Initiating Coverage of QAD Inc.

We are initiating coverage of QAD (QADA) with a $51.00 price target, representing a FY ’21 EV/Sales multiple of 2.5x. QAD is a vertically-focused application software provider in the midst of a transition to the cloud. The company provides global manufacturers with enterprise resource planning (ERP) software and other adjacent applications embedded with deep domain expertise. We expect the launch of QAD’s next-generation Adaptive Applications, along with recent investments in sales and marketing, to accelerate the company’s cloud transition and to boost subscription revenue growth closer to management’s 30% target. Over time, we believe this could garner QADA shares a multiple more consistent with other vertically-focused Software-as-a-Service (SaaS) companies. At present, shares of QADA trade at just 1.9x our FY ’21 revenue estimate as a deceleration in subscription revenue growth, operating deleverage to support future growth, and a reset in management’s FY ’20 guidance have contributed to a depressed valuation. In our view, downside risk is further limited by QAD’s ownership of its corporate headquarters, which is situated on 28 acres of land in Santa Barbara, CA, a net cash position of $130 million, and a dividend yield of approximately 0.7%.

Investment Highlights

Adaptive Applications for a New Era in Manufacturing. Despite the mission-critical nature of ERP systems, manufacturers often fall behind on upgrades. Existing customizations and integrations may not be compatible with each new version of the software, resulting in both higher cost and operational risk to keep legacy systems current. This in turn prevents customers from utilizing the latest features and functionality available, thereby limiting their ability to adapt to evolving business conditions. Recognizing these constraints, QAD has spent the past six years rewriting its software, culminating in the release of QAD Adaptive Applications, which is comprised of the company’s next-generation QAD Adaptive ERP solution and a host of integrated modules addressing various operational processes. We believe the ability to deploy QAD Adaptive Applications in a modular fashion; build, configure, and extend applications on a common low-code/no-code platform; and reduce the total cost of ownership by moving to the cloud will appeal to manufacturers of all sizes, enabling QAD to capture share in a burgeoning market for cloud-based manufacturing ERP systems. The advent of Industry 4.0 should further fuel adoption as we believe manufacturers looking to embrace digital transformation and automation by leveraging robotics, IoT and other emerging technologies will require a more flexible solution than offered by legacy on-premise ERP vendors. As legacy ERP spend moves to the cloud, we expect QAD’s addressable market opportunity to expand meaningfully in concert.

SaaS Transition Story. While QAD has offered a cloud ERP solution since 2003, adoption of SaaS ERP solutions remains in the early innings. QAD has seen increasing interest in its SaaS offering, however, and with much of the core functionality found in its on-premise solution now available via the cloud, we expect adoption to accelerate. Cloud growth has been fairly evenly split between new and existing customers, and we note that the latter group tends to convert to SaaS at a 3x uplift to maintenance, implying a $300 million subscription revenue opportunity from conversions alone. As for new customer logos, we expect the pace of new additions to rise, particularly as competitor SAP’s deadline for its customers to move to the cloud draws near in 2025. The forced migration is likely to fuel an uptick in RFP activity, in our view, given the inherent complexity in deploying a new ERP system.

Enhancing Sales Effectiveness. Over the past 18 months, QAD has implemented a number of changes to enhance its sales effectiveness. The Challenger sales methodology has been implemented, the sales organization revamped, and incentives realigned. From an organizational standpoint, a customer success team now farms the existing customer base for opportunities, freeing the field sales team to hunt for new logos and cloud conversion deals. Additionally, QAD has hired senior business development resources with extensive vertical expertise and is adding both inside sales reps and junior account reps focused on demand generation. In Europe, where sales execution challenges surfaced during the company’s fiscal Q4 ‘19, former head of QAD Precision, Steve Gardner, has returned to his roots and is spearheading a turnaround as evidenced by a strong performance in Q2 ’20, which included the company’s largest cloud deal for the quarter. We believe the changes should eventually boost SaaS revenue growth back over 30%.

Opportunity for Significant Margin Expansion. Reflecting substantial investments in infrastructure, sales and marketing, and product development, we expect QAD’s adjusted EBITDA margin to decline from 7.7% in FY ’19 to 3.4% in FY ‘20. However, we see significant opportunity for margin expansion beyond the current fiscal year as QAD’s SaaS business scales given that subscription gross margin sits in the low-60% range today and could reach the mid-70% range over time. Of note, management aspires to achieve an adjusted EBITDA margin of 15% within three to five years, which we believe is readily achievable. Longer-term, we surmise an adjusted EBITDA margin of 25% or higher is feasible.

