One Way or Another,
Keynote Looks Like a Good Bet

By NEIL A. MARTIN
The Wall Street Journal Online

WHEN TELEVISION'S MANIC, bobble-headed Mad Money commentator, Jim Cramer, recently touted Keynote Systems, a Silicon Valley outfit that measures, monitors and improves the effectiveness of corporate Websites, no one was more surprised than CEO Umang Gupta.

Gupta certainly believes his company has its charms: Keynote, after all, is profitable and growing, although not particularly quickly. And he knows well that, if it doesn't satisfy Wall Street, it easily could become a takeover target. What puzzled Gupta was Cramer's rationale for his recommendation—the TV commentator's contention that a stock-fraud investigation of executives of another firm, Mercury Interactive, was "great news" for Keynote. Cramer told viewers that Keynote shares (ticker: KEYN) were destined to move "a heck of a lot higher" in the next 18 months.

"We appreciated the recommendation," says Gupta, a native of Delhi, India, who has run Keynote since 1997, "but while there is some overlap in our two businesses, we operate exclusively in the Internet space, and there really isn't much to compare. Website-monitoring services are a small part of Mercury's income, while accounting for more than two-thirds of ours," he notes.

The market agreed. After jumping 6.9%, to 13.23, on Nov. 4, the day after the Mad Money commentary aired, Keynote's shares have drifted lower, recently changing hands at 12 and change—not far from where they stood before Cramer gave them some love.

Investors' lack of enthusiasm for the stock has disappointed the San Mateo, Calif., outfit, which charts the performance and reliability of Websites for companies such as Dell, Microsoft, Nissan, Disney and E-Trade. In its 2005 fiscal year, ended Sept. 30, Keynote chalked up a 27% increase in revenue, to $54 million, while a measure of cash flow—earnings before interest, tax and amortization (Ebita)—came to a record $4.2 million. Net income, adjusted for a one-time tax benefit, rose to 24 cents a share, two pennies more than in fiscal 2004.

With some $135 million in the bank, no debt, steady earnings, increasing revenue and a stock-market value of $262 million, the company would normally look enticing to many investors. Adding to Keynote's allure: Behind each of its shares is about $7 in cash and short-term investments and another $2 in real estate, namely, its corporate headquarters, which it owns and are valued at about $35 million. Thus, at the stock's recent price of $12.50, investors are paying just $3.50 a share for Keystone's business.

On a price-earnings basis, the shares do look pricey, selling at about 52 times fiscal 2005's earnings, 104 times this year's likely 12 cents a share and 59 times'07's 21 cents. (This year, for the first time, Keynote is taking a charge for stock options and faces a dramatically higher 40% tax rate. Without these, net would probably come in around 37 cents a share.) However, Keynote trades at about 16 times its projected fiscal 2006 Ebita—a measure analysts view as more pertinent for a young company in its business—versus 17 for the overall stock market.

Jim Cramer: right about Keynote, for the wrong reason.

Stripped of its cash, Keynote's common sports an enterprise value-to-sales ratio of 2.2 times—quite modest for a tech operation. (Enterprise value is stock-market capitalization, plus debt minus cash.) "It's hard not to like Keynote's underlying business," says John Buckingham, chief portfolio manager of Al Frank Asset Management and editor of the Prudent Speculator investment newsletter. Adds Buckingham, whose firm owns the stock: "The company is growing, it's profitable, management has been buying back its stock and it has a mountain of cash, not to mention a compelling valuation. It's one of my favorite stocks."

With online retail sales in the U.S. alone—excluding travel and auctions—expected to top $110 billion this year and hit $210 billion by 2010, according to Forrester Research, his assessment isn't outlandish. While some Keynote clients pay up to $100,000 a month for detailed analysis of how Web surfers interact with their sites and how they can be improved and made more profitable, most of its 2,300 customers pay less than $1,000 a month for more simple technical measuring and monitoring services. The company claims a customer-retention rate of 99%.

American Express uses Keynote to see how long it takes its Internet site to process a customer's charge. Dell, which generates about half its consumer sales online, uses Keynote to find ways to shorten Internet purchase times and chart how it ranks against its competitors in responding to complaints.

