Description

Evolving Systems, Inc. (NASDAQ: EVOL)

Company Overview & Investment Thesis 

Evolving Systems, Inc. (EVOL or the company) is a provider of software solutions for service enablement, on-device activation and management of services for connected devices for network operators.  With 100+ customers across 5 continents, EVOL’s solutions empower brands to increase ARPU, improve retention and maximize customer satisfaction by leveraging big-data for contextual insights.

EVOL has repositioned itself as a next-generation mobile consumer engagement solutions company that drives contextual, real time, personalized, omnichannel consumer actions (new business or mobile marketing) away from its legacy business (SIM card activation). 

Matthew Stecker became CEO in April 2018. CEO Stecker was previously CEO of Livewire Mobile from 2009 until its sale to OnMobile in 2013 and has varied experience across several advertising technology firms (Vindigo, SmartServ, Inc., Marble Associates, Inc. 

Microcap EVOL ($9.7MM market cap) today has little net debt, 70% to 80% of recurring revenue, mid-60% gross margin and $26MM of LTM revenue. The value of the past three acquisitions that form today’s new mobile marketing segment alone value the stock price at a 50%+ premium. A new investor (Stanphyl Capital) just took a 4% stake in the company and on the Q4’19 call urged the company to sell itself for a targeted price well over 100% the current share price, or 1x LTM sales. The shareholder list is filled with past activists and other large holders, mostly deep out of the money on a cost basis who are eager to see change.

Valuation

On a historic valuation basis, EVOL trades near 2008 crisis levels, albeit a very different business. 

Amdocs has been an active acquirer in EVOL’s space, buying two mobile advertising peers (Pontis and CONTIS) for undisclosed valuation metrics. In the past, several of Amdoc’s smaller targets have varied from 1.0-1.5x LTM Sales and 7.0x - 8.5x LTM EBITDA.

London listed peer Pelatro trades for 2.6x LTM sales, 3.1x LTM Gross Profit or 5.7x LTM EBITDA. On a forward basis, with minimal coverage, the peer trades at 2.2x 2020 sales and 5.0x 2020 EBITDA.

Targets

Target price of $2.09/share, or a 162% upside from the current stock price. Assumptions and valuation listed below. 

• Base case assumes three different valuation scenarios, valuation based only on the three acquisitions made to boost the mobile advertising business with zero value for the legacy business. A 1x 2019 sales valuation based on Stanphyl Capital’s Q4’19 call interaction with the company urging a company sale. A 5x 2019 FCF (CFO-capex) plus c-suite and public company expenses eliminated. 

• Blue sky case assumes a multiple of 2020 cases, including 2x sales, 3x gross profits, 6x EBITDA and 8x free cash flow. 

• Downside case is a liquidation of the balance sheet as noted below.

Probabilities are risk weighted to come up with the ultimate target price. 

Company Details

Evolving Systems, Inc. is a global provider of software solutions for service enablement, on-device activation and management of services for connected devices for network operators. Its service activation solution (legacy business) is used to activate voice, video and data services for wireless, wireline and cable network operators and assign resources to Mobile Network Operators devices that rely on SIM cards. Its mobile marketing (new business) solution provides a data consumption and policy management solution for wireless carriers and Mobile Virtual Network Operators that monitor the usage and consumption of data services as well as upsell new services. 

As the communication industry continues to change at a rapid pace, EVOL had impetus to as well. EVOL pivoted to mobile marketing and away from its legacy market leading SIM activation business. 

New Business (Mobile Marketing)

As the communication industry changed, EVOL pivoted towards mobile marketing. The recently launched Evolution platform pulls together EVOL’s 3 acquisitions (Lumata Holdings Ltd, Business Logic Systems Ltd, Sixth Sense Media) in the space from 2015 to 2017 as well as internal efforts. 

Use case examples include:

Orange PLC 

• Customer is engaging their own customers with offers like a discounted two-for-one ticket and concession stand items for any movie anytime nationwide on Wednesdays (typically a slow day at the theater). Customers receive e-vouchers they can swipe at the ticket booths and concession stands to avoid lings – this real time digital solution has engaged over 100MM Orange customers over time, increased their average spend and increased tenure by 40%. 

• EVOL provides this technology in return for a monthly fee for providing the cloud service as well as a performance fee based on customer engagement and program participation.

