turn sell them to vulnerable corporations willing to pay for an extra layer of protection.

Because these products worked best when a computer was equipped with Phoenix BIOS, the company made a staunch effort to preserve, and even expand, their share of the market. This effort entailed entering into fully paid up license agreements, in which a customer received essentially unlimited rights to use Phoenix’s BIOS code for the duration of the contract. This move towards fully paid up licenses was further encouraged by management’s belief that the current generation of BIOS was soon to be obsolete, and that the Vista upgrade cycle would spur demand for their next generation of higher ASP BIOS. These agreements were in contrast to their traditional agreements, in which Phoenix was paid based a royalty based on the number of units shipped.

This plan, however, has been pronounced a failure (as evidenced by explicit comments from management as well as the stock price). By branching into an unfamiliar space dominated by well known brands like McAfee and Symantec, the company seems to have bit off more than it could chew, as they say. VARs were slow to bite, and those that did found themselves with buggy products marred by compatibility issues and installation problems. Once these problems became apparent, the company found itself in dire straits. By entering into fully paid up licenses, in which all revenues were recognized immediately, they had exhausted a large piece of their recurring revenues in their core business. As Vista has been famously delayed, new revenue streams from next generation BIOS have not begun to flow. And the revenues from applications, which were to make up for weak BIOS revenues, did not materialize.

So now new management has entered the picture, and returned to a BIOS centric strategy. The company plans to focus its engineering dollars on adding the functionality and innovation necessary to command higher BIOS ASPs. And the sales force, rather than trying to learn about and pander to the unfamiliar VAR channel, will be focusing on their traditional, established OEM customers. Furthermore, management has already eliminated the practice of using fully paid up licenses, and thus should be able to provide more stability and visibility to the business. However, this plan will take time, and management believes they will be able to get back to breakeven by late 2007. The cleanup at Phoenix will be an arduous process. The biggest question, in our mind, is whether or not Phoenix can indeed add features and functionality to their BIOS business such that they can reverse the ASP declines that have plagued both the company and the industry. At this early stage of the new strategy, it’s too soon to tell.”

Comments:

Needham has established a $52 million sales estimate for PTEC in 2007 and has modeled a breakeven in the 4th quarter based on management comments. Other Wall Street firms are projecting $40 million in sales. Our estimate is closer to the $40 million range. The uncertainty here relates to the terms of the upfront license agreements, and how long it will take PTEC’s management to replace these contracts with new, and more favorable agreements. Clearly a key factor is the speed in which Vista will be adopted by computer OEM’s. If the uptake is slow, it will take longer for PTEC’s sales to recover meaningfully.

Notwithstanding the timing issues for a turnaround, our view remains that the last quarter was probably the bottom for PTEC’s sales drop and that sales should begin to increase sequentially in 2007, as Vista is slowly adopted by the industry.

Given that PTEC has already received a buyout offer of $5 per share from a shareholder group, we see little downside to the stock at current prices. The stock price is also supported by a basic valuation analysis, in which we assume $40 million in revenue in 2007. Given the very high gross margins of the BIOS line, we think that 2X Revenue, or $80 million, is an appropriate valuation for the business, especially since the company could easily far surpass the $40 million revenue run rate in due time. Taking that $80 million valuation and adding back $40 million in expected cash, results in a $120 million company valuation or about $4.60 per share.

On the upside, we expect that once management stabilizes the BIOS business, they will seek complementary acquisitions, and beef up the company for a sale. This may take a few years to play out, but given management’s incredible success in other similar endeavors, the odds of a positive outcome seem high and the upside potential seems significant. Quantitatively, as new BIOS agreements take hold and acquisition activity heats up, PTEC can conceivably reach prior sales levels of $80 million in a few years time, which given the reduced cost structure could lead to substantial profits of nearly $1 per share, suggesting a long-term price target of over $10, or an over 100% gain from current levels over the next few years. Finally, it is also important to remember that the new management team at PTEC faced a more difficult situation during their last turnaround at Intellisync and yet subsequently reinvigorated that company leading to a more than 400% rise in the stock price over a five year period.