Investors Are Judging Legal Technology Provider Daegis Guilty Despite Evidence To The Contrary

(Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.)

Key takeaways

• Daegis (DAEG) trades at a slight discount to its closest peer despite an inflated multiple due to a temporary decline in EBITDA, which should rebound as the ongoing turnaround progresses over the next two years and results in the current valuation disparity becoming even more apparent. Moreover, the expected improvement in profitability should result in the ignored yet significant deferred tax asset gradually being factored into the overall valuation.


• Management has been proactive in response to the current challenging environment by significantly reducing debt and the cost structure as well as transitioning to a recurring revenue model driven by SaaS subscriptions from a more volatile project based model.


• While overall investor interest is low due to the nanocap size and lack of analyst coverage, a small group of long term holders (including a recent activist) who own a vast majority of the stock clearly believe in the long term potential.

Company overview

DAEG is a global provider of eDiscovery, application development, data management, migration and archiving software solutions primarily to corporate legal and IT departments as well as law firms. In June 2010, DAEG acquired Strategic Office Solutions (Daegis) for ~$37.4 million.

The two operating segments include:

The eDiscovery solutions segment provides managed document review, project management, search analytics, consulting and data hosting.

The database, archive and migration segment includes application development, data management and application modernization solutions.

Investors focused on clouds and not silver lining

The clouds in this case include the 25% revenue decline in the mrq and 64% EBITDA decline (due primarily to the winding down of a large, multi-year legal matter for its largest client). However, management is "skating to where the puck is going" by merging its archive and eDiscovery segments in order to meet the growing demand for a single solution for information governance, compliance and litigation readiness. Management said on the most recent conference call that the revenue decline should be reversed by the end of the current fiscal year (ended 4/30/14) while growth should resume over the next 12-18 months.

Moreover, the relatively new management took the below steps, which provided significant tangible benefits and should allow DAEG to emerge as a stronger (and leaner) industry leader.

Sold non-core assets. In fiscal 1Q13, it sold the Unify trade name for $1 million and in May 2013 sold the Composer Mainframe product line to Composer Solutions for $0.4 million.

Streamlining and cost cutting. In December 2013, the merging of the archive and eDiscovery segments was completed, which is expected to result in annualized savings of ~$1.7 million. The redundant real estate footprint in expensive East and West Coast cities as a result of five acquisitions was rationalized (e.g. closed San Francisco and New York offices and moved the corporate headquarters to Irving, Texas) and should result in annualized real estate savings of ~$0.7 million. These savings are offset by a planned investment of ~$0.7 million to strengthen sales coverage.

As a result, the lower cost structure, along with low capex requirements (e.g. only ~$0.25 million on a ttm basis) should provide significant operating leverage once revenue rebounds.

Lower debt. The significant debt reduction (shown in the chart below) since the Strategic Office Solutions acquisition provides greater financial flexibility during the turnaround. Moreover, DAEG received lower interest rates in the recently amended revolving credit and term loan agreement.

Furthermore, in June 2013 ~1.7 million preferred shares were automatically converted into common, which eliminated a 10% dividend.

New revenue model. This should act as the greatest valuation catalyst, albeit over the long term. For example, the shift from a volatile project based revenue model to a recurring revenue model (e.g. SaaS subscription for Daegis Edge based on amount of stored data) should smooth out the recently lumpy results. Moreover, the stronger database, archive and migration segment (e.g. 40% EBITDA margin on a YTD basis, >90% renewal of annual support and maintenance contracts during the past three years) shown in the charts below is supporting the recovering eDiscovery segment.

Disruption finally impacts the legal industry

The 40-50% annual growth in the volume of digital data (according to the INDC) and the high associated costs (e.g. one petabyte of data has a total annual cost of ownership of ~$4 million) should continue to generate demand for an integrated, secure and scalable solution that reduces costs without sacrificing functionality. For example, Daegis Edge can reduce processing and hosting fees by 30-48% as well as import data from the archive without the need for prior manipulation or processing.

Moreover, DAEG continues to innovate by regularly providing value-added updates to existing products (e.g. predictive coding for big data, improved search, mobile access).

Concentrated ownership brings multiple benefits

In addition to the 20% insider ownership, four 5%+ holders own a collective 39% while activist investor Norman Pessin recently built a 12.2% stake and filed a 13D. Management said that it has spoken to him about this investment and noted his "long-term perspective".

As a result, the effective float is significantly reduced (which should magnify gains as the turnaround progresses) while the patient group of holders is well aware of the time required for a turnaround and less likely to sell should any more minor challenges arise.

Valuation

Despite the previously mentioned decline in EBITDA, DAEG still trades at a slight discount to the closest publicly traded, pure play competitor. This means that the valuation disparity should become even more apparent once growth resumes.

Investors are getting two key assets effectively for free. First, as previously mentioned the valuation is almost entirely supported by the database, archive and migration segment while the eDiscovery segment is being valued close to zero (or even a negative value). However this segment should contribute more to results and the valuation once performance improves.

Second, DAEG has $18.4 million of deferred tax assets (DTA) primarily related to significant federal NOLs that don't expire until 2033. However due to the previously mentioned challenging environment, there is a valuation allowance against virtually the entire DTA. While this allowance should not be expected to be eliminated in the short term, even a small but meaningful reduction over the next several years (due to growing revenue and a lower cost structure) should act as a secondary catalyst. The $0.8 million and $1.9 million allowance reduction in fiscal 2013 and 2012, respectively, is an encouraging sign.

Risks

The following are the primary threats to the investment thesis, in order of importance:

• Revenue from the largest customer (who accounts for 21% of overall revenue) is expected to end by the second half of the current fiscal year.


• DAEG competes against many smaller direct competitors (e.g. Epiq Systems), subsidiaries of larger companies (e.g. Kroll Ontrack at Kroll) and larger technology companies (e.g. IBM, Microsoft and Oracle).


• There is low revenue visibility for the eDiscovery segment as business is currently project based (e.g. the settlement of a legal matter would end a project).


• Lower economic growth would most likely result in lower customer demand given the cyclical nature of software license and maintenance spending.

Conclusion

The conservative price target assumes no multiple expansion and only a $1 million increase in EBITDA ($1.7 million in net cost savings alone after sales investment).

The stop loss should be placed below the 50 and 200 DMA ~11% below. The initial position size should be reduced by half in order to compensate for the larger stop. The time frame is 18-24 months given the longer turnaround time indicated by management.

Source: Investors Are Judging Legal Technology Provider Daegis Guilty Despite Evidence To The Contrary

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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