January 11, 2008
Research Associate: Harpreet Sandhu, MBA.
Editor: Payal Jalan, M.Fin.
Sr. Ed: Ian Madsen, CFA; ; 1-800-767-3771, x9417
111 N. Canal Street, Suite 1101 Chicago, IL 60606
Quest Software Inc. / (QSFT - NASDAQ) / $16.34Note: All new or revised material since the last update ishighlighted.
Reason for Report:Financial Restatement Prev. Ed.: December 07, 2007; Partial 3Q07 Results
Brokers’ Recommendations: Positive:71.4% (5 firms); Neutral: 28.6% (2); Negative: 0% Prev. Ed.:5; 3; 0
Brokers’ Target Price: $20.33 (↑$0.33from last edition; 3 firms) Brokers’ Avg. Expected Return: 24.4%
Recent Events
On January 09, 2008, QSFT announced it has received a letter from the Board of Directors of The Nasdaq Stock Market confirming the Nasdaq staff’s determination that Quest has regained compliance with the periodic reporting requirement contained in Nasdaq’s Marketplace Rule 4310(c) (14).
On December 31, 2007, QSFT announced it has filed with the Securities and Exchange Commission its pending quarterly reports and is now current with its SEC periodic reporting obligations.
Overview
Analysts have identified the following key factors for evaluating the investment merits of QLGC:
Key Positive Arguments / Key Negative Arguments- Quest is bullish on Microsoft's advancement in the enterprise business (Windows Server, SQL Server, Exchange, etc.) and is leveraging its business from these benefits.
- Clean balance sheet (over $2.79/share in cash and cash equivalents with no debt).
- Solid organic growth
- QSFT has a track record of outperforming expectations.
- QSFT is investing in growth opportunities from a product perspective to support geographic expansion and to exploit potential market disruption from further industry consolidation.
- Integration risk with recent acquisitions
- Secular trends remain neutral due to a lack of solid IT spending growth.
- The lack of a unifying cross-product strategy
- Significant competition in each of its core markets
Based in Aliso Viejo, California, Quest Software, Inc. (QSFT) engages in the design, development, distribution, and support of application management, infrastructure management, and database management software products. Its application management products, such as JProbe, a performance toolkit for Java tuning; JClass, Java components for visualization and reporting; QDesigner, a database application design tool; Foglight that monitors databases, networks, application servers, Web servers, and applications; and Stat ACM that provides change management and version control for PeopleSoft and Oracle E-Business Suite. The company’s database management products include Code Quality and Optimization tools for database developers working in the Oracle Procedural Language (PL)/SQL environment; Quest Central product family for Oracle, SQL Server, DB2, and Sybase; and SharePlex for real time replication of Oracle databases. Its Infrastructure Management products include Quest Management for Active Directory for diagnostics, recovery, detailed auditing, group policy management, reporting, self-service, role-based delegation, and user provisioning of Microsoft Active Directory; Quest Management for Exchange to migrate, store, recover, and manage Exchange infrastructures; and ZeroIMPACT for planning and executing migration projects to Active Directory from Windows NT or Novell NDS. For more information about the company, please visit its website at Note: QSFT’s Fiscal Year ends on December 31.
Note: On December 31, 2007, QSFT announced it has filed with the Securities and Exchange Commission its Quarterly Reports on Form 10-Q for the periods ended March 31, 2007, June 30 2007 and September 30, 2007, and is now current with its SEC periodic reporting obligations.
January 11, 2008
Revenue
Provided below is a summary of revenue as compiled by Zacks Digest:
SALES - FYE Dec 31 / 3Q07A / q/q % chge / y/y % chge / 2006A / 2007E / 2008ELicense / $70.3 / 6.8% / 3.6% / $288.7 / $305.3↓ / $333.5↑
Services / $82.5 / 7.8% / 19.8% / $271.2 / $318.9↓ / $361.9↑
TOTAL REVENUE / $152.6 / 7.2% / 11.6% / $560.4 / $624.3↓ / $695.4↑
Zacks Digest average revenue for the third quarter was $152.6 million, up11.6% y/yand7.2% sequentially. The revenue was slightly above the consensus estimate of $151.7 million. Managementstated the revenue growth was largely due to excellent sales executionand restructuring of sales. According to the Company, 3Q07 license revenue of $70.9 million grew a meager 4.5% y/y and comprised only 46.2% of total revenue. LTM license revenue growth of 1.0% is disappointing, although the service revenue continues to grow at almost 20%.
