Sybase (102.557 vs. $21.79)
Summary
I would use 200 over L as the credit spread for the convert, which has a 5 year put. The credit risk is low because SY’s software maintenance fees produce a sizable annuity-like cash flow. The primary risk is that management makes big acquisitions with that cash, which is why I am conservatively using a 200 spread. Key points are:
1) SY has $780M in cash and $460M in debt, a comfortable cash cushion. Additionally, the company generates a fairly consistent FCF of about $100M-150M per year. Their business model allows them to collect an annuity-like revenue stream from existing customers.
2) SY is down to 3% market share for new license database sales, which makes it difficult for the company to compete with the scale of IBM (36% share) and Oracle (30%). However, SY has a large customer base that is willing to pay a maintenance stream for support and upgrades.
3) The major risk for the credit is the company’s plans to make acquisitions with its $780M cash position and on-going FCF. Analysts believe management is looking to use about $200M for acquisitions over the next few years, which is a manageable number. The risk is that management decides to make larger acquisitions.
4) Software companies typically like to maintain a sizable amount of cash on the balance sheet to show customers that they will survive long enough to support the software. It is unlikely that SY will move to a positive net debt position by spending too much on capex, R&D or acquisitions.
5) According to Sudeep, we can make 4.75 points if SY were to be acquired at $25 by March 2006. Possible acquirers are Oracle and IBM.
Business Profile
Sybase operates two divisions: 1) Enterprise Database (82% sales) 2) Wireless Middleware (18% sales)
SY’s database product is called Adaptive Server Enterprise (ASE), which began life as Sybase SQL in 1987. The product was one of the first relational databases that was capable of high-performance transaction processing but has lost considerable market share to Oracle and IBM over the years. Its share now stands at just 3% (based on new license revenues), although its maintenance revenues are considerable due to a large installed base accumulated over the many years that Sybase was a market leader.
ASE is sold on a license/maintenance model where a customer pays a license fee for the initial software implementation and a 20% annual maintenance fee for the right to receive support and upgrades. Like many other mature software companies (CA, NOVL, SEBL), SY lives off this annuity-like maintenance stream that their customers are willing to pay due to high switching costs. The company then funnels this cash to invest in the high growth Wireless Middleware products. Revenues for the database group are declining in the 3%-5% range.
Wireless middleware is a group of software products used on wireless devices. Sybase assembled these products through acquisitions of AvantGo and XcelleNet. This division is growing revenues in the 15-20% range.
Capital structure
At the end of 3Q2005, SY had $783M in cash and $460M in debt (all converts). The converts have a put in March 2010.
Cash generation
SY generated $135M in FCF over the last 12 months. The company has generated over $100M FCF per year in 5 of the last 6 years. SY has the ability to generate significant cash due to its annuity-like maintenance stream of cash that is receives from its customer base.
Strategy
The company’s strategy is to use its $780M cash war chest and its on-going cash flow to make acquisitions in the Wireless Middleware space. The company is likely to spend $100-$200M on acquisitions over the next couple of years. Management would like to maintain a negative net debt position to make customers feel comfortable about the company’s long-term survivability. Customers want to be sure that a software supplier will be around for the long-term before committing to a purchase.
Customer base and switching costs
Wall Street accounts for about 50% of SY’s database revenues. These firms have considerable switching costs through the use of Sybase’s stored procedures, which embed application logic in the database and are coded in Sybase’s proprietary language, Transact-SQL.
While switching costs are high for existing applications, customers rarely start new projects with Sybase. They prefer to use Oracle and IBM, who leverage their scale to invest in new features and functionality.
Potential Acquirers
SY could be attractive to strategic acquirers who can exploit the company’s high growth wireless products or large customer base. Both Oracle and IBM has a history of buying mature software companies for their installed base. In 2001, IBM acquired Informix for $1B in cash. In 2005, Oracle bought PeopleSoft for $10B in cash. Both deals were made to get the acquired company’s installed base. Management has not been openly shopping itself but they would likely be receptive to any reasonable offers.
Equity valuation & volatility
SY trades at 16X 2006 EPS of $1.22. The stock price is driven by the growth prospects of Wireless Middleware and to a lesser degree the database product. There is opportunity for some big gap moves on the stock because software companies tend to have lumpy quarters for bookings due to large license deals.
Risks
Sybase makes a big acquisition with its cash.
Management has communicated that it wants to make acquisitions in the Wireless Middleware segment. SY has made 3 large acquisitions in the last 5 years. In 2001, the company bought New Era of Networks for $340M in stock. In 2003, SY purchased AvantGo for $41M in cash. In 2004, the company acquired XcelleNet for $93M in cash. The primary risk is that SY will use more than several hundred million on an acquisition that could deplete their cash balance.
Existing customers migrate away from Sybase more quickly than expected
While it is not likely that existing customers will move away from Sybase due to high switching costs, there are scenarios where it would make sense for the to do so. Companies will switch database vendors if they upgrade an application that requires new functionality. However, even a fast declining installed base would likely not lead to risk in the near term (5 years).