Strong Balance Sheet. QAD’s balance sheet includes $143.0 million in cash and investments offset by just $13.2 million in debt, all of which is associated with a mortgage secured by the company’s owned headquarters in Santa Barbara, CA. We expect QAD’s $0.072 per share quarterly dividend for its Class A shares and $0.06 per share quarterly dividend for its Class B shares to be fully covered by annual free cash flow, but the company’s cash position provides added confidence that QAD will continue to return cash to shareholders going forward while maintaining ample flexibility to pursue acquisition opportunities.

Valuation. Based on our estimates, QADA shares trade at a FY ’21 EV/Sales multiple of 1.9x, which marks the lowest valuation amongst its peer group. We note that the company’s peer group trades at forward EV/Sales multiples ranging from a low of 2.6x to a high of 12.1x with the group median sitting at 5.3x. Our price target of $51.00, represents a FY ’21 EV/Sales multiple of approximately 2.5x.

Investment Risks

Acquisitions. QAD has completed a number of acquisitions throughout its history and remains active on the M&A front. Acquisitions pursued by the company may not be purchased at an attractive price or yield any anticipated synergies and could result in integration challenges, earnings dilution, or other negative outcomes.

Competition. The market for ERP software is highly competitive. QAD competes with several established vendors that have significantly more scale and resources at their disposal as well as emerging companies aiming to disrupt the market.

Dual Class Shares. Under QAD’s dual class structure, Class B shares are entitled to one vote and Class A shares have 1/20th of a vote per share. However, the dividend payout for the Class A shares is 20% higher than that of the Class B shares. Founder and President Pamela Lopker owns approximately 40% of the outstanding Class A and Class B shares, representing 67% of the voting power. As such, Ms. Lopker has sufficient voting control to determine the outcome of board elections, a merger or sale of the company, and other matters requiring shareholder approval, and her interests may not be aligned with the those of other shareholders.

Industry Concentration. QAD primarily targets manufacturers in the automotive, consumer products, food and beverage, high technology, industrial products, and life sciences verticals. A slowdown or other disruption in any of these industries could negatively affect the company’s growth prospects.

Intellectual Property (IP). QAD is dependent upon the licensing of its technology to customers. Should the company fail to maintain its IP or should its IP infringe upon those of third parties, the company’s results could be harmed.

International Exposure. Just over half of QAD’s revenue is derived in international markets, exposing the company to foreign currency fluctuations, geopolitical conditions, regulatory compliance requirements, and other factors that may cause volatility in results.

Missed Expectations. Sales cycles associated with ERP software tend to be long and complex, resulting in large transactions that are inherently lumpy and difficult to predict. Should the company’s results fail to meet the expectations of management, investors, or sell-side analysts, shares of QADA could decline.

Four Decades in the Making

QAD was founded by Pamela Lopker in 1979 and is headquartered in Santa Barbara, CA. The company’s genesis was sparked by Karl Lopker’s search for a software application to help manage his growing sandals company. After no suitable software was identified, Mr. Lopker turned to Pamela to develop a solution, and the two soon recognized that other manufacturing companies also had a need for a complete, integrated software system to run their businesses. Initially, the company focused on a few local companies, but as its customers expanded internationally, QAD followed suit. Today, QAD boasts over 2,000 customers in six core vertical markets that have deployed its software in approximately 4,000 sites across the globe.

Throughout its history, QAD has sought out tuck-in acquisitions to fill product gaps or to expand globally. In the 2000s, acquisitions included the purchase of TRW Integrated Supply Chain Solutions, which expanded the company’s presence in Europe, the Middle East, and Africa (EMEA); Oxford Consulting Group, which added EDI capabilities; and Soft Cell. QAD acquired Bisgen in June 2006, adding customer relationship management (CRM) software, and followed that with the purchase of transportation management software provider Precision Software in September 2006, which remains a standalone division within the company and is now referred to as QAD Precision. The company closed the year with the acquisition of FBO Systems, a provider of enterprise asset management software. FullTilt Solutions was bought in 2008 to add product information management capabilities.

