February 23, 2007

After a somewhat lackluster performance in 2006, shares of Keynote Systems are off to a good start in 2007. It appears that investors are once again taking notice of this former high flying Silicon Valley based technology company. Shares of Keynote, which provides web monitoring and mobile device testing services, have risen over 26% so far this year.

Recently, Keynote reported strong first quarter results. Revenue increased 15% to $15.8 million and net deferred revenue increased 144% to $14.7 million. The SIGOS division, which was acquired in April 2006 and supplies mobile data network testing systems, was a major contributor to this growth. “SIGOS is clearly outperforming our expectations and fueling growth” commented Keynote’s CEO Umang Gupta during the company’s first quarter conference call. Although Keynote managed to earn a small profit in the quarter of $0.01 per share, this figure does not account for about $4 million in subscription revenue which must be deferred under GAAP accounting rules. Cash flow from operations, a more useful measure of current performance in this case, was $5.1 million, or around $0.30 per share.

Keynote’s balance sheet remains in excellent shape. The company is debt free and has approximately $95 million in cash. It also owns its headquarters, which is fully paid for, although it occupies only 40% of the space. Based on Keynote’s first quarter results, it is on track to generate approximately $80 million in cash sales this year. Many subscription-based technology companies sell for a multiple of 2 to 3 times sales. Yet, if we subtract Keynote’s cash and real estate value from its current market value, we arrive at an implied public market value for the remaining business of only $100 million, or just 1.3 times revenue.

Keynote also trades at a comparatively low multiple of only 12 times free cash flow. Similar technology companies command multiples which are much higher. The reason is that once a platform has been built; incremental revenue is usually highly profitable, and the market is willing to look forward to future earnings growth. We believe Keynote is close to reaching this threshold. Management believes that if revenue can reach $100 million, its EBITDA margin would increase to 23% from 5% currently. This would essentially double Keynote’s free cash flow, and could result in meaningful share price appreciation.

May 4, 2007

Building on a strong first quarter, Keynote delivered impressive second quarter results. For the quarter, cash provided by operating activities was $6.9 million, compared to $4.7 million in the prior quarter and $2.5 million in the second quarter of 2006. In addition, Keynote generated free cash flow of $5.5 million for the quarter, compared to $4.0 million in the prior quarter and $1.9 million for the same period last year. Revenue for the second quarter was $16.7 million, an increase of 6% compared to the preceding quarter and a 31% increase compared to the second quarter of fiscal year 2006. In the words of Keynote CEO Umang Gupta “Our team once again delivered strong financial results with solid execution across most business units”.

Keynote’s balance sheet remains in excellent shape. The company is debt free and has approximately $93 million in cash. It also owns its headquarters, which incidentally, we feel is understated on the company’s books. Based on Keynote’s most recent results, it is on track to generate approximately $85 million in cash sales over the next twelve months. Many subscription-based technology companies sell for a multiple of 2 to 3 times sales. Yet, if we subtract Keynote’s cash and real estate, we arrive at an implied public market value for the remaining business of only $100 million, or just 1.2 times revenue.

Keynote also trades at a comparatively low multiple of only 10 times free cash flow. Similar technology companies usually command a higher multiple. The reason is that once a platform has been built; incremental revenue is usually highly profitable, and the market is willing to look forward to future earnings growth. We believe Keynote is close to reaching this threshold. Management believes that if revenue can reach $100 million, its EBITDA margin would increase to 23% from 5% currently. This would essentially double Keynote’s free cash flow, and could result in significant investor interest.

August 10, 2007

Building on a strong second quarter, Keynote delivered impressive third quarter results. For the quarter, cash provided by operating activities was $5.9 million, compared to $6.9 million in the prior quarter and $2.9 million in the second quarter of 2006. In addition, Keynote generated free cash flow of $3.8 million for the quarter, compared to $5.5 million in the prior quarter and $2.1 million for the same period last year. Revenue for the second quarter was $17.4 million, an increase of 4% compared to the preceding quarter and a 25% increase compared to the second quarter of fiscal year 2006. In the words of Keynote’s CEO Umang Gupta “Our team once again delivered strong financial results while our Mobile Test and Measurement business continued to exceed our expectations.”

Keynote’s balance sheet remains in excellent shape. Keynote is not only debt free, but is sitting on $109 million, or $6.41 per share in cash. It also owns its headquarters in San Mateo, California. The land and building is valued on Keynote’s books for $35 million. It should be noted however, that this appraisal occurred during the trough of the Silicon Valley real estate market back in 2002. Vacancy rates have since improved, and we guesstimate that the building’s value has probably appreciated since this time.

