Safeguard Scientifics, Inc.
Q4 2016 Earnings Call Transcript

Published: 2 Mar 2017

[Operator:]

Good morning, and welcome to Safeguard Scientifics’ Fourth Quarter and Full Year 2016 Financial Results Conference Call. All participants are in a listen-only mode. After the speaker's remarks, there will be a question-and-answer session [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to John Shave, Senior Vice President, Investor Relations and Corporate Communications. Please go ahead.

[John Shave:]

Good morning and thank you for joining us for this update on Safeguard Scientifics’ 2016 financial results and outlook for 2017. Joining me on today’s conference call and webcast are Steve Zarrilli, Safeguard’s President and CEO; and Jeff McGroarty, Safeguard’s Senior Vice President and CFO. During today’s call, Steve will review highlights of 2016 as well as other developments at Safeguard and our partner companies, then Jeff will discuss Safeguard’s financial results and strategies. After that, we will open the lines for your questions. As always, today’s presentation includes forward-looking statements. Reliance on forward-looking statements involve certain risks and uncertainties, including but not limited to the uncertainty of future performance of our partner companies, the risks associated with our acquisition or disposition of interest in partner companies, risks associated with our decisions about the deployment of capital, the effect of regulatory and economic conditions generally, and other uncertainties that are described in our filings. During the course of today’s call, words such as expect, anticipate, believe, and intend will be used in our discussion of goals or events in the future. Management cannot provide any assurance that future results will be as described in our forward-looking statements. We encourage you to read Safeguard’s filings with the SEC, including our form 10-K which describes in detail the risks and uncertainties associated with managing our business. The company does not assume any obligation to update any forward-looking statements made today. Now here is Safeguard’s President and CEO, Steve Zarrilli.

[Steve Zarrilli:]

