Ask and ye shall receive! Here are two more writeups from BT Alex Brown and CS First Boston:
PSFT: ANNOUNCES PLANS TO SPIN-OFF SUBSTANTIAL R&D TO AN OFF-BALANCE SHEET ENTITY CALLED MOMENTUM--MARKET PERFORM Bankers Trust Research/BT Alex. Brown Research
Randal Chin,James Moore
November 17, 1998 <Picture>
Moore, James A. 415-477-4269 11/17/1998
Chin, Randal R. CFA 415-477-4274
BT Alex. Brown Incorporated
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---- PEOPLESOFT, INC. [PSFT] "MKT. PERFORM"
Announces Plans To Spin-Off Substantial R&D To An Off-Balance Sheet Entity Called Momentum
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HIGHLIGHTS:
--In an unexpected announcement, PeopleSoft signalled its plans to spin off several of its new R&D efforts (including its e-business, analytic and industry specific programs) into a separately traded company to be called "Momentum Business Applications, Inc."
-- To fund the startup of Momentum, PeopleSoft plans to provide this new entity with $300M in cash (taking PeopleSoft's cash position to $378M from $678M). Management expects this cash infusion should provide Momentum with enough financial wherewithal to fuel 3-4 years of development.
--PeopleSoft will have the option to buy (through the right of first
refusal) the technology that Momentum creates. PeopleSoft also will have the option to purchase Momentum based on a four-prong formula that is outlined in detail in an S-1 statement filed with the SEC.
--By the end of this year, shareholders are expected to receive one share of Momentum for every 50 shares of PeopleSoft stock they own. Based on the number of PeopleSoft shares outstanding (233 million), this ratio should result in approx. 4.7M shares of Momentum stock. Momentum's stock is intended to be listed on the NASDAQ exchange under the ticker symbol MMTM.
--This transaction should give PeopleSoft the flexibility to move at an even more aggressive speed, spending to develop new applications without fear of an adverse impact on its income statement.
-- This transaction seems to be a creative way to unleash the value contained in the PSFT balance sheet while aggressively trying to stay ahead of the competition. But we suspect investors will be intimidated by and wary of this attempt to offload costs to a separate yet related entity.
--We maintain our "Market Perform" investment rating on the shares. We will carefully monitor this new arrangement but for now see no reason to change our investment rating.
DETAILS:
CREATING A NEW R&D SPINOFF CALLED "MOMENTUM BUSINESS APPLICATIONS, INC."
Taking a page of out of the playbook of the biotechnology world, PeopleSoft announced plans to spin off several of its new R&D efforts into a separately traded subsidiary to be called "Momentum Business Applications, Inc." While the Company did not disclose specific details, the new "Momentum" entity likely will incorporate the development of a) e-business, b) analytic applications and c) industry specific solutions that PeopleSoft ordinarily would have paid for through its own income statement.
DETAILS BEHIND THIS ACCOUNTING TRANSACTION
To fund the startup of Momentum, PeopleSoft plans to provide this new entity with $300M in cash (taking PeopleSoft's cash position to $378M from $678M). Management expects this cash infusion should provide Momentum with enough financial wherewithal to fuel 3-4 years of development. When/if the spin-off brings products to market, PeopleSoft will reimburse Momentum on a cost reimbursement basis. One month after the product has become generally available, PeopleSoft will have the option to buy the technology. PeopleSoft has the right of first refusal on all products generated by Momentum. PeopleSoft will have the option to purchase Momentum based on a four-prong formula that is outlined in detail in an S-1 statement filed with the SEC.
Shareholders will receive one share of Momentum for every 50 shares of PeopleSoft stock they own. Based on the number of PeopleSoft shares outstanding (233 million), this ratio should result in approx. 4.7M shares of Momentum stock. Momentum's stock is intended to be listed on the NASDAQ exchange under the ticker symbol MMTM and is planned to consist of two classes: class A voting shares (100% owned by existing PeopleSoft shareholders who receive the spin-off shares) and class B (100% owned by
PeopleSoft and the mechanism by which PSFT will potentially buy MMTM).
Because technically PeopleSoft will own 0% of the class A shares, the Company will not need to consolidate Momentum on its income statement. In conjunction with this transaction, PeopleSoft plans on taking a one time charge based on the following formula: $300M minus the fair market value of Momentum shares based on some future trading price of MMTM shares.
MORE ON MOMENTUM
Momentum is not planning to directly employ any personnel. Instead, it will contract R&D resources from PeopleSoft (at the rate of cost plus 5%) and/or other third party companies. PeopleSoft also has agreed to supply Momentum with all administrative services. Aneel Bushri, PeopleSoft's VP of Strategy/Marketing, has been appointed Momentum's interim President and sole director. Further management and board of director announcements are expected in the near future. Management expects to have 3-4 directors
eventually. We anticipate that existing insiders at PSFT will be required to sell their MMTM shares over time to maintain an arms-length arrangement.
