How much would you say Subex is worth? That is the question surrounding the Indian revenue assurance and OSS vendor after it announced its half-yearly results last week. Since raising $180m in Foreign Currency Convertible Bonds (FCCBs), they have seen the stock markets and their share price tumble. Meanwhile, Subex results have been modest in the last few years. Competition has been tough, but most of the harm suffered by Subex has been self-inflicted. In particular, the FCCBs were used to pay for the $165m cash purchase of Syndesis. With the benefit of hindsight, it looks like Subex badly overpaid for the Canadian firm. Per Subex’s own LSE filing, Syndesis “has been depreciating in value owing to the losses incurred by that business and the global market conditions“. Syndesis was overpriced, but if Subex had swapped its own paper for Syndesis’ paper, there would have been no fallout when the inflated values of paper started to fall. Instead, Syndesis was paid for in cash obtained from borrowing. Paying back that debt has become a severe headache for Subex’s management. They are now trying to find a cure, but no solution will be without some pain.
The problem for Subex is that whilst the value of Syndesis paper was overstated, Subex’s FCCB debt is not getting to get smaller by magic. In a way, that is what Subex had hoped for: that the FCCBs would be converted to equity when due in 2012. If the business had grown and grown, then the conversion of bonds to equity would have been unproblematic. The cake would have been larger, meaning everybody gets more even if their proportionate slice is smaller. Instead, the business shrunk. Where $120m annual revenues had been expected, sales of $100m-$110m now looks like the top end of what can be acheived. An absence of organic growth means cashflows were weaker than expected, leaving less money for reinvestment and further undermining the potential for growth. Meanwhile, the fall in Subex’s share price also guaranteed that the FCCB holders would not chose to convert to equity. This leaves Subex in an impossible position with respect to its current FCCBs, as it would be unable to finance the redemption of the FCCB debt from the cash it generates or by seeking new finance.
To climb out of the 2012 debt trap, Subex’s management has proposed an effective revaluation of the FCCBs. If FCCB holders agree to the current exchange offer, and then swap their FCCBs for equity in 2012, this will avoid the otherwise inevitable crisis of Subex defaulting on repaying its debt. The incentive to take the FCCB exchange offer is that the bond holders will own a much larger share of the company following a decision to convert to equity in 2012. The cost of this solution is paid for by current shareholders, who would see their stake in the post-2012 business greatly diluted. For example, founder Subash Menon’s 12% holding would be reduced to 4% if all bondholders converted to equity. However, the current shareholders may judge this is still a much better deal than one possible alternative. If the business was unable to refinance in 2012 and became insolvent, then bondholders would effectively control 100% of Subex, and the shares would be worth nothing.
Recent events have brought the challenges of valuing small cap software businesses into sharp relief. The value of any decent going concern is determined by how much money investors believe it will generate in future. The tricky aspect of valuing vendors of niche products like revenue assurance software is that, even if you spend all day every day analysing the market, it is very tricky to predict the future value of the market in which they operate. Whatever you or I may think about its importance, there are three possible scenarios for future sales of RA software:
- RA software reaches a level of market saturation and a sales plateau, with steady ongoing sales because the product is seen as essential but boring and unchanging;
- RA software is considered to have ever-increasing importance which demands ever-increasing sophistication, which in turn supports continued growth of the overall market; or
- RA software is a flash in the pan and future sales decline because the business case erodes or the same requirements are met using generic data integrity tools.
The recent investment in TEOCO and the merger of cVidya and ECtel gives yet more data on the value of competitors in this market, and hence the value of the market itself. But even these messages are dischordant, perhaps reflecting the health of the businesses themselves, and not just the overall market. Merging cVidya and ECtel may be a good business decision, but it is hardly a vote of confidence in either business as a stand-alone proposition. It also suggests they are preparing for a future where fewer competitors divide the spoils of a smaller market. On the other hand, pumping money into TEOCO is a sign of confidence about its future. Whatever Subex’s shareholders and bondholders think of the current Subex management team, they also have to consider the factors that a business can try to influence, but never wholly control: the size of the market overall. Right now it looks like investors are at a crossroads. They may feel that the RA market is declining, and want their businesses to react with defensive strategies. They may feel that the market will continue to grow, and back management teams with strategies to match. Right now, a lot of people with money in Subex will be making up their own minds about the prospects for the RA market. The rest of the RA world should take note.