Redknee Solutions Inc.

[TSE:RKN]
By: João Alves

Date: 23/02/2018

Note: Redknee Solutions has been recently rebranded

as Optiva Inc., but since the Investors section of the
website and the stock symbol remain as Redknee
[RKN], the investment will be referred to as “Redknee”
or “the Company” throughout this write-up.

Thesis Summary:
The Redknee Solutions Inc. investment case involves a complicated situation with a simple thesis: a
turnaround involves considerable change, and change creates confusion, which produces a mispricing.

Luckily for enterprising investors, Redknee’s turnaround presents key characteristics that skew the
probabilities towards success, as shown by the following:
§ Investors are fearful of uncertainty and thus misunderstand the dynamics of turnarounds, leading to
a miscalculation of the risks involved;
§ Redknee is only a temporarily struggling company, with a sustainable business model based on high
switching costs from its software solutions and a recurring revenue base, which offsets many risks
and downside scenarios for this investment;
§ The Company has been going through meaningful and value-added corporate change: recently
refinanced, rearmed with a clear and effective strategic vision centered on providing exceptional
value for customers, and supported by a software specialist and turnaround expert firm, ESW
Capital, with the proven ability to support Redknee’s scalable business model;
§ And at a conservative 1.57x forward revenue, an investment in Redknee offers a compelling chance
for investors to generate a 64% return on investment.

Business Overview
Redknee Solutions (recently re-branded as Optiva Inc.), is a Canadian enterprise software company that sells
billing software solutions and services to telecom companies. The Company has over 200 customers in 90
countries, and processes 24 billion transactions every day; making it 2.4 trillion transactions per month. Its
products consist of real-time monetization and subscriber solutions – deployed flexibly either on premise,
cloud, or SaaS – for the global communication industry in order to manage CSP’s operations, customer
information, and financial information.

The Company operates in the really competitive sector of technology, within the software industry.
Nonetheless, the current industry dynamics are favorable. Firstly, Orbis Research expects the “Global
Telecom Software Professional Services Market to grow at a CAGR of 8.14% during the period 2017-2021”1.
This shows that if Redknee comes out of this turnaround improved, it has ample growth opportunities going
forward. And secondly, the software industry has been undergoing massive consolidation, with large software
companies aggressively pursuing M&A “to build out their software platforms, acquiring new products and

1
Orbis Research, “Global Telecom Software Professional Services Market”; also, according to Ovum Ltd., annual revenues for the
global OSS/BSS market will grow from $54.3 billion in 2015 to $63.1 billion in 2020, at a compound annual growth rate (CAGR) of
3.05%.
point solutions in order to deliver market-differentiating, comprehensive product suites to their customers.”2
In this regard, Redknee has two possible avenues in the future, both reliant on the probability of success of
the current turnaround: either Redknee can become a prime candidate for larger software firms consolidating
into the Telecom sector once it reaffirms its product specialization and reaches the customer success levels
expected by management; or, it can become a strategic acquirer itself, acquiring small and specialist
enterprise software firms among the very fragmented industry in which it operates.

On top of that, Redknee possesses emerging economic moats that are being underestimated and unaccounted
for by the market. Its software solutions are mission-critical for its customers, making them highly ‘sticky’.
Complementarily, the complexity around the Company’s products lowers the chances of competitors
replicating their business, and so ensures that customers have high switching costs if they were to change
platforms.

The Mispricing
Redknee had been lagging behind its potential due to operational inefficiencies and balance sheet issues
resulted from poor acquisitions3. This led to Constellation Software (CSU), the software giant, offering to
invest $80m in Redknee. Because of CSU’s interests, new suitors came into play, and in late 2016 ESW
Capital ended up making an offer, and outbid CSU by investing $83m at more favourable terms (the dilution
caused by their deal would be of 30%, substantially lower than CSU’s offer).

ESW Capital is a private equity investment company focused on acquiring, building and turning software
businesses. Redknee is their 41st software investment. Their playbook is centered around cutting costs – by
consolidating SG&A activities and outsourcing R&D – and focusing on profitability generated from
customer success and cost savings instead of price alone.