While it's been making gains in the marketplace, Keynote has been an aggressive purchaser of its own shares, buying back 2 million since March, with another 1 million-share buyback authorized to begin in January.

Nonetheless, Keynote's stock has floundered since its heyday in 2000, when the Internet bubble was at its peak and the shares hit an insane 163.75. In 2002, Keynote's revenue fell 17%, its bottom line turned a deep red and it lost nearly a fourth of its customers. At their nadir in October 2002, the shares were around 7—about 95% below their peak.

Beyond an occasional bump or dip, Keynote has moved in a narrow range, from about 11 to 13, over the past five years, even though Gupta widened the company's reach and scope by buying 11 companies from 2000 through 2004.

"The company's earnings are growing, but at a mild rate, which is the reason why the stock isn't trading at a higher level," says Doug Whitman of Palo Alto, Calif.-based Whitman Capital, whose hedge fund is a major Keynote shareholder. "If they picked up their growth rate, the stock would take off."

In fact, says Eric Martinuzzi, an analyst with Craig-Hallum Capital Group in Minneapolis: "The primary reason the stock has held up as well as it has during the past few quarters is because Keynote has been such a prolific buyer of its own shares. This is a company with a modest float [15 million shares], which is why such buybacks can have a material impact on the price."

Analysts note that even though Keynote enjoyed record results in fiscal 2005—it made $5 million, five years after losing $20 million—this was largely due to the acquisition of three performance-measurement outfits—NetRaker, Hudson-Williams and Vividence—in 2004. Growth from ongoing operations was non-existent, after rising about $2 million the previous year.

To bolster growth, Gupta has shaken up his sales force's management, improved training and begun pushing into new markets in the Asia-Pacific region and Europe. He also wants to expand Keynote's product line and mine "hot" markets like wireless and broadband Web services.

Still, Martinuzzi forecasts minimal top-line sales growth of only $400,000 in the current fiscal year.

Buying growth might help, and Gupta is on the prowl. With more than $135 million in the bank, he has the wherewithal. His goal: to find "something accretive to our stock and our bottom line." A likely area for acquisitions might be Web analytics, which looks at how Internet users respond to a company's Web design, online marketing campaigns and e-commerce offerings.

Google's (GOOG) recent disclosure that it will soon offer free analytics services to its advertisers sent a chill through some companies in the lower and middle level of the analytics market, such as WebSideStory (WSSI) and privately held Coremetrics and Omniture. But Keynote, which has its own proprietary technology, tends to compete for higher-margin, high-end customers.

Gupta hopes to double Keynote's size in a year or two. But if his ambitions don't pan out, shareholders might benefit in another way: Keynote could be taken over.

"It makes all the sense in the world," says Martinuzzi. "Given the increased accounting and due diligence costs of being a public company in the post-Enron age, it doesn't make sense for a technology company under $100 million to try to maintain a public profile," he adds. "It's a waste of owner's money below a certain point to bear those costs," he adds.

Indeed, the need for heft has been a factor in the consolidation that's already apparent in the technology software area, a point underscored by Saba's (SABA) pending takeover of Centra and Captiva's (CPTV) proposed acquisition by EMC (EMC). "Small software companies below $100 million are being swallowed by bigger fish," Martinuzzi says.

With its cash, niche leadership position and proprietary technologies, says Whitman Capital's Doug Whitman, Keynote "is an easy, accretive takeover for almost anybody." It could be very attractive to a private-equity firm, as well as another tech company.

In any case, if someone were to offer $15 or $16 a share, Keynote's board might find it difficult to refuse.

Gupta acknowledges that his company is a potential target.

"The idea of being acquired is not repugnant to me, but it is also not something I go to bed at night worrying or dreaming about," says the CEO, Keynote's largest shareholder, with about 15% of its stock, if options are included.

"I am just as interested as any other shareholder in seeing our business and share price grow," he says. "And, for whatever reason, if we are not able to execute and achieve the kind of growth we need, then we might have to consider a sale or a leveraged-buyout situation," Gupta continues. "Those are all options that should be on the table, but not at this time."

One way or another, Keynote eventually will be a winner for anyone who acquires the stock near its current price.

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