Friday interview with Versant Partners software analyst Tom Liston

Tom Liston will be well known to many a tech CEO and CFO. As the software and services research analyst at Versant Partners, Tom is a well regarded and experienced commentator. He doesn’t push his calls, but he is right a lot more often than he’s wrong. And when he’s wrong, he declares it. Tom is one of the few local fellows that can say he was covering Canadian tech during the 2000 bubble. Great experience for anyone on the sellside.

Question 1. In your coverage of the Canadian software and services sector, what do you look for when you do your work? What makes one story better than the other?

The standard answer is “good management” and I do agree. However, what I view that to mean with technology companies is management that understands the need to position a product to solve a real need. I want to see products or services that a Global 2000 company needs to solve a pain point or which truly makes the company more efficient. Too many companies chase after multi-billion dollar markets, declaring they only need 1% of it to be successful. They usually have a hard time explaining what makes them differentiated. The other major item I look for in a company is leadership that has all departments singing the same tune. Specifically, we need to see a strong link between S&M and R&D. S&M need to prioritize their customer’s top requirements and we like to see a culture where R&D understands the importance of delivering on these specific items.

Question 2. How hard is it for Bay Street institutional investors to take a second look at a story that might have disappointed them in years gone by? Are investors able to forgive and forget?

i.Very/ii.Sometimes. Geac was probably the best example. Geac’s new management team was doing a great job of restructuring the business, but only a few appreciated what was developing there. It was clear to everyone that Geac did not have the world’s leading portfolio of technology assets. However, management took Geac from just over $20m in trailing 12 month free cash flow in Q4/03 to over $80m in a span of only 7 quarters. We saw a large valuation disconnect in the market. As well, software M&A was heating up as was the appetite of private equity for software companies – especially ones with the ability to generate significant free cash flows. But, we had to do a lot of convincing – and often clients thought we had this call completely wrong. Most remember (and owned during) the stock’s decline from $40 to $2 and just could not allow themselves to potentially be burned again. One of the ideas I had to convince some was to build a “reverse” DCF – i.e. see what rate free cash flow had to grow to justify the current share price. It showed something like a 5% decline in free cash flow had to be realized each and every year for the next 10 years in order to justify its current price. Since management had been able to triple free cash flow (although that growth was obviously not sustainable) in such a short period, some investors felt that Geac would do much better than a 5% decline – and thus bought the stock. Those investors realized an 80% return in about 18 months.

Descartes is another stock that is also a four letter word with most. We were also hesitant and didn’t see the potential for such a dramatic turnaround there. Point being is that these types of stories often provide the best returns.

Question 3. You’ve been covering tech stocks since the bubble burst in 2000. Has the sector been able to shake that blowup off yet, even 7 years later?

I believe it has. The past twelve months have been “quietly” very good for tech stocks. The average one year return of the 30 Canadian software stocks that we watch is 44%. Not many would have guessed this if you asked them. Two of my companies have performed very well and have the attention of a large audience of investors – Absolute Software (ABT-TSX) is up 579% in the last twelve months. SXC Health Solutions (SXC-TSX; SXCI-Q) is up 76% in that time frame. We currently only have one Buy recommendation in our universe – largely due to big price moves which have moved us to downgrade several recently based on valuation. Demand for quality technology companies has definitely returned. We are also seeing a solid appetite for more speculative tech names as well.

Question 4. Do you suspect that Canada’s inability to generate any web 2.0 firms speaks to the conservative approach that our investors take when it comes too technology stories? The buyside seems comfortable to take a shot on a neat, yet small, biotech idea, but a novel tech firm. Why is that?

Yes. It is puzzling that there are significant flows into very high risk biotechs, but not Web 2.0 companies, as an example. However, as per my point above, we are seeing flows into more speculative public tech names and I suspect that will spur investments into the privates over time.

Question 5. What are you favourite public companies right now, and why?

Of my three favourites, two of them I rate as Holds. Absolute Software and SXC have been favourites of mine for a long time. Both are clear industry leaders with key competitive advantages. I picked up coverage of SXC 2 ½ years ago at $5.60 (split adjusted) and it’s up 385% to date. We believe their business model will continue to benefit greatly at the expense of the Pharmacy Benefit Managers (PBMs) in the U.S. SXC is solving a major pain point of U.S. corporations – helping reduce the impact of escalating drug costs and an aging workforce. However, we believe SXC is treading towards full value and would be encouraging new investors to add in the C$24 to C$26 range. Absolute Software (ABT-TSX) is in a dominant competitive position with its theft recovery service computers. Every day we see an article where company x lost a laptop with very sensitive data residing on it. ABT is one solution to help mitigate these losses. They are on the BIOS of most of the world’s leading OEMs. Similar to SXC, we believe the stock is close to fair value and would be buyers of ABT in the $20 to $23 range. Finally, we just picked up coverage of Points International (PTS-TSX), a company which provides software and services to 25 of the world’s largest loyalty programs. They provide several modules that allow program members to buy, gift or transfer points for example. These new revenue streams for the program providers come with very high margins. Points also has a consumer portal, Points.com, which allows consumers to track their balances for most of their programs, swap points between programs, redeem points etc. Again, they are in very strong position and have a recurring and highly leveragable business model.

Question 6. Do you see many neat private Canadian tech firms in your daily travels? Are there opportunities out there to excite our VC sector?

Unfortunately not nearly as many as I would like. Hopefully, the mood in the sector over the last year will inspire VCs to invest and tech entrepreneurs to create. M&A multiples are very healthy and hopefully this will encourage the investment in private cos., since the exit opportunities have increased. One of favourite Canadian private software companies is Watchfire, which was just acquired by IBM a few days ago.

Question 7. What’s on your iPod?

A very eclectic mix of genres. The most recent add was the new Artic Monkeys CD “Favourite Worst Nightmare”. The band was a bit overhyped on their debut CD, but this is a solid follow up. What I’m eagerly hoping for is “McQueen’s Daily Podcast”. 😉

Haha, Tom. Thanks for doing this. Lots of great insights for our folks to chew on.

MRM