June, 2010

Broadsoft is a deal that reminds of a prior offering back in 1999 (also from Goldman, if memory serves) that went by the name of Portal Software. It was a similar story and ended up doing well for a while until investors realized how little growth there really was in the business. Ultimately, Portal was put out of their misery in a head-scratching acquisition by Oracle.

Broadsoft has built some very complex and sophisticated software that sits at the core of what communication service providers have to do to run their business. Their model also includes substantial deferred revenue which gives the company good visibility.

The core question for Broadsoft investors to answer is to what extent they will be successful in building a business that is based on usage charges versus sales of their complex software and maintenance.

The company has not yet demonstrated high levels of profitability despite having very good gross margins. Margins will improve over time as revenue grows, but low levels today make the valuation high relative to Intrinsic Value.

A snapshot diagram of the analysis and our analysis comments are included here.

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  • Market = C: While it’s true that the general market for IP-based communication is very large and growing, the more narrowly-defined market for the large complex software that Broadsoft delivers is much smaller. Growth is good but the ultimate size may be limited by the small number of potential customers.
  • Position = B: Broadsoft has achieved a strong market position with many of the top global communication service providers and has been recognized by industry groups as having a solid solution. However, the sheer size of the market means that Broadsoft has very small overall market share considering the total market for communications infrastructure software (packaged and customer-developed.)
  • Industry = B: Industry trends are mostly in favor of Broadsoft. The move to IP-based network services does create demand for their technology and the competitive nature of the carriers helps drive adoption. There are not many direct competitors for Broadsoft that focus on software and not carrier equipment suppliers.
  • Business = C: The best news about the business is that it is high gross margin (>70%) and the company has excellent revenue visibility due to their long-term contracts and book of deferred revenue. However, the company has lost money historically and has operating expense levels that are, in our experience, structurally high. Management has painted a very rosy picture of the future business model but it presumes that the company will go from basically break-even to 25% operating margins as presented in their “target model.” Unless the company can be the first to achieve real usage-based revenue over time, they will be saddled with a fairly high expense for both sales and development.
  • Management = B: The management team is solid and large with the vast majority having plenty of related industry experience. It would have been impossible to get the company this far without them. They appear to have what they need to execute at least the proven elements of their business strategy as a public company.
  • Culture = B: The company has been in development for a long time (1998) and has had the opportunity to develop a strong identity as a communications software engineering kind of place. They have processed some acquisitions and demonstrated an ability to manage hard and soft assets effectively.
  • Valuation = D: This is the weakest point in the analysis by far. Any real appreciation in the shares will hinge on the ability of the company to exceed our already-aggressive expectations for both growth and margins. We can only “push” our Intrinsic Valuation (IV) to $9. That means there will be plenty of risk in the shares for some time to come and the upside is very limited. Goldman will do their best to support the IPO price of $9 in the near-term. Our analysis suggests that investors might want to wait until either a more attractive market price is established and/or the company can demonstrate the type of success that will make their long-term margin targets achievable.

[added IPOIQ]

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