Description

Long CGNT

Cognyte Software (NASDAQ: CGNT) is down >75% from its 2021 spin-off price and trades at ~1.4X NTM Sales. Phrased differently, it was cut in half, cut in half again, and then dropped ~10% from there. It is mission-critical software with a net cash B/S and can realistically accelerate to a 10%+ growth clip from next FY onwards. ADV is ~$3mm.

Business Overview:

CGNT was founded in 1998 as a subsidiary within VRNT before being spun out in January 2021. Today its software platform provides market-leading analytics, AI and machine learning models, and workflow/visualization tools for democratic and “democratic-leaning” type governments globally. Their clients are intelligence agencies and law enforcement units across 100+ countries. They refuse to sell to the bad guys of the world (i.e. Russia, Afghanistan, Iran) but they do operate in the grey zone from time to time (i.e. “intercept software” for the current Malaysian government).

There are three main buckets for clients: Investigative Analytics, Operational Intelligence Analytics, and Threat Intelligence Analytics. Clients use the software to derive insights from a variety of data sources for use cases like drug trafficking, human trafficking, anti-terror, organized crime, and cross-pollination between these categories. Identifying which ports are the most likely drug smuggling routes, flagging financial transactions sent under the guise of a regular invoice (from tens of millions of transactions daily), highlighting connections between people via photographs on social media – these are classic scenarios.

CGNT’s main competition is home-grown solutions. These are expensive/timely to build and become outdated quickly as they are purpose-built. The software is then “stretched” to address new use cases and applications for which they were not intended. Government agencies realized that by using third-party software like CGNT, they could shift the R&D burden and keep their capabilities up to date with minimal effort on their end. Meanwhile the vast majority of software providers in this space are point solutions and are use-case bound. For example, a competitor may provide software for analyzing transactions, but provide nothing for social media analytics. These competitors also tend to focus on only one geography. My view is CGNT is effectively the go-to, all-in-one operating system for these agencies abroad.

For more details on the business, I would take a look at jhu2000’s May 2021 write-up or a sellside initiation report.

Post Spin-Off:

CGNT completed a transition from Systems Integrator to Open Software Provider -> grew at a HSD CAGR from FY18 to FY21 -> expanded its Adj. EBITDA margins to >15% in FY21. From there, CGNT was spun off at >4X Sales. According to management, CGNT has historically been profitable for over a decade (consolidated/hidden within VRNT’s past financial statements). For reference, CGNT’s FY ends on January 31.

It didn’t take long for CGNT to run into trouble: as interest rates rose, clients paused spending and visibility into government budgets fell off a cliff. Then as the war in Ukraine ramped, governments shifted budgets away from security software towards oil/natural gas/military supplies. Finally supply chain issues made obtaining third-party components an issue. CGNT missed street estimates, saw its topline shrink >25% YoY, and its operating margins turned firmly red. During this freefall, management withdrew its topline guidance altogether, burned through the majority of its net cash position and obviously lost a lot of goodwill with investors.

Several things encourage me at today’s price. In December 2022, CGNT divested its Situational Intelligence Solutions segment for $48mm, with an additional $35mm in potential earnouts going forward. This conveniently came just two months after Neuberger Berman (currently the third largest shareholder) issued a public letter insisting they raise cash and install new management/board members. The $48mm returned CGNT to a net cash position and a portion of the proceeds were used to pay off the remaining corporate debt. Management then hired a new CRO in February 2023. This signaled to me that management is willing to 1) listen to shareholders and 2) take the necessary steps to finally turn this ship around.

Earlier in 2023, management also stripped out ~$15mm in headcount to right size their cost structure. With the new CRO, CGNT talked to agencies to get a clearer view on their fiscal budgets. Since then, management has reissued guidance and successfully implemented a beat and raise cadence four quarters in a row. This past quarter, CGNT beat and raised on all KPIs. The quarter prior, CGNT generated positive FCF two quarters ahead of schedule. As macro concerns resurfaced in Q4, CGNT’s gains have nowhere near adequately reflected the impressive turnaround in place. In other words, at today’s price we are getting one of the “flop turn river” cards/additional thesis confirmation for very cheap. I view this as a compelling entry point; this is where I am getting involved.

