ClickSoftware Technologies: Smallcap Value Investment

ClickSoftware Technologies (CKSW) is a supplier of workforce and service management software products and solutions.

The company exhibits a stable and sustainable business model. The historical rate of growth, roster of clients (announced deals), and the recent global reselling agreement with SAP speak well of CKSW in the eyes of clients, and of its competence in delivering service. The expertise of the CEO and founder energizes such competence.

There is no evidence of outsized risks embedded in the business. Business risk is all operational; customers are large and well-established companies. Financial risk – given a debt-free balance sheet and a significant cash cushion – is minimal. All around, risk seems to be well within the company’s risk-taking ability. The CEO seems to be hands-on.

Economic Equation

Free cash flow (FCF) generation allows for rapid growth (23% revenue growth in 2007) without debt, while building up cash (about 24.0 million as of 9/30/08). This self-financing feature is relevant given the envisioned rapid growth. Future growth relies on the development of software products and delivery of solutions to clients. Future growth does not require increasing the risk profile by the use of debt.

Contract accounting and deferred income recognition combine into a continuing source of funds, provided revenue growth is continuing. This accounting stabilizes revenues and earnings and promotes visibility.

Growth in Operating Fixed Assets, largely software development, is measured and within the technical competence of the firm.

In 12/31/07 FYE FCF was $1.34 million.

FCF = $1.34MM in NOPAT + $0.60MM Increase in NOWC - $0.60MM Increase in OFA

NOPAT = Net Operating Profit After Taxes = EBIT (1-Tax Rate)

NOWC = Net Operating Working Capital

OFA = Operating Fixed Assets

Fundamental Value

The Present Value (PV) computed below results in a stock value of $2.56. This compares with recent trading prices around $1.85/share.

PV = FCF (1 + g) / (WACC –g)

The PV of a perpetuity is the next period’s FCF discounted by the spread between the constant discount and growth rates.

• Estimated 12/31/08 FYE FCF = $3.2 million = $2.8MM in NOPAT + $0.60MM NOWC Increase - $0.20MM OFA Increase (expected FYE 12/31/08 FCF is based on 9/30/08, actual 9-month results and assumed FYE 12/31/08 revenues of $58.5MM)
• Growth 6.0% (modest in comparison to historical growth rates)
• WACC (Weighted Average Cost of Capital) 13.0% (note the impact of the cash balance and low beta)
• $24.4 million in cash balances are added to the PV (assumes that the entire cash is cash surplus)
• 28.5 million shares.

If you feel that the assumptions are too conservative and that a more realistic growth rate is say, 8.0% (instead of 6.0%) and 10.0% WACC (instead of 13.0%), then your PV is $6.92 (instead of $2.56).

Alternatively, a growth rate of 2.0% (instead of 6.0%), and 13.0% WACC, would result in a $1.90 stock value, very close to $1.85, the market’s stock price.

Best wishes for 2009.

Disclosure: I hold a long position in CKSW

Comments

[vo2macs:]

What growth rate are you assuming? The only growth you refer to in your definitions is growth in operating fixed assets. Are you referring to growth in earnings?

Jan 02 04:22 PM

[Gino Verza:]

Hello vo2macs,

Thank you for the message.

The growth rate (g) in the PV formula is the growth rate in free cash flow (FCF). The computations cover different assumptions in g and in WACC. This model focuses on FCF. It does not address accrual earnings.

PV is the value of perpetual stream of FCF growing at g and discounted by (WACC – g). Both, g and WACC, apply in perpetuity.

It could be argued that g should be higher than 8% in view of the historical rapid growth in revenues. This argument is supported by the recent reselling agreement with SAP and the likelihood of continuing (or accelerating) rapid revenue growth.
An opposing view would say that in real life rapid revenue growth does not happen either in a straight line or in perpetuity, and that revenue growth does not always result in increased FCF. In fact, revenue growth connotes investments in Operating Fixed Assets, which drain FCF.

One could also argue that WACC should be lower than 10%, given the cash surplus in CKSW’s balance sheet and low beta. Again, arguments can also be made in opposition to this view.

A more optimistic scenario than the three quantified in the article would represent a fourth alternative ---Compute the PV based on $3.2 million FCF, 9% growth, and 10% WACC (and other inputs remaining unchanged). This results in $13.09, stock value.

The set of four alternatives provides a context to consider the attractiveness of CKSW as an investment relative to the market price of the stock. The current stock price ($1.99) would entail a set of assumptions (accepted by the market) that are at the pessimistic end of our four alternatives. If we believe that the market assumptions (and stock price) are too pessimistic, then there is a basis for an investment decision.

Importantly, the article discussed the reasonable level of risk inherent in CKSW’s business model. Implicit in such view is durability and staying power. Both, value and risk are important in the evaluation.

Best wishes in 2009.

Disclosure: I hold a long position in CKSW

Gino Verza

Jan 03 01:11 AM

[vo2macs:]

While it is good that free cash flow is growing for any company, I don't think that it should be used for this small company that is trying to grow quickly, grow and maintain market share and grow and maintain their technological advantage over the competition. It is more important for a growing company, IMO, to spend money on technological improvements that have a positive rate of return (hopefully - of course), R&D,capital improvements and sales and marketing efforts.

The trick in doing a valuation is ferreting out the difference between what a company is merely spending what they should be to stay in business and be competitive and what they are investing in to grow and beat the competition (the difference between the two costs).

There are some things that can't be determined in a small business without actually questioning the CFO or accountant after spotting something in the income statement or balance sheet. An example would be where a small company expensed out the entire purchase of what should be considered a capital improvement (say rigid shelving for the warehouse for example) in one year. Here you may have the shelving going into COGS in addition to 20% of the cost basis being depreciated in the same year and four more years. A mistake, of course, but I have seen it happen.

What I like about Click Software is that while they are doing all of the above they are also growing ttheir cash position year over year. As a matter of fact, their cash position is ludicrously high for a company with their "market value". A company like IBM or SAP would be well advised to take them out strategically for the IP and market share and put the cash to better use.

Jan 03 01:20 PM