Salomon Smith Barney Comment:
PSFT:PeopleSoft Undertakes Sophisticated Financial Engineering Salomon Smith Barney
Neil Herman
November 17, 1998
--SUMMARY:--PeopleSoft, Inc.--Server & Enterprise Software
*Yesterday, PeopleSoft announced that they are creating a separate company, funded by PeopleSoft with $300 million, that will undertake a number of research and development projects as well as joint R&D projects with 3rd parties and/or acquire new companies or technology
*This new entity is an ingenious methodology allowing PSFT to effectively invest more in R&D without negatively impacting its income statement or balance sheet
*Given the infrastructure and revenue lead that SAP has, SAP is way ahead in terms of R&D expenditure by almost an order of magnitude. This is PeopleSoft's way of trying to narrow the gap.
*No change in 3H, Neutral rating, given the complexity of the transaction, we believe Wall St. may view it negatively
Footnotes:
--OPINION:------------------------------------------------------------------
**PeopleSoft Announced Formation of Momentum Business Applications, Inc. Yesterday, PeopleSoft announced the formation of Momentum Business Applications, Inc., a company focused on the research and development of e-business, analytic applications and industry-specific software products based on PeopleSoft's technology. Momentum, which will be funded by PeopleSoft with $300 million, will be spun off to shareholders of a to be determined record date at a ratio of 1 share of Momentum for each 50 shares of PeopleSoft owned. With approximately 233 million shares of PeopleSoft outstanding, approximately 4.66 million shares of Momentum Class A stock will be created. 100% of the Class A stock (voting privileges) will be spun off leaving PeopleSoft with no controlling share of the new company. PeopleSoft will own 100% of the Class B shares which we believe are essentially options to repurchase the Class A shares at a future time. The spun off shares are taxable to existing share holders as a dividend. PeopleSoft has the option to purchase either specific technology developed by Momentum or the entire company. If PeopleSoft were to excercise the option to purchase Momentum in its entirety, the exercise price would be the greatest of the following four scenarios
1) A multiple of payments from PeopleSoft to Momentum over a four quarter period
2) Fair market value of 720,000 shares of PeopleSoft stock at the date the purchase-option is exercised
3) $350 million plus any additional funds contributed to Momentum by
PeopleSoft minus all expenses Momentum occurred in product
development
4) $90 million
**We Expect a One time Write-off in Q4
At the time of the stock distribution, PeopleSoft will take a one time
charge equal to the difference between the market value of the newly created company and the $300 million funded. We expect the transaction to mimic similar transactions done in both the pharmaceutical and biomedical industry where the initial market valuation of the traded company is approximately 25% of the funded R&D amount or in this case about $75 million. If we assume a initial market capitalization of $75 million, we would estimate a one time write-off of about $225 million or $0.86 per share (assuming 260 million diluted shares) in the fourth quarter.
**Enables PeopleSoft to incur R&D without Negative Impact to its Income Statement or Balance Sheet This new entity allows PeopleSoft to effectively invest more heavily in new research and development without having to show the impact on PeopleSoft's income statement or balance sheet. If PeopleSoft were to undertake this level of incremental R&D without moving it off to a new entity, the impact would be greater R&D expense on the income statement resulting in lower earnings per share. Also, PeopleSoft would likely
have to capitalize a portion of the R&D which would weaken its balance sheet. Effectively, PeopleSoft has found a legitimate way to move R&D off of its books and on to Momentum's books and still benefit from the new technologies developed. PeopleSoft has done similar transactions in the past with the creation of separate entities in both the manufacturing and education vertical sectors which resulted in very strong products within those respective verticals. PeopleSoft also did a transaction where it partnered with Intrepid, a maker of retail solutions, integrated their technologies, and later purchased the company resulting in a more solid product in the retail space. In this newest transaction, Momentum is expected to develop products related to PeopleSoft e-business strategy as well as products towards the vertical markets where PeopleSoft currently focuses. At some point in the future, PeopleSoft will have the option to buy back from Momentum either specific technology or the entire company. Similar to previous acquisitions, we would expect PeopleSoft, at the time of any such acquisition, to write-off a portion of the R&D as a one time charge.
** SAP is Way Ahead in Terms of R&D Expenditures
SAP, given its much higher revenue base, is able to spend significantly more on R&D without negatively impacting its margins. SAP has focused its R&D spending on developing extensive vertical functionality into its applications. With the creation of Momentum, we believe PeopleSoft is attempting to narrow this gap with SAP by plowing more money into the development of improved vertical functionality as well as into other new technologies which are geared towards PeopleSoft's longer term strategies. We believe that as the enterprise application market gets further penetrated in the areas of Human Resources and Financial applications, the growth will increasingly come from increased vertical functionality. We estimate that SAP will spend about $1 billion on R&D in 1999. Almost 2/3 of PeopleSoft's current revenue run rate.
**Wall Street May not React Positively
Given the complexity of this transaction, the competitive issue with SAP, Baan's historic accounting issues, the size of this absolute size of this transaction, and the increased likely skepticism that some may have of PeopleSoft's results, we are concerned that Wall Street may not react favorably to this sophisticated financial engineering, particularly given the lower than expected guidance put forward by the company for the fourth calendar quarter and for 1999. We also note that as of yet, that PeopleSoft has not given any guidance for operating margins. With this new structure, we expect PeopleSoft to be that much closer to giving operating margin guidance for 1999. We believe part of the genesis for this financial engineering was related to the slowing of PeopleSoft's business which likely forced the company to allocate less to research and development than the company had hoped to budget. This new structure should help alleviate those pressures as well the internal battles that PeopleSoft for where R&D dollars should go. This helps prevent the company from having to eliminate new areas of development as they can now
be funded through the new entity. Nevertheless, Wall Street is likely to look though this financial engineering. |
