Danger Zone: Interactive Intelligence Group Inc (ININ) by Kyle Guske II, New Constructs

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

With the growth in services and applications moving to the cloud, investors have been quick to buy the stocks of companies that offer cloud-based products, often times regardless of valuation. But what happens when a once profitable company makes the transition to the cloud and has become unprofitable? That company, Interactive Intelligence (ININ: $46/share) is in the Danger Zone this week.

Transition To The Cloud Has Not Fared Well

Interactive Intelligence has been around long before some of the new upstart technology companies. In fact, ININ was once a profitable business, and it grew economic earnings, the true cash flows of the business, throughout 2000-2010. This trend changed in 2010 when the company introduced its first cloud-based product, and the fundamentals of the business have only deteriorated since. ININ’s economic earnings have declined from $12 million in 2010 to -$29 million over the last twelve months. Conversely, the company’s revenue has grown from $166 million in 2010 to $401 million over the last twelve months. Figure 1 highlights the divergence of revenue and economic earnings. See the reconciliation of Interactive Intelligence’s GAAP net income to economic earnings here.

Figure 1: Disconnect Between Revenue and Profits

Interactive Intelligence

Sources: New Constructs, LLC and company filings

Following the downward trend, Interactive Intelligence’s return on invested capital (ROIC) has declined from an impressive 40% in 2010 to a bottom-quintile -6% over the last twelve months. In a quest to move services to the cloud, Interactive’s profitability has cratered. ININ has also lost a cumulative -$188 million in free cash flow from 2010 to 2015.

Non-GAAP Earnings Can’t Hide Issues

Non-GAAP earnings are not a reliable indicator of a company’s operations and are often used to portray a better business than exists in reality. Here are the expenses ININ removes to calculate its non-GAAP metrics, including non-GAAP gross profit, non-GAAP operating income, adjusted EBITDA, and non-GAAP net income:

  1. Stock-based compensation expense
  2. Acquisition-related expense
  3. Amortization of debt discount and issuance costs

By removing these costs, ININ is able to understate the profit decline that has occurred since 2010. For example, since 2010, ININ’s non-GAAP net income has declined from $26 million to $1 million in 2015. While trending downwards, ININ still reported a positive non-GAAP net income in 2015. In contrast, ININ’s GAAP net income has fallen from $15 million in 2010 to -$22 million in 2015 and economic earnings have declined from $12 million in 2010 to -$26 million in 2015. See Figure 2.

Figure 2: Intelligence Interactive’s Non-GAAP Distorts Reality

Interactive Intelligence

Sources: New Constructs, LLC and company filings

Negative Profitability Creates Competitive Disadvantages

ININ provides on-site solutions as well as cloud based services to the contact center/customer engagement industry. By operating across multiple facets of the industry, ININ faces tough competition from large industry incumbents to smaller startups. Some of ININ’s main competition, as noted in the company’s 10-K, comes from the likes of Cisco (CSCO), Microsoft (MSFT), InContact (SAAS), Mitel Networks (MITL), ShoreTel (SHOR), Five9 (FIVN) and privately held firms Genesys Telecommunications, Avaya, and Aspect Software. Of the competitors covered by New Constructs, each earns a higher ROIC than Interactive Intelligence and all but one have a higher NOPAT margin, per Figure 3. Having a lower margin and ROIC than most of its competition means that ININ cannot compete as well on price. ININ needs to charge higher prices to get margins positive. It cannot afford to lower prices as many of its more profitable competitors can.

Lower margins and ROIC also mean the firm has less ability to invest in R&D and improvement of its offerings.

Figure 3: ININ’s Profitability Lags Behind Competition

Interactive Intelligence

Sources: New Constructs, LLC and company filings 

Bull Hopes Tied to The Cloud, Acquisition Risk Against The Bear Case

As we’ve seen with many cloud companies placed in the Danger Zone, such as Marketo (MKTO), ServiceNow (NOW), and Splunk (SPLK), the bull case rests largely on revenue growth exceeding expectations and hopes of future profitability. In the case of Intelligence Interactive, the bull case is no different. Bulls believe that as ININ transitions to the cloud, and cloud adoption increases, ININ will be able to reap large profits from operations that have been largely unprofitable to this point. Unfortunately, this belief is hard to justify when looking at the fundamentals of the business, particularly, rising costs and lack of profitability when compared to competition.

Most concerning for bull arguments, apart from the growing losses noted in Figure 1, is the pace at which the costs of transitioning to a cloud provider have grown. Recurring revenue, a staple of cloud based service providers, has grown by 27% compounded annually since 2010. Meanwhile, the costs of recurring revenue have grown by 37% compounded annually over this same time. As ININ has expanded into more cloud services, the costs of these services have overshadowed any increase in revenue.

Across the entire business, not just recurring services, costs are rising faster than revenues as well. Research & development costs, sales & marketing costs, and general & administrative costs grew by 23%, 21%, and 24% compounded annually from 2010-2015 – all of which are higher than Interactive Intelligence’s 19% overall revenue CAGR over this same time.

Further undermining the bull case, the stock is already priced for perfection. The current stock valuation implies that Interactive Intelligence will grow revenues at a significantly faster pace than consensus expectations for over two decades. We’ll highlight Interactive Intelligence’s overvaluation in greater detail below.

The biggest risk to our thesis is that a larger competitor acquires ININ at a value at or above today’s price. As we’ll show below, unless a competitor is willing to destroy shareholder value, an acquisition at current prices would be ill advised.

Acquisition Hopes Rest On Overpayment

We don’t think ININ is an attractive acquisition target at its current price. To begin, ININ has liabilities that investors may not be aware of that make it more expensive than the accounting numbers suggest.

  1. $73 million in off-balance-sheet operating leases (7% of market cap)
  2. $19 million in outstanding employee stock options (2% of market cap)

After adjusting for these liabilities we can model multiple purchase price scenarios. Unfortunately for investors, only in the most optimistic of scenarios is ININ worth more than the current share price.

Figures 4 and 5 show what we think Cisco (CSCO) should pay for ININ to ensure the deal is truly accretive to CSCO’s shareholder value. Cisco could be a potential acquirer of Interactive Intelligence to bolster its cloud contact center business. However, there are limits on how much CSCO would pay for ININ to earn a proper return, given the NOPAT or free cash flows being acquired.

Each implied price is based on a ‘goal ROIC’ assuming different levels of revenue growth. In each scenario, we conservatively assume that Cisco can grow ININ’s revenue and NOPAT without spending on

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