Thanks, John. Good morning and thank you all for joining us for this update on Safeguard and our partner companies. Today's presentation is an opportunity for us to reflect on both our progress in 2016 and the promise of the New Year. It is also an opportunity to reiterate and highlight aspects of our current strategy. As of December 31, 2016, we have interest in 29 partner companies. We head into 2017 with the specific focus on increasing the number of exit transactions and the associated cash inflow related to such transactions. Our principle goal in 2017 is to achieve a higher level of monetization's both in aggregate dollars and number of transactions. We understand the importance of these profit producing activities. We also understand the value of providing additional data when possible to help our shareholders understand the extend of value creation within these companies during the tenure with Safeguard. We will also use today's call to remind new and existing shareholders of the key elements of Safeguard's business model and strategy for developing growth capital and dynamic vertical markets of the technology sector. First, let’s reiterate key tenants of our business model. We specifically target early stage and growth stage technology companies where we can deploy growth capital over a series of tranches of funding and maintain an ownership interest generally between 20% and 50%. This ownership level provides us with significant minority interest where we can proactively assist in the meaningful development of these enterprises. We do not however control these companies and cannot force an exit to occur on our predefine timeline. Exit timing is impacted by a number of factors including but not limited to, market reception shareholder desires and partner company management team capabilities. We account for our ownership interest in these partnership companies under the equity or cost method of accounting when ownership is below 50%. We do not adjust these ownership interest to market value, we do however record our share of any net income or losses as an adjustment to our original cost basis for those partner companies accounted for under the equity method. Thirdly, we have been on the specific path over the last four years to increase the number of partner companies under management in order to provide for greater asset diversity and a future framework of more regular profit producing activities through monetization's. As of December 31, 2016, we maintained meaningful ownership interest in 29 companies compared to 18 at the beginning of 2013. Within the construct of this business model, we have accomplished the following over the last five years. We had nine exit resulting in 215 million of capital retrieved with an average cash-on-cash return of 2.1x times. For capital deploy since 2012, we have had three right offs approximating 20.4 million of capital. We deployed 337.9 million in partner companies and we have paid no federal income tax on our gains during this period using tax loss carry forward and we still have approximately 225 million of such carry forwards of offset future profits. Also, since January of 2014, we returned over $35 million to shareholders in the form of share repurchases. So, then the question becomes why a lagging stock price and relationship to what appears to be is the successful stream of that activities, including very profitable monetization of this period of time. We believe that there are three reasons. First, as value is being built within the respective partner companies, there is no complete way for shareholders to assess such value creation until the monetization is achieved and the profit from the sale is certain. Our partner companies desire that their financial data generally remained confidential. Secondly, the equity method of accounting does not allow for any fair market value of the individual holdings. And in fact, result in the reduction of our cost basis to a lesser amount, in other words carrying value as a reflection of our share of net losses from these businesses. Does further exacerbating the delta between current value and recorded value. Third and finally, if extended periods of time elapsed between monetization's i.e. profit producing events, investors become vary as to whether such exits will ever be achieved or realized. Specific to 2016, management believes much was accomplished within the context of our core strategic business plan. Highlight include redeploy 22.9 million in four new partner companies, Aktana, Brickwork Software, Moxe Health and T-REX Group. The average capital deploy was $5.7 million per company. We further supported 18 of our partner companies with follow on capital of $56.4 million. The average follow on capital deployed was $3.1 million per company. We have returned more than $58 million from the sale of our stake in Putney which represents a 3.9 times cash-on-cash return. We also realized $5 million from the various Escrows and earnouts from prior year exits of ThingWorx, Quantia and drive factor. Nevertheless, we were and are disappointed with the share price performance in 2016. We believe that such a share price performance is the direct result of lower than expected number of monetization. Thus, our goals for 2017 will focus significantly on this particular aspect of our business. It is however important to understand some of the external broader macro trends impacting us as well in 2016. The exit environment in the U.S. in 2016 was challenging not only for Safeguard but also for the venture capital industry nationwide. According to data compiled by PitchBook and NVCA, liquidity events for venture backed enterprises slumped in both the fourth quarter and throughout the year. All exit transactions totaled 726 in 2016 compared with 961 in 2015 and 1,040 in 2014. The corporate acquisition component of annual exits totaled 595 in 2016 versus nearly 800 M&A transactions in each of 2015 and 2014. The value of exits for venture backed companies also declined in 2016, less than 47 billion versus 50 billion in 2015 and 82 billion in 2014. Further IPOs involving venture backed enterprises also declined. In the fourth quarter only seven venture backed companies went public bringing the total for 2016 to 39. Half the total IPOs in 2015, and the lowest total completed since 2009, when there were just 10 ventures back IPOs. However we are cautiously optimistic that the climate for M&A will be stronger in 2017 under the expectations of our more robust and accommodating business climate. Therefore Safeguard enters 2017 with the number of key objectives including explicit focused efforts on substantially increasing the number of exits at meaningful profit levels and utilizing a variety of transactions structures to facilitate such goals. Secondly, continued support for existing partner companies with their business needs and judicially deploy follow on capital supported by efficient operating cost structures. And thirdly, selectively participate in new deployment scenarios recognizing the dynamics of a potentially frothy valuation environment. To better prepare for our initiatives in 2017 we realign certain internal resources during 2016 in order to more specifically address activities to enhance partner company growth and continually move such enterprises to a moment in the revolution that will provide an exit opportunity for Safeguard. At this juncture outreach has increased across the broad cross section of financial and strategic investors and we are encouraged by their interest in Safeguard stable of companies. Approximately one third of our partner companies are actively exploring potential exit opportunities and our new strategic investment from independent third parties. As you can imagine we get frequent questions about our largest partner company MediaMath. As it relates to MediaMath we are actively engaged with the management of MediaMath in finding an appropriate exit for Safeguard in whole or in part. As MediaMath's revenue profit and market opportunities continue to grow in 2017, management and the Board of MediaMath will desire additional capital to further accelerate these growth objectives. We believe based upon a number of data points assessed that the most successful exit for us will be accomplished in coordination with MediaMath's overall capital strategies. We cannot predict the exact of timing of such, but we believe positive factors may present themselves in 2017. As with most of our companies, we do not control MediaMath or its Board and must work within a process involving the opinions and objectives of a number of shareholders. We have started off strong in 2017, today we announced our first exit in 2017 involving byond.com. Byond has been a partner company since 2007 and was one of our high traction companies, said differently a company generating in excess of $20 million annually with a mature business model. We agreed to a transaction were Safeguard's ownership interest was acquired by Byond. This transaction was structured with both cash and three year note ultimately providing an approximate two times cash on cash return for Safeguard. More specifically, Safeguard stake was acquired for $26 million in comparison to the original capital deployed of $13.5 million. In connection with the transaction, Safeguard will receive 15.5 million in cash and a three year $10.5 million note for the balance due, which will accrual interest at a rate 9.5% per annum. Exit transactions not only drives Safeguards profitability they also drive growth of our partner company platform. Longer-terms Safeguard continues to balance the strategic importance of a greater base of assets under management with a steadier flow of monetization. We are also not forgetting about the importance of a balanced approach to capital allocation. We have returned $35 million to shareholders over the past 36 months, through share repurchases. These transactions were the first return of capital to shareholders in over two decades. We currently have $15 million under an existing share repurchase authorization and will consider it use as we retrieve further capital through our monetization transactions. We also continue to explore other ways to address shareholder's desires for a more considered approach related to capital allocation involving returns of capital to shareholders. As the Safeguard roaster of partner companies grow in the future, investors can expect our deployment thesis to broaden within various vertical markets of the Tech sector. Now more than ever, technology in general and data more specifically touch every facet of our professional and personnel lives. Exponentially more data is being generated that must be collected, translated, analyzed and acted upon. This avalanche of data is creating many opportunities to improve process efficiency and technology and to enhance human computer interaction for better outcomes. In every opportunity the Safeguard deal team will pursue primarily Series A and B deployments and growth stage businesses with proven models and platforms with recurring revenue. We believe that our initial capital deployment should remain in the range of 5 million to 15 million with a target overall cap of 25 million in any one partner company. We will continue to seek ownership seeks between 20% and 50% with Board representation. We also recognize that attractive opportunities may arise where we could exceed that ownership limit. Our goal remains to realize value through well timed exits that deliver aggregate cash-on-cash returns of at least 2x. Over the course of the company's 64 year history Safeguard has always embraced change in innovation. We believe that our focus on deploying early stage capital in select vertical markets of the technology sector has positioned Safeguard on the threshold of another period of dynamic growth. Now I'll turn the call over to Jeff McGroarty, Safeguards Chief Financial Officer. Jeff you have the floor.

