Tuesday, May 02, 2006

WorkStream Will Very Likely Be Acquired

This is a good story, so pay attention.

We spoke yesterday about Kenexa (KNXA), a human capital management solutions provider which went public last year and then quickly captured the hearts of analysts across the Street.

The Industry We like Kenexa because although it is losing money, it operates in a fast growing space: According to the Bureau of Economic Analysis, more than half of US GDP is spent on human capital. The human capital management market is expected to grow rapidly for the next few years as older, technologically obsolete modules & systems are replaced by up-to-date, automated hiring process platforms. We're in the middle of a paradigm shift in which employees are no longer just seen as a cost, but as rather as a significant value driver. HR departments will need talent acquisition solutions and they'll need them fast. On demand software providers such as Kenexa are already capitalizing on this opportunity, as are myriad smaller players that we think will be snapped up.

The Takeover Play Meet Workstream (WSTM), another HCM provider, one we're assuming you have never heard of. At just over $1 a share, its the "cheapest" stock we've ever taken a position in. And we're buying it strictly on takeover speculation.

Workstream provides enterprise workforce management solutions and services that help companies manage the entire employee lifecycle - from recruitment to retirement. It's solutions are offered on a monthly subscription basis, under a Software as a Service (SaaS) model that help companies cost-effectively maximize workforce productivity, engagement, and satisfaction by applying business discipline to key people processes. Hmmm, sounds like Kenexa's business model, right? That's the point.

Workstream has a star-studded customer list, which includes Chevron, Eli Lilly Canada, The Gap, Home Depot, Kaiser Permanente, Motorola, Nordstrom, Samsung, Sony Music Canada, VISA, and Wells Fargo as clients. Insiders own 16% of the company. The company has negligible debt on its books and only 3 analysts follow the stock. Last September, only 3 analysts followed Kenexa. Now 11 do. We believe Workstream could be a mirror image -- we expect analysts to pile on top of this stock the same way they did on Kenexa. Speaking of analysts....

Meet Mr. Michael Nemeroff The whole key to this situation may be an analyst you've never heard of, namely, Michael Nemeroff. Nemeroff was one of the first analysts to initiate coverage on Kenexa, back when he was the chief software analyst at The Maxim Group. He recommended it at $15 back in September of 2005 -- the stock soon went on a tear and now sits pretty at $34. In other words, it looks like Nemeroff knows his stuff. Nemeroff has since left Maxim Group to join Wedbush Morgan Securities, probably because he caught a double on Kenexa in less than 6 months. Now Nemeroff is the strongest bull behind Workstream. He thinks shares could hit $3 very soon. The stock has gone as high as $4.67 over the last year and is priced where it is today because the company missed earnings by a penny on March 30.

Enter William Blair The same day it reported earnings, Workstream also announced that it had hired William Blair as its strategic advisor to assist the firm in exploring various strategic alternatives to maximize shareholder value. Nemeroff immediately issued this note: "While we are disappointed in the company's sales performance in the third quarter, we remain positive about the growth potential of the human capital management software sector in which WSTM competes, as well as management's retaining a financial adviser to explore strategic alternatives to maximize shareholder value, which could include a potential sale of the company."

Conclusion We think Kenexa buys Workstream inside the next 6 months. This is mostly conjectural, but well worth the risk, we think. Workstream's revenues are growing and the choice to "pursue strategic alternatives" is clearly a sign that management has decided to pursue an exit strategy rather than post negative cash flow and give shareholders a rollercoaster ride for several more years. When Workstream CEO Michael Mullarkey came on board in 2001, WSTM stock was trading at $1.50. It's been 5 years and the stock is now trading for less than what it was trading for when he took the corner office. It's time to move on and sell the company to a player who has done its homework better than Workstream has. In the end, we think Workstream is a pitiful company with sorry management. But it has some enviable clients and it did grow its sales more than 50% in 2005. We are still trying to come up with a fair value for a WSTM buyout, but if we assume that it goes for 8 x trailing 12 month revenues ($27M), that'd value Workstream at more than $4 a share ($215M market cap/50M shares outstanding = $4.30 per share). However, paying 8 x revenues for a company with no earnings may be a bit too optimistic on our part. Worst case scenario, WSTM goes for 2 x book or 3 x sales -- that'd still give investors a double. If you can stomach the risk, we'd suggest buying shares now as we feel that the worst has already been priced into the stock. We know we are.

Disclosure: At the time of publication, the author held a long position in the stock. Don't forget that you can also enjoy most of our research at SeekingAlpha.com, which just refurbished its user interface into something truly extraordinairy.

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