Given below is the graphical representation of the segmental revenue:
In 3Q07, License revenue was $70.3 million, up 3.6% y/y and6.8% sequentially.Service revenue was $82.5 million, up 19.8% y/y and 7.8% sequentially.One analyst (Cowen) models an improvement in license going forward as acquisitions drive higher growth, and believes sales execution will improve. 4Q07 is expected to be an important quarter as the company generally has strong sequential growth and builds backlog for 1Q08.
QSFT reported strength in its Windows managementbusiness. Vintela (the AD integration product acquired last year) has also begun to ramp as well and performed well this quarter. Database management and application management were flat year over year,but QSFT expects good improvement in this area in 2H07 given the ongoingtypical inflectionin large deal flow on the database side, as well as the release of new J2EE changemanagement and monitoring products.
One analyst (Cowen) believes sales at QSFT will improve with better focus in 4Q07.
Please refer to the Zacks Research Digest spreadsheet on QSFT for more details on revenue estimates.
Margins
Provided below is a summary of margins as complied by Zacks Digest:
MARGINS - FYE Dec 31 / 3Q07A / q/q chge / y/y chge / 2006A / 2007E / 2008EGross / 89.9% / 0.2% / 0.0% / 89.8% / 90.0% / 90.3%↑
Operating / 18.2% / 2.9% / -0.4% / 19.8% / 19.3%↓ / 19.7%↓
Pre-Tax / 21.4% / 2.8% / 1.9% / 21.9% / 22.1%↑ / 21.8%↑
Net / 14.0% / 2.0% / 0.3% / 15.2% / 14.6%↑ / 14.0%
The Zacks Digest average gross margin in3Q07was89.9% and operating margin was 18.2%.
One analyst (J.P. Morgan) believes QSFT will slow its reinvestment mainly due to theneed to integrate its recent hires rather than a broad change inthe outlook. The company has increased its headcount by about 20% inthe past 12 months, with a significant increase in the pace of sales related hires starting in 4Q07. The analyst believes reinvestments in the business wereslightly more front-end loaded in the year than anticipated and thecompany will look to increase the aggregate productivity of its directsales team as well as improve traction with its indirect channels in 2H07.
Please refer to the Zacks Research Digest spreadsheet on QSFT for more details on margin estimates.
Earnings per Share
Provided below is a summary of margins as complied by Zacks Digest:
Pro Forma EPS - FYE Dec 31 / 2Q07A / 3Q07A / 4Q07E / 2006A / 2007E / 2008EZacks Consensus / $0.22 / $0.63 / $0.76
Company Guidance
High Estimate / $0.18 / $0.23 / $0.30 / $0.91 / $0.94 / $1.00
Low Estimate / $0.16 / $0.16 / $0.26 / $0.68 / $0.78 / $0.83
Digest Average / $0.17 / $0.20 / $0.28↑ / $0.78 / $0.86↑ / $0.93↑
The Zacks Digest average EPS in3Q07 was $0.20, up 20.6% y/y and 21.3% sequentially.
The Zacks consensusprojects EPS of $0.63 for FY07and $0.76 for FY08.
2007EPS forecasts (7 in total) range from $0.78 (J.P. Morgan) to $0.94 (Cowen); the average is $0.86.
2008EPS forecasts (7in total) range from $0.83 (B. of America) to $1.00 (Stifel Nicolaus); the average is $0.93.
In the recent update, two analysts have increased the EPS estimate for FY07 and FY08 based on restatement of the financials, and two analysts have decreased the EPS estimate for FY08 based on higher tax rate.
Please refer to the Zacks Research Digest spreadsheet on QSFT for more details on EPS estimates.