[Jeff McGroarty:]

Thanks Steve. At December 31, 2016, we had 29 partner companies up from 28 companies at the end of the third quarter. The cost of our interest in those companies was $336.7 million and the carrying value was $179.1 million. The average capital deployed in our partner companies at December 31, was $11.6 million. The average length of time that Safeguard has been a shareholder in those companies is 4.1 years. 17 of the 29 companies have been a Safeguards partner company for three years or less. The fourth quarters new capital deployments were Brickwork and T-Rex. Brickwork is the first on the channel software solution to power a new digital presence for physical retail stores, featuring online to in store conversion funnels to influence decision making and to improved overall customer experience. Safeguard led a $4.5 million Series A financing deploying $4.2 million for 20% primary ownership position in Brickwork. Proceeds will be used to expand sales and marketing and to strength Brickworks platform with deeper data science and analyst. T-Rex offers a secure enterprise SaaS based analytics risk and portfolio management platform to global investment banks, that allows banks to finance, securitize and manage assets efficiently across multiple classes. We led a $10 million Series B financing deploying $6 million for a 24% primary ownership position in T-Rex. Proceeds will be used for the expansion of product capabilities and the business development team. During the quarter Safeguard recognized an impairment charge of $2.6 million related to partner company Aventura in which we had deployed $6.2 million since January 2015 and held a 20% primary ownership position. Aventura seized operations in February 2017. During the fourth quarter, we also deployed 15.2 million of capital in 10 existing partner companies. For the year follow-on financings totaled $56.4 million for 18 existing partner companies. Corporate expenses excluding interest depreciation and stock based compensation expense were $3.3 million in the fourth quarter which was unchanged compared to the same quarter of 2015. For the year ended December 31, 2016 and '15 corporate expenses were $16 million and $15.8 million respectively. We expect that corporate expenses for 2017 will range from $16.5 million to $17.5 million. Safeguard’s cash, cash equivalents and marketable securities at December 31, totaled $37.7 million and the carrying value of outstanding debt was $52.6 million. Aggregate partner company revenue for 2016 was $344 million compared to $328 million in 2015 and $283 million in 2014 for those same company. Revenue figures for all periods reflect the reclassification of certain task as a reduction of revenue for our digital media partner companies. These figures do not include new partner companies in which Safeguard initially deployed capital in 2016, or partner companies that were exited or written off in 2016. For 2017, aggregate partner company revenue is projected to be between $395 million and $420 million, an increase of 14% to 21% from 2016 and this includes revenue for all partner companies in which Safeguard had an interest at January 1, 2017. Aggregate revenue for the same partner companies was $348 million for 2016 and $329 million for 2015. Aggregate revenue for all years reflects revenue on a net basis. Revenue data for certain partner companies pertain to periods prior to Safeguard's involvement with those companies and are based solely on information provided to Safeguard by those companies. Safeguard reports the revenue of its equity and cost method partner companies on a one quarter lag basis. Now, here is Steve to lead us through the Q&A segment of the call.

