BMC Software Shows Again That Getting Full Value Is Tough Without Growth

By Stephen D. Simpson, CFA | May 06, 2013 AAA

It's hard to call the last few years a nightmare for BMC Software (Nasdaq:BMC) shareholders, but dishwater-gray mediocrity doesn't seem so unfair. Against a nearly 20% return from the Nasdaq, BMC has actually declined about 10% over the past two years (though up almost 30% over five years, and closer to the Nasdaq return), and has trailed peers/comps like CA (NYSE:CA), Compuware (Nasdaq:CPWR), and ServiceNow (NYSE:NOW) by a meaningful margin too.

The problem here is one that I've lamented before in the tech sector. Although BMC converts a sizable percentage of its revenue into free cash flow (FCF) and sports solid margins and returns on capital, the company's growth has been lackluster due to an inability to change with the times and establish competitive positions in new markets.

Now the story seems to be all but over for BMC as a publicly-traded company. A consortium of private equity investors has put together a bid that gives investors only a modest premium over the 200-day moving average and would seem to undervalue the company's long-term cash streams. And yet, this very well may be the best deal that investors can hope for and a warning to investors in other cash-rich/growth-poor stories.

The Bid
BMC announced Monday morning that its board had elected to accept a $6.9 billion, $46.25-per-share, all-cash bid from a consortium of private equity investors (Bain Capital, Golden Gate Capital, GIC, and Insight Venture Partners). Rumors of such a bid had been swirling for some time, accounting for at least some of the minimal premium to Friday's close (2%) or the 200-day moving average for the stock (< 10%).

At this price, the consortium is taking BMC private at a multiple of roughly 11x to trailing EBITDA and about 3x trailing revenue. Clearly this is nothing like the premiums that companies like Oracle (Nasdaq:ORCL) and SAP (NYSE:SAP) have been paying for software companies lately, and we'll discuss that in a moment.

As mentioned, BMC was actively shopped. Consequently, while there are strategic bidders who could conceivably see operating value in adding BMC (names like IBM (NYSE:IBM), CA, and Hewlett-Packard (NYSE:HPQ)), it's hard to imagine that they didn't have their chance to make a better bid by now.

SEE: Key Players In Mergers And Acquisitions

Slow Growth And An Uncertain Future
There's a good reason that BMC didn't get much of a multiple for the business – growth has been mediocre for quite some time. With the company has had three years of 8%-plus revenue growth in the last five, nevertheless the five-year average revenue growth rate is less than 7% and the 10-year rate is only about 5%. Repeated restructurings have taken costs out of the business and boosted operating income growth ahead of revenue, but the top-line growth prospects are modest at best.

BMC's growth woes are nothing particularly new in the tech sector. The company has a very profitable business in providing services for mainframes, but mainframes are clearly no longer a growth business. BMC attempted to respond by building up its enterprise service management offerings, but the company struggled to develop truly innovative or differentiated products and saw relative newcomers like ServiceNow grab share in markets like IT service desk software. Said differently, BMC hung on too long to its profitable businesses of yesteryear and failed to position itself for the shifting and evolving enterprise IT market.

A Lesson And A Warning
There are more than a few similarities between BMC and other tech names like CA, Check Point Software (Nasdaq:CHKP), Symantec (Nasdaq:SYMC), and perhaps VMware (NYSE:VMW). These companies all have strong positions in their legacy businesses and solid records of converting revenue to free cash flow. They all are also facing rapidly-changing markets and the prospect that their expertise in the business(es) that got them to this point isn't going to be worth much as they attempt to continue to grow.

To a one, these stocks all look undervalued today on the basis of long-term free cash flow models. Unfortunately, there is not only the risk that growth declines further/faster than predicted in the models, but that investors see the pale growth numbers and refuse to pay full value for those cash flow streams.

SEE: Does Active Value Investing Payoff?

While Quest Software was at risk of going private too cheaply, the involvement of a strategic bidder (Dell (Nasdaq:DELL)) helped investors get something closer to full value. Absent strategic buyer interest, those aforementioned companies had best find ways to improve their revenue growth prospects, lest they too see their best option as selling out at a price that seems to undervalue the company's long-term free cash flow because of sluggish revenue growth prospects.

At the time of writing, Stephen D. Simpson owned shares in EMC, the majority owner of VMware.

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