I2 Technologies (ITWO): Turnaround Become a Complete Fool
If there was ever a clear buy signal for a company, it came on November 30, 2005 for ITWO. On that day, the company announced that they had obtained financing which restructured and extended the maturity of their long-term debt, and put them on secure financial footing. On the same day six insiders purchased a total of 60,500 shares at a total cost of over $800 million. The average cost basis for those shares is just north of $13.50, a number worth keeping in mind when trying to determine what a share of this company is worth. Unfortunately, the company was off my radar at that point, I rediscovered it recently when it showed up on the "Magic Formula Investing" screen.
I2 Technologies was founded in 1988 in Dallas by Sanjiv Sidhu a former TXN employee. I2 is a leader in SCM (Supply Chain Management) software. In 1996 they were featured as a potential "gorilla" in The Gorilla Game and went on to become a high flyer in the bubble years. A look at their ten year chart gives an idea how extreme things got, (and, yes, those prices at the left of the chart are correct, though they are adjusted for a 1-10 reverse split). Unlike many bubble companies, I2 had a legitimate and technically superior product. Unfortunately, as good as they were technically, they were not well managed. As one analyst has delicately put it, "[Sidhu is] a great technologist, a great supply-chain expert but... he wasn't always the best businessman." The bubble was probably the worst thing that could have happened to I2, the frothy environment masked management shortcomings that might have otherwise been addressed. As it was, business dried up when the bubble burst, there was an accounting scandal, the requisite shareholder lawsuits followed, and ITWO was exiled to the Pink Sheet desert.
Fast forward to February 2005. A Board member, Michael McGrath, steps up to become CEO replacing Sidhu, who remains as Chairman and customer front man. McGrath had joined the Board in 2004 after retiring from his position as President and CEO of PRTM, a management consulting firm he co-founded. McGrath, a highly respected supply chain veteran, took a series of steps to put ITWO on a sound footing. He restructured the sales force, restructured the product offerings, replaced several high level executives, and put together the aforementioned financing deal. That last was crucial. Buying software like I2's is a long term strategic commitment, and companies are understandably reluctant tom make that commitment when the provider could be belly up or bought out within a year or so. That concern has been largely eliminated.
It is a testament to the quality of their product, and to the quality of the moat that an installed base provides to software vendors, that at the end of 2004, I2 maintained a number two ranking in the (admittedly fragmented) SCM software business. The top five SCM companies at the end of 2004:
SAP: Revenues of 619M, market share 11%
I2: Revenues of 319M, market share 6%.
Oracle: Revenues of 283M, market share 5%
Peoplesoft: Revenues of 271M, market share 5%
Manhattan Associates: Revenues of 215M, market share 4%
In 2005 Oracle will leapfrog over I2 thanks to the Peoplesoft merger, but I2's competitive position remains strong.
In studying I2's financials, I admit that I am swimming in water over my head. I focus on companies with strong, consistent operating histories, for me a company like I2 is an anomaly. I have chosen to pretty much dismiss as irrelevant everything prior to 2005 in assessing the company's financial performance. The only thing that matters to me is how effective CEO McGrath is in turning around the business. I've looked at the 2005 quarterlies, and the numbers are decent, but inconclusive. Most reassuring is probably the Shareholder's equity which has gone from negative $173 Million at the end of 2004 to negative $71 Million at the end of 2005. Operating margin, net margin and net income have also improved dramatically.
Possibly the most useful yardstick (other than the price at which insiders loaded up in November) is to look at Oracle's recent purchase of Siebel Systems. The companies are quite similar, with Siebel in the CRM (Customer Relations Management) niche. While Siebel was on a much sounder financial footing at the time of their purchase, their product was arguably less compelling than ITWO's, and they were facing declining market share thanks to stiff competition from up and coming rivals. After netting out cash, Oracle bought SEBL for about 2.5 times sales. ITWO is currently selling, thanks to the recent run up, at just over 1.0 times sales.
Not surprisingly, this is the major drawback for this company. Though the dilution is significant, I consider the company to be managing it in a reasonable manner. Much of the potential dilution comes from the financing announced on November 30, and the transcript of that conference call is must reading for anyone considering a purchase of this stock. In a nutshell, they issued 75M plus an 11.25M greenshoe (which was ultimately fully subscribed) in 5% converts due 2015, plus 485k in warrants, all exercisable at 15.4675. The converts are not quite as bad as they sound - as the CFO put it, they function as a "senior debt instrument with equity upside". The converts are payable in cash up to the 15.4675 price. If they are in the money, the balance of the converts is payable in stock. As to what this means for dilution, it obviously depends on the price. At $25 it's about 1.8 million shares, at $30 it's about 2.3 million.
You can also assume that employees will be receiving relatively low salaries and high option grants. For example, the CEO in 2005 received a 600k salary, a 600k bonus and a grant of 480k shares (original grant was 700k but it had to be reduced due to some technical complications). I'm awaiting the 10-k for full details, but the company is clearly going to use options as a major incentive for employees. While I'm not thrilled by the inevitable dilution, I think that this is a case where options make sense .
At current prices, this is a one-decision stock for me. Assuming they will survive intact, I consider the stock to be a buy. This could turn into a quick profit if the company is sold or runs up to a price where the risk/reward forces me to sell, or it could turn into a viable long term holding. Either way, at about one times sales, I consider this an attractive opportunity. For the record, I bought a medium sized position at around $16, ceteris paribus I will turn it into a large position if the stock drifts back down to the 13's.
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I2 Technologies (ITWO): Turnaround
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