[Steve Zarrilli:]

Thanks, Jeff. Operator, let's open the phone lines for any questions.

[Operator:]

[Operator Instructions] Your first question comes from Jim Macdonald with First Analysis. Your line is open.

[Jim Macdonald:]

On partner revenue, could you tell us does that -- how are you targeting for byond.com. And could you talk about specifically how much change was there from the accounting change and sort of a little more and what that accounting change was, was it a number of companies or just one company?

[Jeff McGroarty:]

Sure. Jim, I'll update that question. The answer to your first question is, we have not adjusted any of the data presented this morning as it relates to Byond. When we issue our results and have our call for Q1, we will make that adjustment as we historically have to exclude any sold partner companies. So, the data that is in our press release for both 2016, actual revenue and 2017 guidance includes Byond. On the second question, the scope of the adjustments -- again it pertains to our digital media companies, it’s primarily related to one company, but the nature of these adjustment with any of our ad tech companies is, there is a revenue recognition issue, not in terms of timing, but gross to net is always an issue when you have pass through type revenue. So, that adjustment was made within 2016, rather than give you a dollar figure, I'll tell you that the percentage looked something like this. When we started the year, our revenue guidance was on average about 11% growth. And then when we had some transactions, most notably, selling Putney which was a pretty high growth company, we issued new guidance during the year and that on average would have had us at 8% revenue growth. And then these adjustments which were just decided upon in the fourth quarter at our partner companies and we then adjust our results, would have changed that revenue guidance to about 6% growth. And where we ended up I think is about 5%. So that gives you a little bit of magnitude of those adjustments. So then compared to our 344 million, the actual. Had we known these items at the start of the year our --- or I should say our adjusted guidance midway through the year, after accounting for the exited companies, would have been somewhere around the high 340 million range, 348 is an estimate. So we were at the lower end of that guidance on the adjusted basis.

[Jim Macdonald:]

Did you do any re-purchases during the quarter?

[Jeff McGroarty:]

Re-purchases of common stock? No, we did not do any re-purchases during the fourth quarter.

[Jim Macdonald:]

And just on your -- I appreciate your discussion and especially the concept of trying to get out there of the real value of your investment and how they are actually creating value rather than going down in value as your book value would indicate. Have you thought about -- maybe you could talk a little bit more about how you are going to do that? I mean if you thought about I assume you have 49A [ph] valuations for a lot of these companies that you could potentially show some kind of value accretion like most center capital companies do where they value their positions. Is there any ability to do that?

[Jeff McGroarty:]

Yes, you know that something Jim we talked about for many years how to provide a better view of the value that’s being built in our partner companies given that the carrying value is generally going down and we only recognized that value when its realized in the form of an exit. So it is something we continue to evaluate different metrics that we might be able to use that we would be comfortable with and we would feel that would be helpful to our shareholders and others, I don’t know if Steve has anything further to add on that?

[Steve Zarrilli:]

No, I think that’s a good summary and Jim and the only other thing I would mention is, as we evaluate these other potential data points we want to make sure that we can consistently apply them in the future and not be using them just opportunistically to try to provide a perspective at a moment in time. So we are continuing to look at a number of things and discussing those actively with our Board to see where we management and they the Board can be comfortable.

[Jeff McGroarty:]

And the one other I would add Jim as always as we talked about our private partner companies anything we would do in that regard would likely be at an aggregate level.

[Operator:]

Your next question comes from Bob Labick with CJS Securities. Your line is open.

[Lee Jagoda:]

This is actually Lee Jagoda for Bob. Good morning.

