This article examines Q3 results within a multi-year time span from the perspective of fundamental value, and the impact of R&D expenses as enabler of future growth. The conversion of R&D expenses under GAAP, into a tax advantaged capital expenditure is central in the analysis and assessment of prospective growth and shareholder value.
Value Metrics Definition
- ROIC (Return on Invested Capital) = NOPAT / Operating Capital
- NOPAT (Net Operating Profit after Taxes) = EBIT (1- Tax Rate)
- OC (Operating Capital) = NOWC (Net Operating Working Capital) + OLTA (Operating Long-Term Assets)
- WACC (Weighted Average Cost of Capital)
- EVA (Economic Value Added) = (ROIC - WACC) OC
- FCF (Free Cash Flow) = NOPAT - (Changes in OC). As an approximation FCF = CFO (Cash Flow from Operations) minus Depreciation and Amortization
- EV (Enterprise Value) = PV of prospective FCF, growing at g; discounted by WACC
- IR (Investment Rate) = Increase in OC / NOPAT
- g (Growth) = IR x ROIC
Value Metrics Performance
The chart below shows value metrics for the last five years, for the last two quarters, and estimates up to 2015.
|ClickSoftware Chart --Value Metrics|
|(Amounts in millions of US$, unless otherwise noted)||FYE 12/07||FYE 12/08||FYE 12/09||FYE 12/10||FYE 12/11||3-Yr. Avg.||Q 2/11||Q 2/12||Q 3/11||Q 3/12||FYE 12/12 (E)||FYE 12/13||FYE 12/14||FYE 12/15|
|Revenue Growth (y-o-y)||23%||31%||17%||16%||23%||19%||9%||18%||18%||17%||17%||14%|
|NOPAT / Revenues||3%||12%||18%||13%||14%||15%||13%||0%||20%||10%||5%||9%||10%||11%|
|OC / Revenues||-19%||-6%||17%||9%||12%||15%||7%||15%||7%||12%||12%||12%||11%||11%|
|ROIC = NOPAT / OC||-18%||-194%||105%||137%||114%||119%||181%||2%||298%||85%||47%||79%||88%||103%|
|FCF (CFO - Dep.&Am.)||4.29||7.79||6.15||14.32||8.69||6.03||1.82||2.43||3.82||4.33||8.00||11.60||15.10|
|FCF / Revenues||11%||15%||10%||20%||10%||13%||29%||8%||10%||14%||4%||7%||8%||9%|
|FCF Growth (y-o-y)||-18%||82%||-21%||133%||-39%||24%||-70%||57%||-50%||85%||45%||30%|
|R&D Growth (y-o-y)||11%||2%||21%||12%||11%||30%||60%||43%|
|R&D / Revenues||15%||13%||11%||11%||10%||12%||11%||13%||10%||13%||13%|
Q3 metrics improved sequentially over Q2, notably ROIC (85% vs. 2%), revenue growth (18% vs. 9%) and FCF ($3.8 million vs. 1.8 million).
Q3 year over year comparison shows decreases in NOPAT (and in ROIC) from $4.6 million to $2.8 million, due to increases in Selling and Marketing Expenses ($2.8 million) and in R&D ($1.4 million). In Q3 R&D increased 60% y-o-y.
Below we examine the true magnitude of R&D.
What are the value metrics when we treat R&D as a capital expenditure, instead as an ordinary expense?
The rationale for converting R&D expense into a tax advantaged capital expenditure is that the benefit of R&D is not consumed in the current period, but carried over into future periods. This conversion is necessary because current accounting rules require that R&D be expensed in the period they are incurred.
The conversion treats current R&D expenses as investments, which are amortized over a 3 year period (reasonable in the technology sector). When converted, the FYE 12/12 metrics displayed in the chart, show the following changes:
- NOPAT increases from $5.6 million (computed from GAAP) to $10.6 million (converted) due to the net of the addition of R&D Expenses and subtraction of R&D Amortization
- Operating Capital (OC) grows from $11.9 million to $33.5 million due to the creation of the R&D Asset ($21.6 million), which equals the sum of the unamortized portion of previous years' R&D expenses
- ROIC decreases from 47% to 31% due to increase in OC, which more than offsets increase in NOPAT
- Investment Rate (IR) increases from 15% to 55% due to increased OC
- Growth (G) increases from 7% to 17% due to increased IR, which more than offsets decreased ROIC
- (Net Profits after Taxes increases from $4.5 million to $9.5 million due to same adjustments as in NOPAT).