In December 2010, shareholders of QAD approved a recapitalization plan, establishing two classes of common stock. The new Class A shares had 1/20th vote per share and the new Class B shares had one vote per share. Each existing share at the time was reclassified as 0.1 shares of Class B common stock, and a dividend of four Class A shares was issued for each Class B share outstanding. Class A shareholders are entitled to a dividend payout 20% greater than the payout received by Class B shareholders.

In 2012, QAD acquired DynaSys for $7.5 million in cash. The purchase added supply chain planning capabilities and became a new standalone division now known as QAD DynaSys. This was followed by the acquisition of CEBOS in December 2012 for $3.5 million, which became the company’s final standalone division, QAD CEBOS. In FY ’15, QAD completed a secondary offering of 2 million shares of Class A common stock, netting proceeds of $37 million. More recently, the company acquired the assets of one of its software distributors in Indonesia and completed another purchase to add functionality to its product suite for $2.7 million in cash.

Adaptive Applications for the Fourth Industrial Revolution

QAD develops, markets and sells an integrated suite of business applications used by manufacturers around the globe to manage core aspects of their operations, including finance, sales and support, production, and supply chain. The company’s products may be deployed on-premise, in the cloud, or in a hybrid configuration and are embedded with deep domain expertise arising from decades of experience within QAD’s six key vertical markets: automotive, consumer products, food and beverage, high technology, industrial products, and life sciences. Originally branded as MFG/PRO and sold as a perpetual license for on-site deployment, QAD has rewritten its software with an eye towards transforming the architecture and user experience of its platform. This initiative, dubbed Channel Islands, was first launched during FY ’16 and has culminated in the general availability of QAD Adaptive Applications. In addition to a new user interface accessible via any modern web browser, the release features the QAD Enterprise Platform, which serves as the underlying architecture supporting personalization, embedded analytics, and modularization across the entire Adaptive Applications suite. Moreover, QAD Enterprise provides customers with a low-code/no-code platform to extend existing applications, connect with external systems, and build entirely new applications. Importantly, these development and integration efforts are not affected by future software upgrades. As such, customers can deploy QAD Adaptive Applications with the knowledge that new innovation forthcoming in the fourth industrial revolution, also known as Industry 4.0, can be successfully leveraged. At present, QAD counts over 2,000 manufacturing companies as customers and has over 300,000 active users, of which 43,000 utilize its products in the cloud. Given that QAD Adaptive Applications was only recently released, the vast majority of customers remain on older versions of the software.

*Source: QAD Corporate Overview, August 2019*

The advent of Industry 4.0 has significant ramifications for the manufacturing economy as the explosion of data, hyper connectivity, artificial intelligence/machine learning capabilities, and cyber-physical systems give rise to smart factories featuring far more automation, real-time optimization of production yields and quality, and synchronization of processes. Given the breadth of data and business processes supported by ERP software, we believe such systems will remain mission-critical as manufacturers embrace digital transformation. In our view, QAD’s next-generation platform and staunch focus on six primary verticals (and the 26 segments within these verticals) position the company to benefit disproportionately given the deep domain expertise embedded in its applications and the ease with which new integrations, extensions and applications may be adopted. Per Gartner, enterprise spending on ERP software totaled $37.3 billion in 2018 and is expected to increase at an annual rate of 6.8% through 2022. This sizing includes Human Capital Management software spend of $13.8 billion, of which an estimated $9.4 billion has already shifted to SaaS and is not currently addressed by QAD’s offering. However, Financial Management software spend of $14.8 billion, of which only $3.4 billion has been spent on SaaS so far, is an opportunity for QAD as is operational ERP, which by Gartner’s definition spans manufacturing and operations software as well as Enterprise Application Management software. Of note, spending on SaaS-based operational ERP systems trails the other categories, portending a significant growth opportunity for QAD as more of the $8.7 billion in spending shifts to SaaS. Competition for this spend primarily arises from legacy ERP vendors such as Epicor, Infor, Microsoft (MSFT), Oracle (ORCL), and SAP (SAP). The company also competes with ERP vendors like IQMS and Plex as well as point solution providers targeting specific business processes such as customer relationship management, global trade compliance, or supply chain management.