[Steve Zarrilli:]

Good morning Lee.

[Lee Jagoda:]

Starting with the cash balance, historically and generally you want to have about 80 million in cash to invest in your new and existing companies and sitting here today you probably have about half of that. What's the plan to get back to that 80, if any and how you are thinking about cash these days?

[Jeff McGroarty:]

It's we are about half of that number, I'm not sure if I would have suggested $80 million, it was the number. I think we've said in the past $50 million is a kind of safe number for us to be at, I think with the Byond transaction we’re right back to where that lower end of the range of would be. If we succeed the activities that we have our focus on in 2017 as I've highlighted, I think you'll see that cash and cash equivalent should rebound properly within the construct of the business model to something you're accustomed to seeing.

[Lee Jagoda:]

Okay. Great. And the other one for me, your revenue guidance for the core of about 14% to 21% is a nice acceleration year-over-year. So, what are the drivers of that and if you want to get company specific that’s great. And what gives you the confident, given we’re coming off of somewhat of the muted growth here?

[Jeff McGroarty:]

Sure. I'll take that question, William. We definitely have some slower growth in 2016 with some of our more mature high traction partner companies. And we knew that to some extent going in. Putney at the time was one of the high traction company that is growing quite nicely. So when that was sold we did have a large number of earlier staged companies, very early that we’re our more recent capital deployments over the past two years. And now that we’re a year further in, those companies the growth in their revenue is more impactful on an aggregate basis. And we’re starting to see some of our more mature companies are growing again at a -- we expect a level that will be much more in line with what it had been a couple of years prior.

[Lee Jagoda:]

Okay. That’s sounds good to me. Thank you very much.

[Operator:]

Your next question comes from Paul Knight with Janney Montgomery. Your line is open.

[Paul Knight:]

Hi, Steve. Regarding with the goal of more regular liquidity events, I'm guessing that three to four a year. But, where -- or what's the magic number on portfolio companies. Is this 29, is it 35, what's the range on that. And then what's your average age goal, 4.1 is that should it be 3.1, could you put metrics around kind of the parameters for this goal of liquidity events?

[Steve Zarrilli:]

Yeah. So, just to address some of those questions. You're right in that three to four exit this year would be in line with the target and to create that meaningful monetization level of cash. The 4.1 is kind of the in the mid-range right now of what we’ve always historically have suggested is the average holding period of three years to five years. It crept up a little bit on us because some of the more recent deployments over the last 24 months have been a bit earlier in the lifecycle of the company that we’ve engaged ourselves with, but that also allowed us on a positive side to a get a bigger ownership stake in these companies. So, as they grow and mature that should accrue benefits to Safeguard. I think it’s if we can stay within an average goal of 3.5 to 4.5, I think that’s a good number to think about. It's an art not a science, we have a mix of Series A and Series B and three points with regard to these companies which has been deliberately designed so that we can create some interesting opportunity for us. So therefore that range of 3.5 to 4.5 years I think is a valid range to think about at this point in time.

[Paul Knight:]

And then your do have the share repurchase program. Do you have a goal as you achieved liquidity events would you increase your re-purchase activity or there any parameters around that? Do you wanted to deploy a certain percentage of liquidity events in the future to repurchase, is it repurchase what's your shareholder return goal on that?

[Steve Zarrilli:]

We haven’t defined a specific shareholder return goal, point number one. Point number two, we have insured that this discussion around capital allocation is front and center with our Board every quarter. I think as monetization increase there is obviously opportunity for us to revisit repurchases that are already authorized under the current authorization that exist. I also failed to mention or answer your other question with regard to number of companies in the portfolio, we still strive to continue to increase the number, but we are waiting to make sure we balance deployment again monetization and the activities associated with both. And then going back to capital allocation I think you should continue to be informed by our recent activities over the last three years that would continue to shape our future activities as it relates to returning shareholder -- capital to shareholders. We hadn’t done anything in close to two decades until January of 2014 and this is a topic that is important to the Board to retain and understand and act upon when appropriate.

[Paul Knight:]

And then lastly Steve you lost cited some venture capital numbers earlier in terms of exits in the industry. How are your cash on cash returns comparing to some of the composites that you might look at?