However, turnarounds are unreliable. The three following factors concerning the dynamics of turnarounds
(which the market seems to be overly focused on) explain why Redknee’s stock remains mispriced:
1) The complexity around this turnaround, involving significant cost-cutting, a new strategic vision,
and dramatic changes to the company’s business model;
2) The time taken for these changes to play out and be reflected in the company’s fundamentals, and
thus be fully recognized by the market; and
3) Poor investor communication by Redknee and its new owner, ESW, during this turnaround, which
makes the two points prior way worse in terms of the uncertainty.

Nevertheless, one can look at the frightening factors of ‘time’ and ‘communication’ in a different way – they
dramatically increase the confusion and uncertainty that is inherent to turnaround plays, and thus induce un-
economic and irrational decision-making in the market, which opportunistic investors can take advantage of
to buy Redknee at more attractive prices.

All of this combined is an opportunity for enterprising investors, given that the Company’s share price still
sits at 79% lower than its high in mid-2016, right before ESW’s investment.

The Solution
By following ESW Capital’s playbook, Redknee has reaffirmed the strategic vision it lacked, and now has a
clear pathway to steer back from the complacency and correct the current mispricing around the company’s
stock.

2
GP Bullhound, “Global Software Market Perspectives Q3 2017”, pg. 3
3
Redknee’s previous management team bought a division of Nokia Siemens in 2013, and acquired Orga Systems in 2015. These deals
were expected to generate significant cost savings and value-creating synergies, but only generated substantial debt loads for Redknee,
which resulted in the Company violating debt covenants in 3Q16.
In vogue here is ESW Capital’s new Strategic Plan for Redknee, which so far, has yielded positive and
tangible results:

• Improved Business Model: restructure its sales model from three to two key operating units,
“Strategic Global Accounts” and “Packaged and Cloud Solutions”, allowing the Company to focus
on core businesses, and to discontinue operations focused on industries other than Telecom. By
concentrating on providing solutions to CSPs, Redknee can ensure specialization and focus on
growing its recurring revenue streams, which safeguards against many of the obstacles that come
with the scale and difficulty of turnarounds.
o Results so far: Financial highlights from fiscal year 2017 display progress, as recurring
revenues reached 69% of revenue, compared to 60% by the end 2016. Also, although the
Company’s revenues and gross profits decreased, as expected in the first year of a
turnaround like Redknee’s, their margins improved from 54% to 58% in the same time
span.
• Cost Restructuring: utilizing ESW’s vast and unique portfolio of businesses to integrate Crossover’s
services to reduce Redknee’s SG&A expenses, and using DevFactory to outsource the Company’s
R&D and tech talent to India, where its way cheaper, in order to improve efficiency and catalyse
growth. While some of Redknee’s competitors, like Amdocs and CSG Systems, also operate under
low-cost centres, they do not enjoy the same advantages that ESW provides to its companies, with
around 90% outsourced R&D.
o Results so far: According to the Company’s 2017 annual report, Redknee expects to reduce
530 employees globally and vacate premises in 18 locations. By the beginning of 2018,
management terminated approximately 520 employees globally and vacated buildings in
around 11 locations worldwide.
• Customer-Centricity: = customer captivity = increased pricing power, thus creating barriers to entry
to protect against competition in Redknee’s product segment.
o Results so far: As learned from Amazon and a few other companies, an obsession for
delivering the best service for customers is imperative for durable success, and a
consistency of doing so may become an economic moat in its own right. ESW knows this
and has made customer focus a pillar of Redknee’s new mandate. Therefore, the constant
assessment of customer success must become a priority for investors weighing the
probabilities of Redknee’s success post-restructuring. Fruitfully, according to Company’s
most recent 1Q18 results, Customer Success (rebranded Optiva AdvantageTM) metric, has
increased from 20% in 1Q17 to 27%.
• New Management: key personnel changes to ensure that Redknee’s management team brings
turnaround and cost management expertise to the table.
o Results so far: There has been a complete shake up in the management of the Company.
The ex-CEO, Lucas Skoczkowski, was replaced in early 2017 by Dannielle Royston, who
is a proven turnaround expert, as shown by her tenure as CEO of Versata as of 2009, a now
private company focused on buying and restructuring underperforming software
companies. In addition to senior operators like the Redknee’s CEO and CFO, much of the
Company’s board has been replaced. This should fix the long-standing problem in
Redknee’s management, which was the lack of ability to integrate large acquisitions while
trying to focus on core operations.