RATIONALE FOR THIS COMPLICATED SPINOFF. As management indicated at its heavily attended user conference in S.F. in early November, PeopleSoft plans to move at a rapid rate to diversify its business model beyond its core ERP applications. E-business (especially the PeopleSoft Business Network aka PSBN), analytic applications and industry specific solutions
are three central thrusts of this effort. With the creation of Momentum, PeopleSoft now has the flexibility to move at an even more aggressive, breakneck speed spending to develop these new applications without fear of an adverse impact on its income statement. This is not the first time the Company has experimented with creative off-balance sheet financing programs. For example, the Company developed its higher education software through Campus Solutions which was kept off-balance sheet for several years
before it ultimately was purchased and integrated by PeopleSoft.
BUT AT WHAT COST TO SHAREHOLDERS?
While this type of R&D spin-off has become relatively common place in the biotechnology sector, this type of transaction is foreign to the enterprise software world. We suspect investors will be intimidated by and wary of this attempt to offload costs to a separate yet related entity. This move appears to be above the board and fully disclosed (in contrast with Baan's relationship with Vannenburg Ventures). Because this transaction may leave a bad taste in the mouths of the investment community, management will need to spend a great deal of time convincing investors of its merits, in our view.
IMPACT ON PEOPLESOFT'S FINANCIALS
Other than the initial transfer of $300M to Momentum and the associated write-off, management does not expect substantial further impact on its financials until the point in time when PeopleSoft begins buying back technology from Momentum. PeopleSoft plans to continue to target spending 15-17% of its total revenue on R&D efforts that stay on its income statement. Projects that fall in this category include human resources, financial management, supply chain and materials management, global functionality and the development of release 8 of its core product.
REITERATE "MARKET PERFORM" RATING
Because of the major deceleration in license revenue, intense competitive pressure, and continued uncertainty around the Y2K and macro economic issues, we remain on the sidelines. At the moment, we do not see any significant increase in attrition at PSFT and believe that the strong corporate culture of the firm is still intact. Longer term we believe that the Company has many solid opportunities to rekindle growth (new verticals, ancillary products, e-business, manufacturing, international penetration) but over the short to medium term, the Company faces a very stiff headwind.
This transaction seems to be a creative way to unleash the value contained in the PSFT balance sheet while aggressively trying to stay ahead of the competition. If the Company can effectively leverage this arrangement to accelerate time to market on these (potentially) revenue generating products, it will gain a jump start on its competitors who are saddled with traditional R&D structures. We will carefully monitor this new arrangement but for now see no reason to change our investment rating.
CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research-Americas
Industry: Enterprise Application Software
George Gilbert 415/836-7717 george.gilbert@csfb.com
Brent Thill 415/836-7712 brent.thill@csfb.com
HOLD
PeopleSoft (PSFT)
Summary
R&D budget under current operating model insufficient for publicly
announced initiatives Differentiation required in order to prevent price
erosion on core Financials and HR $300M invested in spin-off shell entity to fund 3-4 years of R&D for industry solutions, analytic applications, and e-business to maintain/restore differentiation and for new growth opportunities Q4 one-time charge likely to be $225M, 4.75M shares in new entity issued at rate of 1 for 50 existing PSFT - likely to trade at heavy (75%?) discount to $64 book value PSFT shares likely to react negatively: if spin-out's P&L is "consolidated" with PSFT's in anticipation of ultimate buyout, many will perceive lower operating margins Although we view this as a strategically meaningful use of cash, PSFT remains competitively exposed
until this entity delivers successful products and meaningful revenue after CY99. Maintain Hold.
Highlights from Momentum S-3 Registration Statement
We had an opportunity to review Momentum's S-3 registration statement last night. An abbreviated analysis of the 75- page document includes: Momentum Business Applications to be traded on NASDAQ under ticker "MMTM"; MMTM will facilitate in development of 3 primary initiatives: 1) industry applications; 2) analytical ap- plications; 3) e-business applications; MMTM will have limited staff and facilities; PSFT will contribute $300M to MMTM- decreases cash from $677.6M to $377.6M. PSFT expects this to cover research and development expenses for next 3 to 4 years; What is the approximate share price to existing shareholders? -
$300,000,000/4,750,000=$63.16/share * .25 (est fair value based on likely initial trading range) = approximately $15.79/share - stock dividends taxable; PSFT sole holder of MMTM Class B Stock (non-voting rights) following distribution, with option to re- purchase all, but not less than all, outstanding shares of MMTM Class A Stock (voting rights); PSFT record one-time charge = $300M - $75M (fair market value upon distribution) = approximately $225M charge in Q4:98.