Valuation:

To start things off, there are a few things I don’t like about CGNT: macro/currency exposure to Israel/EMEA, a smaller natural buyer pool (a bid from PE doesn’t seem as likely given the nature of the work), and reduced visibility into the business given the confidentiality of government contracts. Some people may be turned off by the lack of “true” comps in the market. How then do I get comfortable here?

First, I think CGNT can accelerate growth to a 10%+ clip as budgets normalize away from Ukraine and as pushed out contracts are finally implemented at a shorter cadence. The problem last year wasn’t shrinking demand: backlog still grew along with new orders. Customers simply had to shift prioritization of their budgets. I am inclined to believe management when they say customers are now standing by their commitments and payment terms. We are seeing the early innings of this within their Current RPO/backlog numbers. This explains why CGNT has been able to execute accordingly in the past three quarters. Additionally, I would note CGNT was undergoing its transition from Systems Integrator to a Software model in prior years. This caused a mismatch between the optics and the actual underlying fundamentals. The sellside is not giving CGNT’s growth engine enough credit here in their estimates. Normalization of the macro (already troughed) will make this apparent.

Consider this: At the time of sale, SIS was not profitable, had a declining topline, and required a capital injection as management openly admitted the SIS offering was outdated. The business itself is unsexy: products to guard physical facilities against disruption/attacks (card readers, keypads, public safety cameras, license plate readers). Management was under pressure to raise cash, meaning the sales timeline was likely expedited as well. And despite this, management sold it for 1.5X Sales! This is my cushy valuation floor.

Today CGNT has three segments: Software, Software Services, and Professional Services. Software refers to the one-time component of the perpetual licensing model. Software Services is the crown jewel here: the classic, 20% recurring maintenance revenue that comes afterward. Both run at ~80% GM. Then you have Professional Services (implementation-type services/hardware, cost leader with slightly negative GMs). I think consolidated GM can trend above 70% in the medium term, driving incremental operating leverage.

To be conservative/account for macro risks, I value the Software segment at 1.5X Sales. This is the same multiple SIS received, despite the Software segment being significantly higher margin, more up-to-date and growing. The maintenance revenue can realistically grow at a 10%+ clip. I emphasize this is mission-critical software with retention being high like you would expect. Management doesn’t disclose the renewal rate, but 90%+ of revenue comes from existing customers. When I pressed management for color, they admitted net retention was “not far off from what you see with Enterprise SaaS”. Obviously you have to trust management here but that is one reason why this opportunity exists. I’ll acknowledge this isn’t SaaS; let’s say it should trade at 3X Sales. The Professional Services revenue is worth 0. Based on my estimates for FY25 (~1.5 years out from today), I get to ~60% in upside even with the recent run. Growth should also come at a higher incremental margin than before post-restructuring. If growth accelerates an additional 100-200bps and/or the market gets out of its hunch, the upside could be closer to ~100%. Again I am erring on the side of conservatism to account for the aforementioned risks. You don’t need much for this to work very well.

What’s the bear case here? Let’s say the macro doesn’t ease up and growth normalizes at a ~4-5% CAGR (basically GDP, going against the recent acceleration, lower than its HSD CAGR during its software transition). EBITDA could realistically get to at least 7-9% in this case as the cost structure is right sized once more. Applying 1X Sales to the Software and 2X to the Software Licensing Revenue gets us ~5% in upside through FY25! I like that risk/reward skew. Neuberger has shown that it is willing to play activist if things go south operationally and CGNT has signaled its willingness to act. I wouldn’t say the chance of this going private is null either: there is a market for this software asset at the right price. Management informally seems to think so as well. It’s not a stretch to think that price would be higher than what SIS went for.

Catalyst

Earnings