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Beyond The "Strip And Flip"


It was brutally cold in Ottawa in January, 2003, when partners at private-equity firm Vector Capital were negotiating the purchase of software maker Corel Corp. More than once their flights were canceled after temperatures as low as -16F froze aircraft hydraulics. Alex Slusky, founder of San Francisco-based Vector, jokes that the inhospitable weather may be the reason his company was the only bidder. More likely it was the fact that Corel was losing money, suffering a severe cash crunch, and falling badly behind competitors Microsoft Corp. and Adobe Systems Inc. With its WordPerfect application, Corel was once a serious alternative in word processing, but over the previous decade the company had watched as Microsoft's market share climbed to 97%.

Three and a half years later, Slusky and a lucky few investors in his Vector Capital II fund have extracted plenty from the company. By ramping up Corel's debt from next to nothing to as much as $140 million prior to a May 2 initial public offering, Slusky has been able to secure a payout in cash dividends and stock sales of more than three times Vector's $58 million investment. For average Joes, however, it has been a different story. Since the IPO, the stock has dropped 30%, to a recent 11.27, down from 16. That makes it one of the worst performing IPOs of the year, far behind other technology deals and tech stocks in general. It's also near the bottom of the list of deals backed by buyout firms, at 31 on a list of 35 such IPOs, according to Thomson Financial.

But this isn't quite a simple case of a "strip and flip" by a private-equity player. In the past, Slusky has sold investments off to other companies. But by taking Corel public, and holding on to 70% of its shares, Slusky has found a way to cash out--and cash in. He says there are plenty of opportunities for Corel to consolidate midsize software companies. With its equity stake, Vector has a chance to participate in Corel's acquisition strategy. An industry player like Corel can always pay a bit more for an acquisition than a purely financial buyer, Slusky notes, since the operating company can exploit redundancies--synergy, in other words.

LITTLE PROFIT

judging by the stock's dismal post-ipo performance, however, most investors aren't buying that sales pitch. Should Vector indeed be able to use the stock of a highly leveraged Corel as acquisition currency, it would be applying a typical private-equity strategy to an industry, tech, that is very uncomfortable with it. Traditionally, tech investors have been growth-focused and debt-averse. Corel, meanwhile, is likely to double its already hefty debt load.

It's even tougher to sell the idea that Corel, which hardly boasts gold-plated assets, can generate enough cash to keep an M&A machine churning. Phil Stiller, an analyst at independent Greenwich (Conn.) IPO research firm Renaissance Capital, says investors simply aren't excited by the company or its line of second-tier offerings--WordPerfect and Adobe rival CorelDraw (now both on their 13th versions)--or its niche products like compression software WinZip. "A company like that competing against so many bigger companies like Microsoft and Adobe--there's nothing that appealing about it," says Stiller.

Corel has turned a profit only once in the past five years. (It made $1.2 million in 2004.) The company lost $3.5 million on existing products and services last year, according to a filing with the Securities & Exchange Commission. To try and turn that around, Vector focused Corel's research and development dollars on its biggest brands, like WordPerfect, and tied new product introductions more closely to consumer demands. And as Vector cut Corel's costs, the company was able to get bank lending again. That debt eventually went to fund the $130 million in dividends that Vector took before the IPO. The company's shareholder equity remains a negative $28 million, but it has improved over time, and Chief Financial Officer Douglas R. McCollam calls it a "legacy."

Corel managed to boost revenue 7% and 11% in the first and second quarters of this year, respectively, but investors are likely more focused on the red ink. Indeed, according to David Menlow, president of IPO Financial Network, IPO investors this year have especially punished companies that have posted losses. Corel's bankers, led by Morgan Stanley, at first predicted the shares could sell for as much as $20 each, though eventually weak demand forced them to lower that to $16.

CROWDED MARKET

But trading publicly is integral to the company's major strategic thrust. CEO David Dobson, 44, who joined Corel last year after a 19-year career at ibm, is convinced more deals are the way to overcome the slow performance of the company's current products. Vector and Corel have an active list of 60-plus companies they are monitoring. "Corel spent hundreds of millions of dollars [in the past] to build its sales infrastructure," says Dobson. "We can leverage that platform through acquisitions."

With deals come more debt. Its most recent announcement, a plan to purchase DVD software maker InterVideo Inc., will set the company back $196 million. The board there had other offers and demanded cash. InterVideo does have $75 million in free cash on its books, but investors expect almost all of the remaining $121 million balance to be borrowed. Corel has only $33 million in cash on its own balance sheet.

Even if it manages to bulk up, Corel still faces withering competition in its core markets. Its oldest rivals, Microsoft and Adobe, will introduce major upgrades of their products next year. On the other end of the spectrum, free offerings from the likes of Google Inc.--and software Corel itself delivers over the Web--could pressure its 30% operating margin. "We've reached a point where it's possible to do more in a browser and to deliver a compelling experience there, in many ways as good as [you can have with] software," explains JupiterResearch analyst Joe Wilcox.

Corel's traditional answer to the threat of Microsoft has been to offer a full set of features at 40% to 65% of its rival's price. But today, with a broader set of competitors, Corel is often giving away basic versions of its software or selling them at very low cost in the hopes users will pay to upgrade. That's the plan for its newest offering, the Snapfire digital photo organizer. But Corel is arriving years late to a crowded market, which includes Google's Picasa, Yahoo!'s Flickr, and Eastman Kodak's EasyShare. Microsoft's upcoming Vista is expected to offer some photo-sharing element, as well.

As Vector's M&A vehicle, Corel has an uphill climb. But some smart money, ranging from California Public Employees' Retirement System to GE Capital, has done very well by investing in Vector. The Vector II fund was launched in the waning days of the tech bubble in 1999. By making no new investments from mid-2000 to early 2002, Slusky avoided the froth and had plenty to invest when prices came down. Most funds launched in 1999 have negative returns, but Vector's is in the top quartile, according to London researcher Private Equity Intelligence Ltd., with an internal rate of return of 13.3%.

Even fans of the company acknowledge that its approach, though common to private equity, is foreign territory in the tech industry. "They are employing the same model many industrial companies have employed," says James M. Tringas, manager of the $2.4 billion Evergreen Special Values Fund, which bought most of its Corel position after the stock had dropped. "The big question is: Are the cash flows as stable as an industrial company? And I guess that remains to be seen."

By Nanette Byrnes


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