RELATIONSHIP BETWEEN PSFT AND MOMENTUM
Formation and Funding
MMTM will have no assets other than $300 initial contribution
Governance Consist of 4 directors - one select by PSFT, 3 by voting A shareholders
PSFT Purchase Option
PSFT has right to purchase all outstanding shares of MMTM at any time prior to Dec 31, 2002. Further review ex- tended by six-month increments if MMTM meets specified guidelines. Exercise price will be greatest of: 15x actual WW payments made by or due from PSFT to MMTM with respect to all licensed products and de- veloped technology for 4 calendar quarters preceding quarter which purchase option is exercised; fair market value of 720,000 shares of PSFT common stock; $350M plus additional funds contributed to MMTM by PSFT; $90M
Contractual Arrangements
Development - both parties agree on development timetable, budget, and product specifications. Most development work expected to be done by PSFT under contract to MMTM. Marketing - prior to becoming generally available, PSFT has exclusive license to market and distribute MMTM product. PSFT will pay MMTM 6% royalty on sale. Option to obtain - PSFT must exercise within 30 days after MMTM product becomes generally available. PSFT pays royalty
on net revenues of MMTM product based in development agreement for period of ten years Services - provide administration, legal, HR for MMTM employees.
Reason for Distribution
Separate new business with its own unique market opportunity and
risk/reward profile from PSFT's traditional cross-industry ERP apps; Enable PSFT to increase/decrease level of participation; Allow PSFT to reflect traditional cross-industry ERP apps business and industry initiatives
Motives -------------------
R&D BUDGET UNDER CURRENT OPERATING MODEL INSUFFICIENT FOR PUBLICLY ANNOUNCED INITIATIVES
As PSFT's projected license growth rate has slowed significantly, the
company faced a classic trade- off of growing constraints in its R&D
budget. It could fully fund the ongoing development of existing core
products (Financials, HR, materials management, supply chain). These products require more globalization, more advanced tools technology, and additional interoperability with 3rd party products. Or PSFT could address the competing needs of newer initiatives such as e-business, analytic applications, and the industry solutions that represented future growth opportunities. By putting $300M into a new company, funding for these initiatives will not be subject to the quarterly pressures of PSFT's own financial performance.
DIFFERENTIATION REQUIRED IN ORDER TO PREVENT PRICE EROSION ON CORE FINANCIALS AND HR
We believe PSFT's elevated investment levels reinforce our thesis that back-office administrative products are becoming relatively commoditized as standalone products. It is integration with the industry solutions that provides meaningful differentiation. SAP can make headway in utilities, for example, against PSFT because it can offer a financial accounting system integrated with the core operational process of customer care and billing. In fact, SAP can charge less for the Financials because it can recoup the revenues on the billing system. SAP fully appreciates current and future follow-on revenue opportunities in new, non-manufacturing verticals (that happen to be PSFT's core business) and is pricing for market share to secure them. That is the source of price competition in PSFT's business in our opinion. We believe the new R&D initiatives would
deliver meaningful differentiation and growth opportunities. Our only
concern is timing. The company is not expecting significant contributions from the new insurance, retail, or utility solutions in 1999. The existing higher education, public sector, financial services solutions and the new analytic applications will be the likely sources of growth. The e-business initiative, while very ambitious, is likely to be a contributor in 2000 or beyond.
SHAREHOLDERS WILL HAVE OPTION TO REARRANGE RISK EXPOSURE
Shareholders will be able to choose to reweight their holdings between the more conservative PSFT shares and those of the potentially faster growing new entity, MMTM.
Negatives -------------------
PERCEPTION OF LOWER MARGINS
There is the likely perception of a "consolidated" P&L between the two entities with lower margins and a heavy initial trading discount on the new issue.
DIMINISHED FINANCIAL TRANSPARENCY
Although PSFT is not engaging in "card-shuffling" by any stretch of the imagination, analyzing their results will be somewhat more complicated. Investors will have to examine the results of both companies for an apples-to-apples comparison with the PSFT we know today.
Investment Conclusion When the furor over the mix from licenses to
services began this spring, PSFT was very clear on the issue of sales and marketing expenses. They would be tied to the license growth rate, not the top-line. Sales & marketing sold licenses, not services. The R&D growth rate was less a focus of discussion. As license growth slowed, something had to give in order to keep up with SAP's larger absolute R&D spending. We expected acquisitions and partnerships. We believe this is an effective way to leverage the balance sheet for additional R&D. But we just don't think the rewards will be visible for 18 months or so. We maintain our Hold. |