• Competitors: 

• Pontis (acquired by Amdocs for $85-90MM in 2016, valuation metrics not available), CONTIS (acquired by Amdocs an undisclosed sum), FlyTxt, Pelatro and Pegasys (used by Verizon).

Going forward:

• “As we anticipated at the end of the third quarter, the headline today is that fourth quarter revenues rose from the preceding quarter. Based on a lot of hard work behind the scenes, it has been our expectation that our business will begin an upward trend after a lengthy period, focused on internal investment and consolidation of our multiple acquired companies.” Matthew Stecker - Evolving Systems, Inc. - President, CEO & Executive Chairman, EVOL - Q4 2019 Evolving Systems Inc Earnings Call, EVENT DATE/TIME: MARCH 30, 2020 / 9:00PM GMT

Legacy Business (Activation)

EVOL sold its high free cash flow Number business (divested in 2011) to acquire smaller SIM activation companies. Previously called Dynamic SIM Allocation (or DSA) the now legacy business focuses on providing SIM activation services to mainly emerging market carriers. 

In 2019, EVOL repackaged this product a package called the eSIM life cycle management suite, and its component products were updated significant new version releases. The recent investments in the product as well as in marketing in 2019 has yielded multiple opportunities, including a recent substantial new customer win.

Use case examples include:

India

• The largest mobile operator in India is an EVOL customer. In India, there are more than 900MM people with mobile phones and only 15MM have internet connections at home. 

• India is a bring-your-own device (BYOD) market where getting to a carrier store to stand in long lines is a bad customer experience. EVOL’s solution allows carriers to enter the market with blank SIM cards where a customer can self-enroll anywhere, anytime by installing the Evolve-powered SIM which then launches an app which navigates the consumer through the know-your-customer process which is required by local law using fingerprint technology on their device. 

• After onboarding the customer, the operator can up-sell the customer a higher level data plan, additional apps and services. One of India’s largest carriers is up-selling plan services to over 100K customers a day which results in higher priced services that drive total enterprise customer lifetime value.

Unique characteristics:

• High gross margins: 

• First use activation revenue is 100% margin, it's just a license extension, so it involves no labor on EVOL’s part other than rendering the bill and collecting.

• Total normalized gross margins for the legacy activation business runs 75 – 79% and 30% EBITDA margin. 

• Product

• The contract sits with the carrier, and EVOL’s software is installed in the carrier's data center.

• EVOL activates the SIM card on the end-user's phone and the support for the system takes place in the carrier's operation. 

• And all of the products EVOL sells carry with them an annual maintenance contract, and that annual maintenance contract gives them upgrades to new releases, break-and-fix support, and a certain amount of technical support.

Market Share

• Leader in the space. EVOL has the largest number of production customers and does the highest volume of SIM activations. 

Geographic focus

• Emerging market.

Transition 

• Attempt to move from licensed to manage services 

• License: traditionally EVOL had a license of $500,000, would recognize the $500,000 immediately. Requires EVOL to continue to sign up deals and not predictable. 

• Managed Services: EVOL would take $20,000 a month managed service. The first year you EVOL would get $240,000; the second year, $240,000 again. And thereafter, continuing to charge $20,000 or more based on their growth in subscribers, based on the growth in activations or other services. 

Going forward:

• “Over the past 24 months, we have built an evolving systems that can continue to compete in the telecom market today. Digitization, the advent of eSIM and other trends are including the ongoing -- even including the ongoing global situation, all influence operators buying decisions when it comes to enabling software that we can address often for the first time. As a result, I'm confidently anticipating that 2020 will see a continuation of the upward trend started in the fourth quarter.” Matthew Stecker - Evolving Systems, Inc. - President, CEO & Executive Chairman, EVOL - Q4 2019 Evolving Systems Inc Earnings Call, EVENT DATE/TIME: MARCH 30, 2020 / 9:00PM GMT

Competitors: 

• Nokia, Amdocs, Huawei, Ericsson, 6D, HPv 

Divested Business in 2011 (Numbering)

Beginning in 1995 EVOL was involved in the planning for industry implementation of Local Number Portability (LNP). Evolving developed Interoperability Interface Specifications, which were adopted as the industry standard by the North American Numbering Council. These protocols covered carrier level communication with Number Portability Administration Centers (NPACs) to facilitate LNP as mandated by the Telecommunications Act of 1996.