QAD’s cloud and on-premise ERP products encompass a myriad of applications for manufacturing, supply chain, customer management, demand and supply chain planning, global trade and transportation execution, financials, analytics, integration, and enterprise quality management that may be run discretely or as an integrated solution. QAD Manufacturing supports an array of manufacturing modes, including discrete, process, repetitive, and lean, and is used to manage business processes ranging from planning and scheduling to material and shop floor control to quality management and reporting. Manufacturers may also employ QAD Enterprise Asset Management to manage the maintenance and installation of capital equipment. QAD Supply Chain Execution provides manufacturers with tools for managing requisitions, supplier performance, purchasing, and warehousing. To manage the entire customer lifecycle from acquisition through customer service, the company offers QAD Customer Management, which provides manufacturers with a comprehensive view of all customer interactions, supports the creation of quotes and sales orders, allocates inventory, and processes invoices; QAD Configurator, which allows for the mass customization of products while maintaining effective cost controls; and a web store-front for taking orders. Additionally, QAD Service and Support, which features capabilities for service call management, field service scheduling, and mobile field service, may be used for managing post-sale customer service and support. QAD’s demand and supply chain planning solution is branded as QAD DynaSys and is used for demand planning, distribution planning, production planning, sales and operations planning, procurement planning, and analysis. QAD’s global trade and transportation execution solution is branded as QAD Precision and includes capabilities for managing multi-modal shipping, facilitating the correct documentation and control for moving shipments across borders, and ensuring compliance with regulations and free trade agreements. QAD Financials provides a comprehensive solution for managing accounting and operational processes, financial controls, and reporting at all levels of an organization. QAD Internationalization may be used by manufacturers that sell globally and require a local, country-specific solution for regulatory compliance and reporting. QAD Analytics is used by decision makers to measure and track performance against key performance indicators. To manage product quality and compliance with industry-specific standards, QAD offers an enterprise quality management system branded as QAD CEBOS. Finally, QAD offers several integration solutions, including QAD Cloud EDI, QAD EDI eCommerce, QAD Boomi AtomSphere, and Q-Xtend, enabling customers to integrate with non-QAD business applications.

Transition to a Vertical SaaS Story

QAD generates revenue from traditional perpetual license sales, maintenance and support associated with on-premise customers, subscription fees from cloud deployments, and professional services such as consulting, implementation, and training. While the company’s roots date back four decades to a time when all deployments were on-premise, QAD has offered a cloud-based ERP platform since 2003. The company’s cloud business has exhibited meaningful growth over the past decade with subscription fees rising from $4.0 million in FY ’10 to $91.9 million in FY ’19, reflecting a CAGR of 42%. However, this growth has come at the expense of license fee revenue, resulting in total revenue increasing at a lower CAGR of 5% over that same time frame. More importantly, the mix shift in revenue makes for a more predictable business as subscription fees now comprise approximately a third of revenue, which combined with maintenance revenue results in over 70% of revenue from recurring sources. License fees, which tend to be lumpy and difficult to forecast, now account for less than 10% of revenue with professional services comprising the remainder. Of course, the transition from license fees to subscription negatively affects margins given the up-front recognition of the former versus the ratable nature of the latter. As such, the company’s adjusted EBITDA margin declined from 9.4% in FY ’15, which marked the highest level of license fees in recent memory, to 3.0% in FY ’18. Non-GAAP EPS attributable to the Class A shares declined from $1.13 to $0.13 in that same timeframe.

*Sources: K. Liu & Company LLC; QAD’s SEC Filings*

In FY ’19, QAD posted a second consecutive year of top line growth near 10% and saw its adjusted EBITDA margin rebound to 7.7%, resulting in non-GAAP EPS of $0.91. However, the company exited Q4 with revenue growth in the low single-digit range, reflecting headwinds from foreign currency fluctuations, the completion of a large implementation project, and sales execution challenges in the EMEA region. Those dynamics continued in early FY ’20, resulting in subscription fee growth decelerating below 20% and total revenue down close to double-digits. In addition, management ramped investments in sales and marketing and product development designed to reaccelerate QAD’s cloud growth, bringing about operating deleverage and non-GAAP EPS falling below breakeven. The company’s recently reported Q2 ’20 results were similar in terms of the headline numbers, but management’s underlying commentary was more positive, reflecting cloud bookings ahead of internal expectations, a rebound in EMEA performance, and a 37% Y/Y increase in the cloud funnel. Still, the improved bookings were not sufficient to offset the slower start in Q1, so management reduced its outlook for the year. Specifically, guidance for FY ’20 now calls for revenue of $313.0-$318.0 million and non-GAAP pre-tax income of $6.7-$8.7 million, down from $330.0-$335.0 million and $10.3-$13.3 million, respectively. Reflected in the revenue guidance is subscription revenue of $108.0-$109.0 million, implying Y/Y growth of 18%-19%.