Based on Keynote’s most recent results, it is on track to generate approximately $85 million in cash sales over the next twelve months. Many subscription-based technology companies sell for a multiple of 2 to 3 times sales. Yet, if we subtract Keynote’s cash and real estate value from its market cap of $250 million, we arrive at an implied public market value for the remaining business of only $60 million, or less than one times revenue.

Keynote also trades at a comparatively low multiple of only 10 times free cash flow. Similar SaaS (Service-as-a-Software) technology companies typically command a higher multiple. The reason is that once a platform has been built, there are significant economies of scale. We believe Keynote is close to reaching this threshold. In fact, management believes that if revenue can reach $100 million, its EBITDA margin would increase to 25% from 5% currently. This would essentially double Keynote’s free cash flow and could result in significant investor interest in Keynote’s shares.

November 9, 2007

Building on a strong third quarter, Keynote delivered impressive fourth quarter and fiscal year end results. For the latest quarter, cash provided by operating activities rose to $2.9 million compared to $1.2 million in the fourth quarter of 2006. In addition, Keynote generated free cash flow of $1.6 million for the quarter compared to $3.8 million in the prior quarter and $0.3 million for the same period last year. Revenue for the quarter was $17.8 million, an increase of 3% compared to the preceding quarter and a 17% increase compared to the fourth quarter of fiscal year 2006. According to the company’s CEO, Umang Gupta, “Fiscal year 2007 has been the best year ever for Keynote. Our team delivered total cash from operations of over $20.3 million and free cash flow of $14.8 million, which is a record high for any twelve-month period in our history.”

Keynote’s balance sheet remains in excellent shape. The company is not only debt free but, more importantly, is sitting on $108 million, or $5.89 per share in cash. Although Keynote is actively looking to deploy its war chest, management is quite patient and discipline. Instead, the company is utilizing part of its overly capitalized balance sheet to repurchase its common shares. For instance, approximately 92,000 shares were repurchased by the company in the latest quarter, and a further 2 million shares have been authorized for repurchase by the company’s board. Since January 2000, Keynote’s share base has declined from 23 million to 18.3 million today via company buybacks.

In addition to its strong liquidity, Keynote also owns its headquarters - located in San Mateo, California. Keynote, which occupies only a portion of the building, recently signed long-term agreements with tenants for the remaining unoccupied portion. The company estimates this will generate close to $270,000 in excess occupancy income per quarter. Incidentally, the building is valued on Keynote’s books for roughly $35 million. It should be noted, however, that this appraisal occurred during the trough of the Silicon Valley real estate market back in 2002. Given the recent strength of the technology sector, vacancy rates have since improved and we figure that the building’s value has probably appreciated over the past five years.

August 15, 2008

When we purchased Keynote Systems in April of 2006 our investment thesis was quite simple. We were buying a company for its cash and real estate value and essentially getting a technology company thrown in for free. If you recall, Keynote at the time had approximately $137 million or $7 per share in cash. It also owned its corporate headquarters. Although the building was valued on its books for $35 million, we believed its market value was probably higher. The value of these two pieces together was essentially equal to the company’s market cap of $209 million or $11 per share. Therefore, the market was assigning virtually no value to Keynote’s web monitoring business, which had sales of over $53 million!

However, in the past two years, Keynote has spent approximately $40 million (after earn-outs) to acquire SIGOS, a European based telecommunications network specialist and an additional $50 million to repurchase approximately 5.4 million of its own common shares. Consequently, its large war chest has dwindled to just $54 million or $4 per share. At the same time, the market now appears to have recognized the value of its monitoring business. If we back out Keynote’s cash and real estate from its current market capitalization, we arrive at an implied value for the business of roughly $100 million. Admittedly, at just 1.2 times sales, it may appear attractive relative to other technology companies in the same space. However, with roughly 60% of this value made up of goodwill and intangible assets, we no longer feel that Keynote represents a deep value investment.

In the last few months, a number of small brokerage firms have published positive research on Keynote shares and as a result, we decided to take advantage of this recent investor interest to sell our entire position. Although the shares may eventually reach some of Wall Street’s lofty price targets, we are finding more attractive opportunities in other fundamentally undervalued securities which have been crushed by the present market turmoil.