[Steve Zarrilli:]

We well first we are hitting our internal goals which are on average 2x beyond, it's just another example of that. If you look at the last nine exits prior to that as we highlighted we are right in that sweet spot of 2. That compares pretty favorably to the industry at least in the way we compare ourselves to other platforms of similar size focused in the market in the similar way. And while we would love to continue to incrementally see our average increase we have been pretty consistent and pretty deliberate in delivering returns that are on target with what we've expressed in the past.

[Operator:]

Your next question comes from Alex Paris with Barrington Research. Your line is open.

[Alex Paris:]

I had a question in regard to Good Start Genetics. Can you just, if possible, provide some more color on this company? And where it currently stands with the potential exit over the next 12 months?

[Steve Zarrilli:]

Good Start came, off as a little bit of a rocky 2016, its regained its footing, it's back in the growth mode. There potentially is some capital need that could be satisfied in some other ways, other than involving Safeguard, but we also believe that there may be some opportunity that would result in good start. Ultimately, being held by someone else they have some really interesting signs that is being appreciated by others in the marketplace and we’re exploring a variety of alternatives for a good start.

[Alex Paris:]

Okay. Thank you. And then I have one follow-up. Could you provide some color on what led to the transition of Aprenda and NovaSom to the next stage. And I guess leading to my next question, where does QuanticMind currently stand on making it to that next stage?

[Steve Zarrilli:]

Sure. Alex, I'll start with NovaSom, you've hit on really the companies that have moved up a stage this year starting InfoBionic which went from a pre-revenue company to the initial revenue stage in 2016. Aprenda went from the initial revenue to the expansion stage and that’s just the natural progression as the company continues to gain traction with some of this large enterprise customers. And, QuanticMind is another one that moved into that expansion stage of greater than $5 million, they are performing very well. And NovaSom on which has been with us for a number of years over the past three years or so is really gained traction that has allowed them to grow to just over 20 million in revenue in 2016 and we’re looking forward them to continue to grow at a nice pace in 2017.

[Alex Paris:]

Thank you for taking my questions.

[Operator:]

[Operator Instructions] Your next question comes from Jim Macdonald with First Analysis. Your line is open.

[Jim Macdonald:]

Yeah. A couple of follow-ups, you used a lot of money in 2016 on follow on investments and is there any thought process to try to limit that, I think you hinted at that in some of your marks, but maybe you can give me more detail?

[Steve Zarrilli:]

Sure, Jim. I'll take a step in answering your question. 2016 was the largest the follow-on funding year for us. And we had -- we came in really right on what we expected at the beginning of the year, that was all budgeted. I think that was a result of the larger number of new deployments over the prior three years where we had done an average of six new deals per year. And as Steve has mentioned they were typically Series A, Series B initial revenue stage companies. So, we -- that was a high point I would not expect it to be that high in 2017, I think I mentioned our average capital deployed in our partner companies today is about 11.6 million. The average initial capital deployed into our partner company is about 6.5 million. So, if you look at that that’s nearly a 100% of our initial deployment in follow on funding and that’s generally our target, is when we do a new deal, we assume we’ll put in a similar amount of capital and follow-on funding over the lifecycle of the company and every situation is different, but I do believe that the follow-on funding will be significantly lower in 2017 for the existing companies.

[Jim Macdonald:]

Thanks. And one thing that at least will help me in terms of kind of understanding value creation is, maybe a little more discussion on getting some of these initial revenue companies up to expansion stage and maybe are there any -- you can highlight that you expect to get to expansion stage in 2017?

[Steve Zarrilli:]

Sure, we do have -- I think about 16 of our partner companies today are in the initial revenue stage. A lot of them are growing very nicely, but getting from that 1 million to 2 million up to 5 million takes a couple of years of growth at fairly decent rates. But for 2017 the companies that I think could be moving into that greater than 5 million category include a newer company for us Aktana, Cask I think could be one that could be not in the that door, Lumesis and Syapse. So, maybe 25% of the companies in that stage could be moving over that next hurdle in revenue in the next 12 months.

[Operator:]

There is no further question at this time. I’ll turn the call back over to presenters for closing remarks.

[John Shave:]

Thank you all for joining us today. We look forward to keeping you apprised of our activities in 2017. And as I've mentioned we will have some specific focus monetization in addition to the other elements of our business model. Thank you.

[Operator:]

This concludes today's conference call. You may now disconnect.