The Strategic Plan will be funded by the rights offering that occurred in July 2017, which managed to raise
C$96 million. Positively, the stock price movement post-refinancing (from its 52-week low at C$0.67 to
around C$1.05 today) shows that the market does respond to progress in Redknee’s turnaround. However,
much of the improvements in Redknee’s business model and management’s ability have not yet been fully
priced in. The reason is simple – turnarounds take time, and Redknee is just at the beginning. The market is
largely composed of impatient and anxious participants, which explains the mispricing. It also does not help
that Redknee itself is a micro-cap company with balance sheet issues that does not screen well, and that it is
followed by only six banks, four of which are primarily focused on Canada. None of these factors help attract
attention to the Company and the progress it has been making.
Our Partners
One of the pillars of this investment thesis is management. When assessing management, aligned incentives
are a necessity. This is especially true in Redknee’s case, given the negative narrative around the Company’s
stock. ESW has around $100m worth of skin in the game from its investment, and following the rights
offering last year, the firm and its affiliates now own around 28.2% of the Company. It is safe to say that
Redknee’s largest owner-operator, ESW Capital, and the rest of the management team, have their interests
aligned with investors’.

Valuation
Valuing the Redknee situation is not clear cut. Firstly, the Company is hard to compare accurately, given its
size (Redknee is a micro-cap) and the fact that its operations are focused on the telecom industry, while most
of its public peers are industry agnostic. And secondly, Redknee is still in the early stages of its restructuring,
so looking at earnings or free cash flow do not reflect the true earnings power of the Company. Therefore,
the best metric to value the Company is by its Sales.

I look at valuing Redknee using: (1) ESW’s factual history of under-promising and over-delivering; and (2)
a worthy comparison to Redknee’s restructuring situation, based on ESW’s sole other public market
investment, Upland Software.

Firstly, based on management’s guidance (which in ESW’s previous investment have proved to be
conservative), the Company would be looking at $120m in revenue post-restructuring4. At this ‘normalized’
level, and current Enterprise Value, Redknee trades at an EV/Sales forward multiple of 1.57x.

The comparison I draw to value Redknee is the Upland Software turnaround, which happens to be
tremendously analogous to Redknee’s current situation. Upland is also a provider of real-time, mission-
critical software solutions; focused on a single market (in their case, enterprise work management software);
and is a small-cap, making it a worthy comparable company in my opinion. The resemblance between the
two turnarounds is uncanny – Upland Software also suffered from balance sheet issues due to an acquisition-
driven growth strategy, and saw its stock price fall more than 40% in a single quarter. The company managed
to increase their EBITDA margins from 2% at the end of 2014 to 10% in Q4 of 2015, and of 30% in 2017.
Based on Upland’s current post-turnaround 3x EV/Sales multiple, and management’s conservative guidance,
this implies a share price of C$1.72 for Redknee, which corresponds to a 64% return.

For a downside scenario, based on management’s worst-case of a 20% decline in the guided revenue5, the
stock would trade at around 1.96x EV/Sales. In this case, the lowest Redknee’s stock price would go would
be to C$0.90, equating to 14% loss.

Overall, the risk/reward of an investment in Redknee seems significantly skewed to the upside.

DISCLOSURE: I am long Redknee Solutions Inc. [TSE:RKN], purchased at an average price of C$1.02 per share.

DISCLAIMER: All commentary on this write-up represents solely my own opinion, and does not constitute a recommendation
to buy or sell any security. I may trade in any mentioned security, both in the direction of and against my published views, at
any time thereafter, without notice. Past results are no guarantee of future results, and no representation is made that an investor
will or is likely to achieve results similar to those shown. All investments carry risk, including the risk of loss of principal.

4
2017 Annual Report, pg. 16
5
2017 Annual Report, pg. 16