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OneSpan Inc. (OSPN) combats identity fraud, primarily within the banking industry, where 60 of the top 100 global banks are using its products. The company is transforming from a hardware and perpetual licence software-based business model to cloud-delivered software services. But therein lies the problem for the most recent quarter. The pandemic is causing an acceleration of the business transformation which is blurring the financial picture for the company.
Q2 2020 Performance
On the surface, the performance appears to be pretty mediocre, with revenue decreasing by 2% YoY for Q2 2020. This is primarily the result of a faster-than-expected drop in hardware and perpetual license sales due to the pandemic. Of course, some of the lost product sales have migrated over to term license software or services. During the transition to Software-as-a-Service (SAAS), lower revenue is expected, along with margin compression, thus blurring the company’s performance.
Expansion into Adjacent Markets
One encouraging factor is OneSpan’s diversification into adjacent markets, including electronic signatures, and verticals such as government insurance and digital healthcare. In particular, the company is making inroads with OneSpan Sign, the company’s electronic Signature application. For those readers not familiar with the business potential for electronic signatures, one only needs to have a look at DocuSign (DOCU), which would be a competitor in this area. DocuSign has been extremely successful with product portfolio and experienced 250% stock price appreciation in the last year alone, as opposed to OneSpan, whose share price has (only) grown by 50%. According to the company management, OneSpan Sign achieved a revenue growth of approximately 30% for the most recent quarter.
Bookings Are Up!
Another encouraging factor is that OneSpan’s recurring contract bookings are up by more than 50% YoY. It should also be noted that the success of recurring contracts comes at the expense of perpetual licences and product sales.
Pandemic-Driven Drop in Banking Transactions
On the bearish front, OneSpan management indicated that it experienced a lower transaction volume from auto finance customers using its Secure Agreement Automation application. This is understandable given the economic environment.
I should point out that auto sales have been improving through the summer and it is likely that there will be some financial improvement in the second half due to the recovering auto market. On the flip side, COVID-19 infections are on the rise and there are no new government subsidies in sight. As we head into the winter, there is significant danger to the economy which is already on the ropes.
Withdrawal of Guidance
Another negative for OneSpan was the withdrawal of forward guidance for the rest of 2020. It was an action by company management that resulted in the stock price dropping overnight by ~40%.
(Source: Yahoo Finance/MS Paint)
In making the announcement, the company management cited poor visibility, expressing concerns regarding its banking customers in the Q2 2020 earnings call:
The surge of coronavirus infections and deaths beginning in early June in U.S. and Latin America and continued flare ups in Europe make it clear the virus will not be quickly contained. Most banks are now expecting a deeper, more extended economic downturn and it increased their loan loss reserves and expectation of more bankruptcies in small and medium businesses in the quarters ahead.”
Another black mark against the company, and also a likely contributor to the falling stock price resulting from the announcement that there was an error in previous financial reports:
During Q2, we identified errors relating to certain contracts with customers involving software licenses that originated in prior periods. We investigated and the errors that we found resulted in overstatements of revenue of $2.2 million from the beginning of 2018 through Q1 2020. This $2.2 million represents less than one half of 1% of the $523 million of revenue we recognized over that same time frame.
And while we did make errors, we do consider these errors to be immaterial and we are adjusting the prior period revenue and related amounts in our earnings release today and in future filings with the SEC.”
Needless to say, investors were upset with this announcement, and the disappointment was reflected in the earnings call Q&A session, and a lawsuit, actually several lawsuits, popped up as a result of this gaffe. The accounting error, in all likelihood, was partially responsible for the large drop in share price after the earnings call.
There are numerous techniques for valuing stocks. Some analysts use fundamental ratios such as P/E, P/S, EV/P, or EV/S. I believe that one should not employ a simple ratio, and the reason is simple. Higher-growth stocks are valued more than lower-growth stocks, and rightly so. Growth is a significant parameter in discounted cash flow valuation.
Therefore, I employ a technique that uses a scatter plot to determine relative valuation for the stock of interest versus the remaining 170+ stocks in my digital transformation stock universe. The Y-axis represents the enterprise value/forward gross profits estimate, while the X-axis is the estimated forward Y-o-Y sales growth.
The plot below illustrates how OneSpan stacks up against the other stocks on a relative basis based on forward gross profits multiple.
(Source: Portfolio123/private software)
A best-fit line is drawn in red and represents an average valuation based on next year’s sales growth. The higher the anticipated revenue growth, the higher the accepted valuation. In this instance, OneSpan is positioned well below the best-fit line, suggesting that the company is undervalued on a relative basis relative to its peers.
There are several risks that investors should consider before investing in OneSpan. First of all, I view the current stock market action to be reminiscent of the dot.com era, immediately prior to the crash starting in 2000. Technology stocks were performing well beyond what many analysts considered acceptable valuations. It wasn’t long before the market turned into a disaster, and the same could happen here, although I believe that there is much more substance behind the internet companies than existed 20 years ago.
OneSpan’s performance is very much tied to that of the major banks, and they have already come out with warnings of increased loan loss reserves and expectations of further bankruptcies in the quarters ahead. The longer the pandemic persists, the lack of government subsidies, and possibility of a long deep recession or even a depression could severely impact the fortunes of banks and such fortunes will be passed on to OneSpan.
Summary and Conclusions
OneSpan is an industry leader in identity verification primarily within the global banking industry, with 60 of the top 100 global banks as customers.
OneSpan’s YoY revenue decreased by 2% in the most recent quarter, primarily as a result of pandemic-driven reduction in hardware/perpetual software licence sales and transition to a SaaS business model. The business transformation has blurred the financial situation to some extent. The pandemic did not help as the depression in certain industries, such as the auto industry, led to declining bank transactions and hence declining revenue for OneSpan. The bright side is that the economy is recovering to some extent. Sales within the auto industry have been improving quite nicely as the summer progressed.
Currently, OneSpan has a stock price that I consider to be undervalued, primarily due to the perceived mediocre performance in Q2, withdrawal of guidance for the remainder of the year, and the accounting gaffe. I believe that this is a good time to be bullish on this company. The economy is recovering, bank transactions are improving, and OneSpan’s e-Signature business is performing quite well, up 30% YoY. For these reasons, I am giving OneSpan a long-term Buy rating. You may have to be patient with this one.
Digital Transformation is a once-in-a-lifetime investment opportunity. Businesses need to convert to the new digital era or risk being left behind. And the pandemic has dramatically accelerated this paradigm shift.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.