Target Price/Valuation
Of the 7 brokerage analysts rating the stock, 5 gave positive ratings and 2 gave neutral ratings. The Digest average target price is $20.33(↑$0.33 from the previous Zacks Digest report, 24.4% above the current price).Target prices for QSFT range between $20.00(22.4% upside from the current price)(B. of America) and $21.00(28.5% upside from the current price)(Stifel Nicolaus). The analyst (B. of America) with the lowest target price hasderived the target price using19x CY08 EPS of $0.89. The analyst (Stifel Nicolaus) with the highest target price has valued the stock based on 20.0x FY08 EPS. The valuations are primarily based on P/E multiple.
Rating DistributionPositive / 71.4%
Neutral / 28.6%
Negative / 0.0%
Avg. Target Price / $20.33
Maximum Target Price / $21.00
Minimum Target Price / $20.00
Analysts with Price Target/Total # / 3/7
Metrics detailing current management effectiveness are as follows:
Metric (ttm) / Company / Industry / S&P500Return on Assets (ROA) / 6.2% / 15.4% / 8.9%
Return on Equity (ROE) / 8.6% / 29.1% / 21.9%
Return on Investment (ROI) / 7.9% / 22.7% / 12.9%
ROA of 6.2%, ROE of 8.6% and ROI of 7.9% are lower than the market averages (as measured by the S&P 500) of 8.9% and 21.9%, and 12.9%, respectively.
Please refer to the Zacks Research Digest spreadsheet on QSFT for more details on Valuation estimates.
Capital Structure/Solvency/Cash Flow/Governance/Other
Quest reported cash, equivalents and investments of $345.1million in 3Q07. QSFT used $77.4 million of its cash to complete the acquisition of ScriptLogic, which closed on August 08, 2007. Accounts receivable was $109.9 million in 3Q07.
Cash flow in the quarter was $95.6 million.
In the past, Quest has been a very acquisitive company and its primary focus has been on acquiring small companies with interesting technologies so that it can leverage through its distribution, as opposed to large deals. Quest is expected to continue in this path. The company indicated early in 3Q06 it has made a small acquisition in the database management area. One analyst (Stifel Nicolaus) views software as a consolidating market and believes acquisitions are healthy, and are important for driving the future growth of some companies. In the case of Quest, it believes management has done a fairly good job on the acquisition front and the company’s Microsoft infrastructure management business has been built largely through acquisitions. Another analyst (Cowen) believes Quest has shown a clear ability to hold up its future to software platform trends, most recently with acquisitions and organic development in the Microsoft area. The analystsees this as a multi-year business driver, and with Microsoft accelerating marketing activity to drive adoption of SQL Server, Exchange, Sharepoint and Windows Server, Quest would also benefit from these initiatives.
Update on Nasdaq listing Matters
On January 09, 2008, QSFT announced that, following the filing on December 31, 2007 of its quarterly reports on Form 10-Q for the first three quarterly periods of 2007, it received a letter from the Board of Directors of The Nasdaq Stock Market confirming the Nasdaq staff’s determination that Quest has regained compliance with the periodic reporting requirement contained in Nasdaq’s Marketplace Rule 4310(c) (14). The Nasdaq Board also remanded to the Listing Qualifications Panel for further consideration Quest’s failure to hold its annual shareholders’ meetings in 2006 and 2007 and to solicit proxies from its shareholders, as required by Marketplace Rules 4350(e) and 4350(g).
Financial Restatement, Current with all Sec filling
On December 31, 2007, QSFT announced it has filed with the Securities and Exchange Commission its quarterly reports on Form 10-Q for the periods ended March 31, 2007, June 30 2007 and September 30, 2007, and is now current with its SEC periodic reporting obligations.
Other
On December 5, 2007, Quest Software announced that it has signed an agreement to acquire PassGo Technologies Limited, a privately-held, Britain-based leader in access and identity management solutions. The addition of PassGo’s market-leading identity management and compliance products to Quest’s existing user authorization and authentication product set means customers will enjoy a more comprehensive method of managing users and controlling access in multi-platform environments including Microsoft’s Active Directory, Unix, and other platforms including IBM zSeries and iSeries (S/390 and AS/400) systems. The deal is expected to close in early 2008.
