August 18, 2005
Research Associate: Deepa Agarwal, M Sc.
Editor : Christopher R. Jones, CFA
www.zackspro.com 155 North Wacker Drive l Chicago, IL 60606
Mercury Interactive Corp. (MERQE - Q) $37.54
Note: All new or revised material since last report is highlighted.
Reason for Report: NASDAQ Delisting Under Appeal, but until settled it must trade as MERQE.
Overview
California-based Mercury Interactive Corp. (MERQ) is a provider of software and services for the business technology optimization (BTO) marketplace. The company has introduced a variety of BTO software and service offerings, including offerings in application delivery (pre-production quality and performance testing), application management (in-production application performance management) and, following the acquisition of Kintana, Inc. in August 2003 - information technology (IT) governance. The company's BTO offerings for application delivery, application management, and IT governance help customers maximize the business value of IT by optimizing application quality and performance, as well as managing IT costs, risks and compliance. MERQ also provides a range of customer support and professional service offerings that enable its global partners and customers to implement, customize, manage, and extend its offerings. The company operates in 35 countries and employs over 2,300 people. For more information, please visit www.mercury.com.
On July 28 MERQ reported 2Q05 results with total revenues of $207.1M, up 30% Y/Y. GAAP net income was $18.6M, or $0.19 diluted GAAP EPS . Deferred revenue declined $1.5M Q/Q. Europe was identified as a source of weakness in the quarter as the company continues to restructure its management and sales operations. Management lowered full-year 2005 guidance for revenue, operating margin, non-GAAP EPS, and GAAP EPS.
Key Positive Arguments / Key Negative Arguments· MERQ introduced the concept of Business Technology Optimization (BTO). BTO improves the quality of software through all aspects of its development and maintenance lifecycle.
· Management team is considered one of the best in the industry, they have been with MERQ for almost a decade; execution remains one of MERQ’s strong points.
· The company has over 50% market share in the software testing market; the company has not suffered any pricing erosion like so many other software names.
· MERQ products are available on a subscription-pricing basis, and this will enhance future revenue and earnings visibility. / · ITG sales continue to be inconsistent and likely to continue once Sarbanes-Oxley deadline passes.
· MERQ could be adversely affected if the ERP market continues to perform sluggishly.
· Most of MERQ’s R&D operations are based in Israel, and the volatile political and economic climate in that country poses risks to Mercury.
· MERQ faces increased competition from IBM, Computer Associates, BMC, and Hewlett Packard in the application performance management (APM) market.
· MERQ Board of Directors inquiry into stock option expensing has delayed SEC 10Q filing and has triggered the NASDAQ’s non-compliance delisting process. Company has appealed, but must trade under “extenuating” circumstances as MERQE.
MERQ’s Fiscal Year ends on December 31.
Sales
Total revenue for the second quarter of 2005 was $207.1M, up 4.2% Q/Q and 30% y/y. License revenue (38% of total revenue) was $79.4M, down 12% Q/Q and up 32% y/y. Subscription revenue (22% of total revenue) was $45.4M, down 1% Q/Q and up 31% y/y. Service fees contributed revenues of $22.5M, up 37.7% y/y. Maintenance revenue was $59.8M, up 5.7% Q/Q and up 24.2% y/y. Subscription revenue declined sequentially as the company had to revalue some deferred revenue due to the fluctuation in the value of the dollar.
Mercury’s portfolio of BTO products and services is organized into three primary groups: IT governance, application delivery (AD), and application management (AM). The company’s application delivery division, its largest revenue segment (contributing 64% of revenue), grew 17% y/y to $79.3M. Mercury’s application management segment (contributing 30% of revenue) grew 86% y/y to $37.7M. Majority of the revenue in the application management segment comes from its license revenue. Mercury’s IT governance (ITG) segment (6% of revenue) grew 22% y/y to $19.7M.