The point of this exercise is to uncover the growth potential of the firm, as follows:
- The true magnitude of R&D; $21.6 million of R&D assets are hidden by GAAP
- IR, the engine that propels growth, is extremely high (55%)
- Growth is high (17%) --even when computed based on FYE 12/12 estimates, a year of low NOPAT (NOPAT / Revenues is 5% in FYE 12/12 vs. 14% in FYE 12/11)
- Expect expansion in ROIC, and rapid growth in FCF in FYE 12/13 and beyond -a reversion toward normalized performance (FCF / Revenues), as shown in the chart.
Growth and Investment, Leadership, Expectations
The Q3 Conference Call provided considerable useful information. Remarks by Moshe BenBassat, Chairman and CEO, and Shmuel Arvatz, CFO, dovetail with our judgment regarding prospective growth. My takeaway, paraphrasing their comments, is shown below.
Growth and Investment
- Year-over-year increases in Q3 operating expenses (47% to $13.3 million) reflect growth initiatives to address increasing market demand in mobility and cloud offerings. Growing R&D and sales and marketing are expected to drive future growth.
- Headcount increase (496 employees at the end of Q3, up 31 from Q2, and up 91 from end 2011) is primarily in business development in new territories, mobility and cloud-based products; and professional services. Growing demand in Russia and the Americas, particularly South America, has more than offset weakness in Europe.
- Investment is expected to increase further, mostly R&D and sales and marketing, to accelerate top-line growth. The main objective is to accelerate the rate of growth, faster than the historical 15% to 20%, as the economy recovers.
- Gartner's Magic Quadrant report, ranked CKSW again as market leader in workforce and service optimization.
- Very good visibility, all the way to 18 months ahead, provides confidence for a great 2012; and for continued double-digit growth in 2013.
- Previous full year 2012 guidance is reiterated--revenues in the range of $98 million to $103 million representing about 13% to 18% growth over 2011.
ROIC and Growth
At the end of the day, value is created by deploying greater amounts of capital that yield a ROIC that exceeds the cost of capital (GM:WACC). The difference between today's investments and future cash flows, adjusted to present value by the cost of capital, is value added.
Revenue growth is a compelling strategy, given robust historical ROIC. The acceleration of revenues pursued by management requires investment in R&D and expansion in the sales force, both of which are underway. GAAP hides the true magnitude of R&D and prospective growth.
Attractive ROIC is sustained by a combination of favorable industry structure (which enables the players to make reasonable capital returns), and by the firm's own competitiveness (including effectiveness in the use of capital in the interactions with operating stakeholders).
The competitive position of the firm has been improving over many years and continued to strengthen in 2012.
Traditionally, high NOPAT generation (NOPAT / Revenues) enables the firm to finance growth, pay dividends (Q3 earnings announcement); and maintain a stable financial position, no debt and healthy surplus cash.
A previous artice in Seeking Alpha estimated the value of the stock at $13.00/share. Underlying this estimate was $13.4 million in 2012 FCF, growing at 9% per annum in the following three years, and 5% in perpetuity; 10% WACC in 2012 and 9% thereafter. In retrospect, 2012 FCF did not keep previous years' pace.
The price of the stock is now estimated in the range of $10.0 - $10.5 per share based on the projections shown in the chart --$4.3 million in 2012 FCF, or FCF/Revenues = 4%; growing to 7% in 2013, 9% in 2014, and 10% in 2015. Thereafter, FCF grows 5% per annum in perpetuity.
WACC is 10% in 2012 and in the following three years, 9% thereafter in perpetuity.
Clarity of purpose and consistency in the message by the CEO and the CFO were evident in the Q3 Conference Call. Execution is proficient.
Rapid expansion in product and market capabilities, sizeable growth opportunity, and reaffirmed industry leadership, support the proposition that the model of the firm is unchanged --robust ROIC is a rather permanent attribute, revenue growth is the appropriate strategy, and outsized Investment Rate is the enabler of both.
Additional disclosure: The material presented here is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion. Views and opinions in this article may be wrong. The analysis, including financial computations, presentation, and views, do not necessarily conform to any sanctioned or accepted standards. Presentation and computations entail a probability of error, which is entirely possible. I am not an investment management professional. Please do not rely on this material, do your own due diligence.