When LNP was rolled out, EVOL captured 60% of industry implementations from wireline providers in the late 90’s and established a 17% share of the wireless segment (WNP), leading to a growth spurt in sales and earnings that culminated in 2003.

The company continued with Numbering as its core business until 2011, when the company walked away from its previous core legacy business that has been a significant free cash flow provider. 

The company sold Numbering business to Nuestar for $39.0 million. This represents a valuation of 3.1x Sales and 5.8x EBITDA. In 2010, this segment generated 38% of revenues but 93% of operating income. Following this transaction, the company paid a one-time $2.00 per share dividend and a small quarterly dividend payout followed. Management made the decision to sell the core Numbering business to concentrate on the higher growth international mobile phone industry and the potential for activation. 

Post-Mortem 

What went wrong? 

New business (mobile marketing)

• Acquisition integration proceeded poorly

• The three acquisitions were different systems and not compatible with EVOL’s current systems (i.e. BLS used windows, the other two Java) and EVOL had no history of integrating acquisitions in this area.

• “The first half of 2019 has been undeniably difficult. As you know, a major and complex rebuild of our offering in customer value management loyalty was time-consuming. Turning 4 products with 4 code bases into 1 updated fit-for-purpose solution is not an easy journey…. The first customers of Evolution are existing Evolving customers who would have surely left for competitive offerings had we not built it….” Matthew Stecker, President, CEO & Executive Chairman EVOL - Q2 2019 Evolving Systems Inc Earnings Call AUGUST 19, 2019 / 9:00PM GMT

Timing of new business 

• While EVOL’s new mobile advertising platform has been launched, there’s a lag between revenue realization between 2 and 4 quarters that has only recently (Q4’19) surfaced. 

• “Products that we sell today realized revenue between 2 and 4 quarters into the future. We expect improvements in top line financial in the later part of this year or at the early part of next.” Matthew Stecker, President, CEO & Executive Chairman EVOL - Q1 2019 Evolving Systems Inc Earnings Call MAY 15, 2019

Too much, too soon

• Over two years EVOL bought three companies, unrelated to its legacy business and at the same time attempted to migrate the legacy business from an upfront license to a recurring revenue model while fending off an activist attack.

• “Just 2 years ago, Evolving leveraged a significant chunk of its working capital and just about all the debt it could raise to buy 3 companies. Through these acquisitions, it entered a new market, the telecom-centric customer value management space. All 3 of the acquired companies were generally operating at a significant loss.” EVOL - Q3 2019 Evolving Systems Inc Earnings Call NOVEMBER 12, 2019 / 10:00PM GMT

Poor targets 

• All three acquisitions were starved for capital pre-sale to boost earnings into EVOL’s purchase

• “On top of all of this, all 3 acquired companies had proud but aging technology platforms that had been deprived of R&D as their sellers shopped the companies and tuned them for sale. Evolving was left with having to do the investment necessary to integrate the companies while simultaneously rebuilding their platforms. I came onboard as full-time CEO as the breadth and scope of this challenge was coming into view for us.” EVOL - Q3 2019 Evolving Systems Inc Earnings Call EVENT DATE/TIME: NOVEMBER 12, 2019 / 10:00PM GMT

Legacy (activation)

• Transition from license to services business model. 

Can it be fixed? 

New business (mobile marketing)

• Yes - the recent launch of the company’s mobile marketing products in one platform suggests the business is moving forward after a long integration and re-investment process. 

Legacy (activation)

• Largely not in need of being fixed, though not a growing market, new product will help EVOL retain share.  

Evidence of improvements? 

Financial metrics

• Q4’19 revenue rose 9.3% sequentially and the year over year decline slowed to 3.4%, adjusted EBITDA improved for the quarter as well. 

Operational 

• The new business (mobile marketing) has been rebuilt with past integrations fully integrated and updated. This resulted in the Evolution platform, recently implemented at its first customer site. 

Deal flow

• Significant pick up in contracts announced in 2020 compared to a very dry 2019. 

M&A History

The value of the company’s three acquisition that composes the new business is $1.36/share, or a 50%+ upside from the current share price assuming no value for the legacy activist business. 

