Ultimately Ultimate goes private - what next?

Profile picture for user brianssommer By Brian Sommer March 26, 2019
Summary:
Ultimate Software will go private after all. The go-shop period has now passed and the deal can proceed. The debt load that Ultimate will get as a result of this deal is certainly material. How will this work out for employees, customers, etc.?

Judge's gavel standing on a dollars
It appears HCM software vendor, Ultimate Software (NASDAQ symbol: ULTI) will be taken private by a consortium of private equity and other investors. When the deal was initially announced, it allowed for a 50-day go-shop time period that expired on Monday March 25. There are differing statements about whether other bidders came forward with other offers.

The StreetInsider reports:

The analyst comments "With Ultimate Software's go-shop period expiring on 3/25/2019 at 11:59PM New York City time, we think the likelihood of another bidder coming in over the top at this point is quite low.

In a short piece from Seeking Alpha , we see:

Ultimate Software announced this morning that its go-shop period expired yesterday with company deciding to stick with Hellman & Friedman. The last-minute bidder mentioned by Stifel was unsuccessful.

That newsletter also had this tidbit:

Stifel downgrades Ultimate Software (NASDAQ:ULTI) from Buy to Hold saying that another bidder has come forward, but the bid is "quite low.

Ultimate themselves issued a press release that states:

At the direction of Ultimate’s board of directors, during the go-shop period, Ultimate and its financial advisor solicited and responded to inquiries relating to the proposed merger and alternative acquisition proposals from 22 parties. During such time, three parties executed non-disclosure agreements with Ultimate and were offered access to certain members of Ultimate’s senior management and were provided access to certain non-public information regarding Ultimate. During the go-shop period, no alternative acquisition proposals were received by Ultimate. Following the expiration of the go-shop period, Ultimate became subject to customary no-shop restrictions that limit its and its representatives’ ability to solicit alternative acquisition proposals from third parties, subject to customary “fiduciary out” provisions.

So, whether there was another bidder or not is moot: the original deal is going forward.

The debt this deal brings

Investment banking firm William Blair issued a research note on this deal. They state:

H&F (Hellman & Friedman) is proposing to finance the deal via $8.1 billion of equity and $3.2 billion in debt, implying roughly 9.4 times pro forma leverage based on management's view of 2019 adjusted EBITDA.

In two prior pieces, I noted how the servicing and cost of this debt could affect headcount, R&D, growth and/or customer support. Those articles are here and here. In those articles, I showed how the new company would have to pay the PE firm its management fees and at least make the interest payments on its debt. Servicing the debt is one challenge – paying it down would be another.

At $3.2 billion, the debt is significant and the servicing costs will be material. Hopefully, the company’s debt agreements will allow ULTI to defer paying debt service costs for a couple of years. This cost would get rolled into the debt balance and would be paid later. While that compounds the pain, it buys time. In time, one would hope ULTI becomes a materially bigger firm that can afford this level of debt.

$3.2 billion in debt represents, to me, the upper most limit of debt the company could assume (I believe a $1 billion level is more appropriate). It also leaves the company little wiggle room as most, if not all, of its earnings would be needed to service the debt. That would leave little money to use for other purposes like geographic expansion or product line re-investment.

The subject of earnings is interesting as ULTI’s most recent financials on ULTI (EOY 2018) reported EBIT (earnings before interest and taxes) is only $83.657 million (figures reported to the SEC are GAAP numbers).   9.4X of this would be only 790 million in debt. That’s a far cry from the proposed $3.2 billion that is being considered.

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Image from Yahoo Finance – amount in 000’s USD.

Why would the company accept so much debt? The answer may be found in management’s guidance for FY2019 and the fact that the debt load is being based on a non-GAAP estimate of future earnings. Specifically, management thinks it can generate $267 million per year in operating income.  In 2018, the company did $1.1 billion in revenue and plans approximately a 10% increase for 2019. That’s possible if the economy remains strong and ULTI doesn’t lose key people or customers.

The William Blair report also notes:

Management's disclosed long-term projections (prepared in mid-2018 and refined in early 2019) are relatively in line with Street expectations on the top line though slightly below on margin over the next three years. Management's model for 2019 suggests $1.210 billion of recurring revenue (Street: $1.208 billion) and $267 million of non-GAAP operating income (Street: $275 million).

Readers can form their own opinion as to whether they want to utilize GAAP or non-GAAP numbers as part of their assessment of this deal.

For a company with $1.1 billion in sales, an EBIT value (GAAP) of almost $84 million is okay. I suspect that the non-GAAP estimate of $267 million for next year assumes some cost reductions. I fully expect ULTI to pare down its headcount in certain non-sales related areas (e.g., back office accounting). Whether there will be cuts (and how deep they’ll be) in other areas (e.g., Marketing, Development, etc.) remains to be seen.

Guidance

A material change of control with a software vendor can stress some customers and vendor employees. The new owners will have their own ideas re: product development, product direction, technology direction, etc. Everything the customers and employees thought about their relationship with the vendor could change. For a detailed review of the impact that a material change of control can have see this and this.

Private equity firms also have a timetable they will follow. They’ll want to exit their investments in approximately 7 years or less. So, ULTI customers can likely expect another material change of control in a few years.

My take

For current and future customers, employees and partners, these parties should seek answers to the following questions:

  • Exactly how will ULTI afford to service the debt, pay management fees and/or pare back headcount and expenses while also growing the firm, funding R&D, expanding globally, etc.? You can do one or the other but doing both could be a real challenge.
  • To make its new $267 million non-GAAP operating income target for next year, what steps will ULTI take to make this goal? Will it cut headcount, audit more customers, raise prices, etc.?
  • Would headcount cuts adversely affect customer service, development, etc.?
  • How will the new owners grow the company and make it even better?
  • Will the new owners grow the firm (or will it treat this as something to financially engineer)?

Within a short time after the deal closes, customers should demand communications from ULTI about product roadmap changes, new investment focus areas and more. Smart customers stay on top of changes occurring within their software vendors. Whenever a vendor ceases to be aligned with the objectives, culture or finances of the customer, smart customers have backup contingencies in mind. And while change is inevitable, even in software, customers have to decide if the changes still fit their needs/requirements. Caveat Emptor….