Friday, July 23, 2010

Autonomy (AU) to Announce Large Acquisition: Open Text (OTEX) Tipped As Possible Target

Autonomy, the UK-based enterprise software group may announce a large acquisition very shortly. Open Text, the listed Canadian software company, as a possible target. These are the two remaining independent Enterprise Search and Content Management players. Both have been struggling organically given the worst economic cycles in enterprise software spending while trying outgrow each other to get acquired first. However, a bid by Autonomy will have serious challenges - both as rival bidders and internal execution-related. I had expected the announcement on the analyst call yesterday which did not happen.

Yesterday Autonomy has announced its second quarter results; Some management highlights from the earnings relesease:

• Record six month revenues of $415.3 million (within the range of analyst expectations of $412-417m), up 28% from H1 2009 with overall organic growth at 14%

• Six months organic IDOL revenue growth at 24%; organic growth excluding professional services at 18%

• Gross profits (adj.) at $363.4 million, up 26% from H1 2009; gross margins (adj.) at 88%

• H1 2010 operating margins (adj.) at 44%

• Record H1 profit before tax (adj.) at $182.7 million, up 24% from H1 2009

• Record H1 fully diluted EPS (adj.) of $0.53 (within the range of analyst expectations of $0.52-0.55), up 22% from H1 2009 (IFRS: $0.42, up 17%)

• Q2 DSOs decreased to 82 days (Q1 2010: 93 days, Q4 2009: 88 days)

• Cash conversion for the second quarter was 98% (Q2 2009: 66%), and for the first half of 2010 was 93% (H1 2009: 72%)

According several analysts following the firm including Paul Morland and Richard Nguyan, there are some positives and negatives about the details of the quarter:


• Sustainable momentum in OEM revenue (17% group revenue) with FY10 growth of 30%+ thanks to strong OEM activity over the last two years;

• Large standardisation deals (>$1M), more profitable, maintain a good momentum (Q2: 25, Q1: 19, Q4 09: 24, Q3 09: 13);

• Focus on M&A. Management have consistently stated that the firm would make an acquisition in second half to expand further its product footprint. As with previous deals (Verity, Interwoven), a move could provide Autonomy with additional scope for growth and improve margins via cross-selling opportunities within the installed base, noting the group’s excellent execution track record.


• Decelerating overall organic growth (Q2 13%, Q1 17%, Q4 09 18%) due to decelerating product revenue (66% group revenue) and

• Increased sales and marketing expenses which may slow the pace of profit increase.

• Cash conversion is worse than it should be and some unusual balance sheet movements may be masking warning signals such as high DSOs and falling deferred income.

• The rising working capital trend is not adequately explained either by growth or the acquisition of companies with low working capital that needs several quarters to normalise. Debtors appear to be higher than they should be and creditors lower.

• The model Autonomy uses to defend its low cash conversion ignores creditor movements and looks flawed to us.

• A focus in presentations on high growth rates that are largely due to acquisitions is misleading.

• The phrase “very strong cash collections” seems out of place when debtors and DSOs are on upward trends.

• Consider that Autonomy’s closest competitor was bought by Microsoft in 2008, and yet no one appears to have shown any interest in acquiring Autonomy.

• Stated organic growth rates regularly exceed our own estimates.

• Many balance sheet movements at the time of acquisitions are hard to explain and do not appear to reconcile with the cash flow statement.

• Recent deals (e.g. Microlink) appear to lack business logic.

Autonomy’s poor Q2 results will inevitably force the firm to grow inorganically. Given the firm’s rich valuation, Autonomy’s buying OTEX would make sense. Autonomy’s own story on paper sounds great: Class-leading IDOL technology with multiple vertical applications; defensive end-markets such as government, very high margins, impressive earnings growth and a strong balance sheet. However, I believe there are plenty of reasons to believe that the reality may not live up to the spin from the management. If Autonomy ends up acquiring OTEX (which is an acquisition machine itself with about the same size), I would stay away from the stock until the dust settles….because this would be just too big to swallow…almost two drunk men trying to stand still by leaning against each other.

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