Activist Cases 

Q4’2019 – Stanphyl Capital

Q4 2019 Earnings Call (2020-03-30)

“You have this tiny little company, you're probably doing, $1 million a year in free cash flow…. C suite and all that could cost $2 million a year…would be such an obvious strategic acquisition for somebody looking to pick up 65% gross margin revenue. And at $2 a share… They'd be paying only one times revenue for you.” Mark Spiegel, Portfolio Manager, Stanphyl Capital 

“We got a lot of -- when we continue to generate a lot of unsolicited strategic input…. this thing would clean up a lot and become a different business if we didn't have those public costs.” Matthew Stecker, Chief Executive Officer and Executive Chairman

2017 – Piton Capital Partners LLC (Kokino LLC)

4/27/2017 Kokino filed a 13D and added shares throughout 2017 and had direct conversations with the company. 

2011 – Post Numbering Solutions 

Upon selling its Numbering Solutions business to Neustar on 4/21/2011: 

“As the process advanced, it became clear that some companies were interested in our numbering business and other companies were interested in our Activation business.…. Finally, we believe this sale positions Evolving Systems as a pure activation growth play, making us a more attractive acquisition candidate.”

Financial Review 

In 2011 the company sold its numbering business leaving a pure play activation business. The activation business (legacy) on a normalized basis had gross margins in the 75-79% range and 30% adjusted EBITDA margin (CFO comments on Q2’16 earnings transcript).

EBITDA margin declined in 2017 and 2018 as EVOL acquired Lumata Holdings Ltd and Business Logic Systems Ltd (BLS), boosting the mobile marketing business after the 2015 acquisition of Sixth Sense Media (SSM). While the SSM acquisition didn’t impair EVOL’s margins, the other two did. EVOL’s goal with the later acquisitions was to migrate their customers to EVOL’s centralized managed services environment, however this proved to be challenging for EVOL and gross margin has been pressured after 2017. This was compounded by the two mobile marketing acquisitions have structurally lower gross margins due to the product difference. 

Revenue was especially challenged in 2019 and the company printed its weakest revenue decline in its history (excluding the decline artificially caused by the 2011 numbering asset sale). The decline was driven by a lack of product in mobile marketing as the company struggled to integrate all their acquisitions and launch their new mobile marketing platform. This has since abated and EVOL has released several new customer wins. The company also simultaneously refreshed its legacy product and has since announced wins.

While projecting is challenging for EVOL given its transition, revenue growth is assumed for Q1’20 to continue on q/q basis similar to Q4’19 and slow for the remainder of the year, driving EVOL back to robust annual growth for 2020. 

EVOL Chart & Key Events

10 Years 3 Years

Key Events

• 8/13/2019 – Postponement of earnings release due to calculations around its goodwill.

• 4/01/2019 – Independent auditors requested additional info that around company's tax.

• 8/14/2018 – Q2 2018 Evolving Systems Inc Earnings Call Matthew Stecker Evolving Systems, Inc. - President, CEO & Chairman

o “One of them, and I've been asked a lot in different ways, is whether I'm here in an interim or a caretaker role. The answer is a resounding no. Evolving is my only full-time paid position, and I'm planning being here as long as I can help the company stabilize and grow.”

o “Since coming on board as the Executive Chairman late last year, I spent much of my life in airplanes and hotels, visiting Evolving's customers, employees and offices globally. I plan to continue doing this for the years to come because I see enormous potential for the company to grow. Our geographically dispersed workforce is really a great competitive advantage as it allows us to respond quickly to the needs of carriers worldwide, many in geographies that are difficult or even impossible to access for our competitors.”

• 7/18/2018 – EVOL removed President and Chief Executive Thomas Thekkethala "for cause" and appointed Matthew Stecker to the Chief Executive role effective immediately. 

o Evolving Systems said it doesn't intend to pay Mr. Thekkethala any severance. "There were, however, no disagreements between the company and Mr. Thekkethala as to any financial or accounting issue." 

o Evolving Systems said it "anticipates no change in financial condition or outlook related to this change." 

o Mr. Stecker joined Evolving Systems' board in March 2016, was named chairman of the board in August 2016, and executive chairman in April 2018.

• 9/07/2017 –Evolving Systems Completes Acquisition of Lumata Holdings Ltd. 

• 8/03/2017 – Piton Capital Partners LLC  has had and will continue to have talks with company representatives. 

• 7/06/2017 – Completes acquisition of Business Logic Systems.