Somewhat disappointing for the quarter were bookings (revenue + change in deferred revenue) that grew only modestly at 11% y/y in 2Q05. Deferred revenue declined $1.5M Q/Q. The deferred revenue balance was impacted approximately by a $7.6M decrease resulting from foreign exchange fluctuations as compared to the prior quarter. Deferred revenue occurs when business customers sign multi-year software subscription licenses and/or service contracts. Revenue is only recognized for the current period and future payments are recorded as deferred revenue (a ST liability for next 12 months and a LT liability if due more than 12 months out). The net change (growing or shrinking) of these combined accounts shows if new business signed is keeping up with revenue drawn into each quarter (or “pulled in” from the deferred revenue accounts). Such long-term contacts are becoming the norm among many enterprise vendors like SAP, ORCL, MSFT, and COGN.
On a geographic basis, revenue from America (63% of total revenue) grew 32% y/y, while that from the EMEA region (29% of revenue) grew 25% y/y, Asia-Pacific (6% of revenue) grew 48% y/y, and Japan (2% of revenue) fell 8% y/y. The company said that difficulty in Europe was primarily responsible for the shortfall in the 2Q05 revenue. The region performed poorly due to management changes, sales transitions, and big deal slippage. Mercury plans to make an additional organization chart and resource restructurings over the next few quarters, and expects Europe to underperform for the rest of 2005.
Please refer to Zacks Research Digest spreadsheet for specific revenue estimates.
Margins
Gross margin was 81.0% compared to 81.8% in 1Q05 and 82.0% in 2Q04. The operating margin for 2Q05 fell to 18.6% from 19.9% in 1Q05; however, this was better than 2Q04’s operating margin of 15.3%. Higher R&D expense was offset by lower sales and marketing.
Please refer to Zacks Research Digest spreadsheet for more details on margin estimates.
Earnings per Share
MERQ reported a GAAP net income of $18.6M, which equates to a diluted GAAP EPS of $0.19 in 2Q05. However, excluding a stock-based compensation and amortization of intangibles of $3.9M, the impairment of Allerez intangible asset of $0.6M, the impairment of certain technology related to a license from Motive of $15.4M, expenses incurred from an SEC inquiry of $0.9M and related tax effect of these items above, non-GAAP net income was $36.7M and diluted non-GAAP EPS was $0.37.
As required by SEC regulations, MERQ must prominently report its financial results according to US GAAP; however, they will also have to provide an alternative non-GAAP format to adjust for many non-cash items, which impact the GAAP income statement. Such non-GAAP results are often the basis of internal corporate performance measurements, as well as on what many analysts base their earnings’ forecasts.
Zacks Consensus EPS is $1.48 for 2005 and $1.76 for 2006.
2005 forecasts (28 of them in total) range from $1.44 to $1.54; the average is $1.48
2006 forecasts (28 of them in total) range from $1.67 to $1.92; the average is $1.76.
Please refer to Zacks Research Digest spreadsheet for more extensive EPS figures.
Company Guidance
The company provided guidance for 3Q05 revenue of $205-$215M, GAAP EPS of $0.17-$0.22 and non-GAAP EPS of $0.31-$0.35. Deferred revenue is expected to increase by $20-$30M. Fully diluted shares outstanding for 3Q05 should be 99-101M, including the effect of EITF 04-08 i.e. the effect of contingently convertible debt on diluted earnings per share.
Management lowered guidance for FY2005 revenue, operating margin, non-GAAP EPS, and GAAP EPS, to provide projections for deferred revenue and operating cash flow. For fiscal 2005, the company guided GAAP EPS of $1.01-$1.07 down from $1.41-$1.48, and non-GAAP EPS of $1.45-$1.50 down from $1.50-$1.57. Total revenue is expected to grow 23-27% and bookings growth is expected to be in the range of 13%-16% down from 25%-30%. Management has not provided guidance for full year cash from operations.
Target Price/Valuation
Our Digest average target price is $45.21
Target prices for MERQ range from $35 (Garban) to $57 (Buckingham). The consensus average target price target quoted by 19 analysts is $45.21 a share. The analyst with the lowest price target has not specified the valuation. The analyst with the highest target price (Buckingham) values the stock on the basis of 30x FY06E EPS of $1.92.
The valuations are primarily based on FCF/share, P/Revenue, DCF, P/FCF, and P/E multiples to calculate the target price.
Please refer to Zacks Research Digest Spreadsheet for further details on valuation.
Other Events
On June 15, 2005 MERQ announced a strategic agreement to help customers improve the business value of IT operations. As part of this agreement, the companies plan to market and sell a set of information technology infrastructure library offering.