January 11, 2008
Potentially Severe Problems
There are none other than those discussed in other sections of this report.
January 11, 2008
Long Term Growth
Long-term growth rates for QSFT range from 12.0% (Broadpoint Capital) to 18.0% (B. of America), and the average is 14.1%.
Analysts point to the company’s re-investment plans (back into the business) as primary catalystsfororganic growth moving forward. QSFT plans to invest heavily in Asia Pacific, where growth opportunities are strong. Additionally, analysts like the company’s strategic move to focus on the tele-marketing business. It will likely take 1-2 years to determine how successful management is in growing the business organically. Most analysts believe topline growth in low double digits is sustainable. Margins are expected by analysts to trend downward in the next year; however, once investments into the business have been made and hiring of sales representatives are complete, analysts expect margins to rebound once again, likely back to the mid 20s for operating margin. The company is also likely to make strategic acquisitions in the future to boost growth, given its solid balance sheet, and opportunities to gain market share and exploit the technological advantages that itcurrently enjoys.
Risks to long-term growth include a downturn in global IT spending, increased competition, integration and execution risk associated with recent acquisitions, and uncertainties associated with the new investment strategy implemented by management.
January 11, 2008
Upcoming Events
On February 05, 2008, QLGC is expected to report its 4Q07 & FY07 financial results
Individual Analyst Opinions
POSITIVE RATINGS(71.4%)
B. of America –Buy ($20.00 price target): 01/04/08: The analyst maintainedaBuy rating and atarget price of $20.00. INVESTMENT SUMMARY:The analyst is of opinion that QSFT could potentiallyearn $23.00-$24.00per share in anMBO. The analyst believes that the company’s fundamentals remain intact. The analyst also opines that the Microsoft migration tools, particularly around Directory and Exchange, remain the key drivers of growth for QSFT.
Cowen – Outperform (no price target): 01/03/08: The analyst maintained an Outperform rating.INVESTMENT SUMMARY: The analyst believes there is 20% upside versus the market over 12 months. The provisional acquisition is viewed as a good extension of the existing Quest portfolio (Windows, virtualization and desktop) at a likely reasonable price.
J.P. Morgan – Overweight (no price target):01/02/08: The analystreiteratedanOverweight rating on the stock. INVESTMENT SUMMARY: The analystbelieves QSFT has a number of positive catalysts in the forthcoming future, including increasing large deal flow, scale with inside sales and improvements with channel sales,which will generate margin outperformance for the company.
Stifel Nicolaus – Buy ($21.00 price target): 12/10/07:The analyst reiterated a Buy rating and a target price of $21.00on the stock. INVESTMENT SUMMARY:The analyst continues to believe that becoming current with filings represents a positive catalyst as this improves financial transparency.
Thomas Weisel – Overweight ($20.00 price target): 01/02/08: The analyst reiterated an Overweight rating and the target price of $20.00. INVESTMENT SUMMARY: The analyst believes that QSFT has attractive fundamentals and recommends the stock to investors.
NEUTRAL RATINGS (28.6%)
Broadpoint Capital – Neutral (no target price): 01/03/08: The analyst reiterated a Neutral rating on the stock.
CIBC – Sector Performer (no target price): 12/10/07.The analyst reiterated a Sector Performer rating on the stock. INVESTMENT SUMMARY: The analyst believes the fundamentals of the company are solid, but prefers to remain on the sidelines until further clarity on the ongoing stock option investigation is received. The analyst further believes at current levels, the shares are fairly valued to account for the impact of the ongoing stock option investigation. The analyst expects Quest to benefit over the next few years due to its exposure to both the Microsoft and Oracle product cycles.
NEGATIVE RATINGS (0.0%)
None
Research Associate: Harpreet Sandhu
Copy Editor: Oindrila Banerjee
Content Ed: Payal Jalan
Zacks Investment Research Page 1