*Sources: FactSet; K. Liu & Company LLC*

With expectations reset, we believe guidance is readily achievable and project FY ’20 revenue, adjusted EBITDA, and non-GAAP EPS of $315.4 million (-5.3% Y/Y), $10.8 million (3.4% margin), and $0.20, respectively. We expect a reacceleration in subscription revenue growth to the mid-20% range in FY ’21, fueling top line growth of 7.0% and approximately 240bps of expansion in the adjusted EBITDA margin to 5.8%. Our non-GAAP EPS estimate is $0.57. Beyond the out-year, we model subscription revenue growth exiting the year near management’s targeted 30% growth rate along with continued improvement in margins. We believe this should translate into low double-digit revenue growth in the intermediate-term and achievement of management’s targeted 15% adjusted EBITDA margin within three to five years.

Valuation

Shares of QADA currently trade at 2.0x and 1.9x our FY ’20 and FY ’21 revenue estimates, respectively. On a historical basis, shares have traded at a median forward EV/Sales multiple of approximately 2.5x over the past three years, reaching a low of 1.2x and a high of 3.7x during that time frame. We note that QADA traded above the median valuation referenced earlier when top line growth approached double-digits and margins were expanding but has seen its valuation multiple dip below that level amidst decelerating growth and operating deleverage in recent quarters. As sales execution improves and the company’s fundamentals reflect more positive trends, we QADA’s valuation to rebound. Our price target of $51.00 represents a FY ’21 EV/Sales multiple of 2.5x.

As many of QAD’s primary competitors boast far more scale and derive revenues from sources other than ERP software, we have constructed a peer group comprised of small and mid-cap application software vendors providing integrated business software solutions designed for specific verticals, offering point solutions competitive with modules available from QAD, or with significant customer representation in the manufacturing vertical. For the most part, QAD’s peers are expected to generate top line growth in the high-single to low-double digit range and the majority are solidly profitable. In this regard, we acknowledge that QAD’s lower growth profile and marginal profitability at present warrant a discounted valuation relative to peers. However, we believe the magnitude of the current discount is excessive with shares of QADA trading well below the lowest forward EV/Sales multiple in the group of 2.6x.

In our opinion, QAD’s scale in the manufacturing vertical, highly regarded technology, and growing SaaS business could attract the interest of an acquirer, garnering the company a valuation more akin to those realized in recent transactions in and around the manufacturing ERP space. We note that 2019 has already proven to be an active year in this regard starting with Dassault Systèmes’ (DSY-FR) acquisition of IQMS, a manufacturing ERP software vendor serving small to mid-sized manufacturing companies for $425.0 million in cash in January. Management’s initial guidance for the year contemplated revenue contribution of approximately $69.0 million, implying top line growth of approximately 10% and a forward EV/Sales multiple of 6.2x. In June, manufacturing ERP software provider Acumatica was merged with IFS, another ERP software vendor that had been taken private by EQT partners in 2016. The following month, E2open acquired Amber Road, a competitor of QAD Precision, for $425.0 million in cash, representing a TTM EV/Sales multiple of 5.0x and a forward EV/Sales multiple of 4.5x. Consensus projections at the time reflected expectations for Amber Road to generate revenue growth of approximately 7% with an adjusted EBITDA margin in the high-single digit range. Earlier this week, MAM Software Group (MAMS), which sells business management solutions to the automotive parts, tire and vertical distribution industries, agreed to be acquired by Kerridge Commercial Systems for $154.2 million in cash. The purchase price represents a TTM EV/Sales multiple of 4.1x and a FY ’20 EV/Sales multiple of 3.8x. Consensus forecasts assumed revenue growth of approximately 10% and an adjusted EBITDA margin in the mid- to high-teens. Considering each of the aforementioned targets had yet to fully move to the cloud and our view that QAD should ultimately achieve a growth and margin profile at least in line with these companies, we see little reason why the company would not be similarly valued in a takeout scenario.

Our model is available here.

QAD Inc. (QADA)Kevin LiuSeptember 5, 2019Industry 4.0, Manufacturing ERP, SaaS