On June 7, 2005 MERQ announced its integration strategy with Microsoft Visual Studio 2005 Team System as part of its commitment to support the entire application quality ecosystem from product design and development, to application delivery and management. Microsoft Visual Studio 2005 Team System is an extensible lifecycle tools platform that helps software teams collaborate to reduce the complexity of delivering modern service-oriented architecture (SOA) applications on the Microsoft net framework.
On May 18, 2005 MERQ announced Mercury Managed Services™ for the SAP NetWeaver™ platform. Mercury Managed Services for SAP NetWeaver enables customers to address the challenges of managing performance and ensuring high-quality end-user experience for enterprise deployments serving thousands of users. MERQ also announced its support for the Enterprise Services Architecture (ESA) from SAP AG. ESA provides the blueprint for a business-driven approach to service oriented architectures (SOA) to help customers automate business processes across different enterprise systems and applications and reduce the complexity and costs of integration.
On, May 16, 2005 MERQ launched Chinese, Korean, and Japanese Versions of Mercury Business Availability Center. The Mercury Business Availability Center will help customers to take a lifecycle approach in optimizing application quality and management. MERQ made this announcement as part of its market expansion strategy in Asia-Pacific and to meet the demands of the fast-growing markets in China, Korea, and Japan.
Other/ Capital Structure/ Governance/ Business Development/ Strategy/Cash Flow
Cash flow from operations was $47.7M , up 16% y/y. The significant decline in cash flow was largely due to the declining deferred revenue in the quarter. Cash and investments at the end the quarter was $1.3B.
Informal SEC Inquiry: The Company believes it will need to restate its financial statements as a result of the SEC inquiry relating to historical option grants. Management expects the restatement to impact its FY03 and FY04 audited financials, and possibly the current GAAP guidance for 2005. However the management has not specified the magnitude of restatement.
MERQ is in noncompliance with regulatory standards for its financial results releases. It is in possible violation of the Sarbanes-Oxley reporting requirements under the US Securities and Exchange Commission. Hence, it remains on the main trading system for Nasdaq, but under extenuating circumstances, indicated by an "E" added to its normal ticker symbol – MERQE. The situation is related to the treatment of stock option-based compensation expense. MERQ currently estimates that the expenses incurred from its board of Directors' special committee investigation and the SEC inquiry to be approximately $13.5M. No malfeasance has been alleged or should be inferred at this time.
Recent Management Changes: MERQ management has been in place for over 10 years and is considered one of the best execution teams in the industry. In December 2004, Tony Zingale, the former president and chief executive officer of Clarify, joined as the company’s new president and chief operating officer.
Long-Term Growth
The long-term growth rate ranges from 31% (Lazard) to 18% (Smith Barney), with the Digest average being 22.5%.
The company is expected to perform at the high end of this range in the next 1-2 years as it benefits from customers focusing on governance compliance software issues. Beyond FY2006, the analysts believe growth for the company will come from further dominance in the AD (application delivery) segment, which already boasts 60%+ market share. The analysts feel that MERQ will continue to benefit from a number of industry trends including a tightening of relationship between IT and the business, cost savings from eliminating software problems before deployment, applying management and governance disciplines in IT operations, and the associated need for visibility in the business process. Some analysts also believe that MERQ is the first infrastructure management provider to deliver its products via an On Demand service offering, and as a result of this the company will be able to achieve 20% plus growth rate. Other significant growth catalysts for the company moving forward include further adoption of BTO (Business Technology Optimization) deals. As MERQ offers customers a broad and flexible set of solutions that include term licenses and managed services, customers will be benefited, as it accelerates its time to value, leverages implementation expertise, and reduces project risk.
The analyst (William Blair) is confident about the long term prospects of the stock for a number of reasons. First, Mercury dominates the testing market, and companies are testing more of their applications before deploying them. Testing represents 70% of revenues and should grow 10%-15%. Second, Mercury has garnered an early lead in the fast-growing APM and IT governance markets, which the analyst expects will grow 20% over the next few years. The analyst is also comfortable with MERQ’s ability to steer the company in the long term, due to its management team. Mercury continually has demonstrated the ability to enter and dominate new markets, which the analyst believes is a necessity for grow and prosperity in the long term.