• 5/4/2017 –Evolving Systems responds to comments made by SITO Mobile, Ltd.in SEC Filings.

o SITO asserted that the nomination by certain SITO stockholders of certain members of the Evolving Systems board to the board of directors of SITO is in furtherance of an undisclosed agenda to acquire SITO by Evolving Systems. 

o Chief Executive Officer of Evolving Systems Thomas Thekkethala had a routine meeting with members of SITO's management on March 31, 2017. This meeting was for preliminary high-level discussions about potential marketing and sales synergies between Evolving Systems and SITO. Evolving Systems has no plans, intentions or proposals to enter into business arrangements, nor does it have any intent or interest to acquire SITO Mobile.

o Mr. Matthew Stecker, chairman of Evolving Systems, and Mr. Thekkethala were nominated to stand for election to SITO's board of directors. 

• 4/27/2017 – Original 13D filed by Piton Capital Partners LLC (Kokino LLC).

o Piton is a pooled investment vehicle formed for the benefit of a single family, PM is Robert Averick.

o Piton believes shares are undervalued and represent an attractive investment opportunity. 

o Intends to have discussions with the Issuer's representatives regarding topics including: (1) the Issuer's strategy, governance, business and operations and (2) improving the performance of the Issuer's stock.  

o https://www.sec.gov/Archives/edgar/data/1052054/000089383817000038/evolving13d.htm

o https://www.wsj.com/articles/hedge-fund-tosses-family-that-controls-maker-of-oxycontin-11551985100

• 8/02/2016 – Dividend suspension. 

o “Having returned over $65 million in dividends to Evolving Systems stockholders since 2010, our Board of Directors has decided to suspend our quarterly dividend in order to provide maximum financial flexibility to fund these and other growth initiatives that will create long-term shareholder value. The Board will continue to monitor our progress and make determinations on potential future dividend payments accordingly.”

o https://www.sec.gov/Archives/edgar/data/1052054/000110465916136101/a16-16028_1ex99d1.htm

• 1/1/2016 –Thomas Thekkethala takes over as CEO.

• 9/30/15 - Acquisition of Sixth Sense Media, beings pivot to adding in non-activation business. 

• 5/29/2012 – Special dividend of $2.00/share (or $1.70/share adjusted) from Numbering Solutions proceeds. 

• 7/1/2011 – Evolving Systems sold its Numbering Solutions business to NeuStar, closed on July 1, 2011.

o Sold for 3.13x training revenue on $14.5MM. A result of divesting numbering left EVOL as a pure play activation company.

Top Holders / Management / Insider Transactions 

Top Holders 

Holders cost excludes special dividend of $2 per share payable on January 3, 2012.

Management

• Chairman/President/CEO Matthew Stecker (50 years old)

• Joined Evolving Systems' Board of Directors in March 2016, was named Chairman of the Board in August 2016, and Executive Chairman in April 2018. 

• Matthew studied Computer Science at Duke University and earned his law degree at The University of North Carolina at Chapel Hill. After putting himself through law school working for NeXT, he worked at and eventually became President of Marble Associates, Inc., in Boston. Matthew has also run advertising technology at Vindigo, was the CTO of SmartServ, Inc., and was a Vice President and Principal at TMNG/Cartesian and its strategy consultancy CSMG.

• Additionally, Matthew has been a Vice President at Real Networks, and served as CEO of Livewire Mobile from 2009 until its sale to OnMobile in 2013. 

• From 2015 to 2017, Matthew was a Senior Advisor at the United States Department of Commerce where he helped to launch FirstNet, the Federal network for Public Safety. He has served on multiple boards and has been an advisor to many startups. He has a high profile in the mobile and digital ecosystems.

Insider Transactions

10 Years 3 Years

• Over the past three years, insiders have been buying starting in mid-2019.

Key Sources

• IPO document (5/11/1998)

o Original https://www.sec.gov/Archives/edgar/data/1052054/0000927356-98-000021.txt

o Revised https://www.sec.gov/Archives/edgar/data/1052054/0000927356-98-000758.txt

Risk Factors

• Projections

o With a company in transition and limited insight into customers or contract sizes, any forward projections are challenged. 

• FX

o The majority of the company’s revenue are generated outside the US.

Catalyst

Revenue growth driven by thew new business as well as new product launch in legacy.