The title refers to a long-standing classic TV show of many years ago, "To Tell the Truth", where two imposter contestants try to convince a panel that they are the real person, the third contestant. All three present themselves as a real person to a panel that tries to resolve the puzzle by asking questions. At the end of the questioning session the host asks the contestants the long-awaited question: "Will the real (so and so) please stand up? After some jiggling by the three contestants to feed suspense, the "real" person stands up.
In this analysis we endeavor to find the real ClickSoftware. Our investigative tool is the conversion of R&D expenses into tax-advantaged capital expenditures. The impact of the conversion is major in the realm of enterprise value. It reconfigures the value profile of the firm; operating income, capital invested, free cash flow, and growth.
We begin with the definition of key metrics, the rationale behind the conversion, and discussion of three key value metrics. This is followed by salient management strategies and the conclusion.
- 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)
- Growth = IR x ROIC
- IR (Investment Rate) = Increase in OC / NOPAT
- FCF (Free Cash Flow) = NOPAT - (Changes in OC)
- EV (Enterprise Value) = PV of prospective FCF, growing at g; discounted by WACC
- WACC (Weighted Average Cost of Capital) -estimated at 10%
- EVA (Economic Value Added) = (ROIC - WACC) OC.
Table 1 shows the conversion -from R&D as operating expenses under GAAP into R&R as tax advantaged capital expenditures. The rationale is that the benefit of R&D expenses is not consumed in one period but is carried over into future periods (say three years in the fast-changing technology sector) and appropriately depreciated.
Treating R&D as an operating expense negates benefit in future periods, which is contrary to the purpose of R&D. The conversion of R&D from an operating expense into a tax-advantaged expenditure removes the GAAP restriction and reveals concealed value.
Table 1a computes the value of the R&D Asset at $21.86 million, by amortizing R&D expenses over a three year period.
Table 1b converts GAAP-based metrics into the metrics after R&D conversion.
|Table 1. ClickSoftware, R&D Conversion --from Operating Expense to Capital Expenditure (Amounts are US$ in millions, unless otherwise noted)|
|Table 1a. Computation of R&D Asset Value|
|Year||R&D Expense||Unamortiz. Portion||Unamortiz. Portion||Amortiz. This Year|
|R&D Amortized this Year||7.92|
|Table 1b. R&D Conversion|
|2012 GAAP-Based Metrics||2012 Metrics After R&D Conversion||Change||Change as %|
|+ R&D Expenditure||13.15|
|- R&D Amortization||7.92|
|Operating Capital (OC)||8.02||8.02|
|+ R&D Asset||21.86|
|ROIC = NOPAT / OC||89%||41%||-47%|
|+ Inc. in WC||-3.25||-3.25|
|- R&D Amortization||7.92|
|= OC Investment||2.88||8.11||5.23||182%|
|Investment Rate = OC / NOPAT||40%||66%||25%|
|Growth = ROIC x Invest. Rate||36%||27%||-9%|
|+ R&D Amortiz.||7.92|
|-Inc in NOWC||-3.25||-3.25|
|FCF = NOPAT - Increase in OC||10.74||10.74||0.00||0%|
|Net Income & EPS Computation|
|Operating Income (EBIT)||7.27|
|(+) R&D Expenditure||13.15|
|(-) R&D Amortization||7.92|
|= Operating Income||7.27||12.50|
|- Income Taxes||0.17||0.17|
|= Net Income||7.48||12.71||5.23||70%|
|# Diluted Shares||32.83||32.83|
|EPS = Net Inc. / # Dilut. Shares||0.23||0.39||0.16||70%|
2012 Metrics after R&D Conversion
Three metrics are relevant to shareholder value; ROIC, Growth, and FCF. Shareholders' purpose is to invest capital that generates FCF at a rate of return (ROIC) that exceeds the cost of capital (WACC), and to grow FCF to create greater value (EV). Growth in FCF results from growth in revenue, which is enabled by a high rate of capital reinvestment (IR).
- ROIC is 41% in 2012 --NOPAT $12.35 million, Operating Capital $29.88 million
The firm generates 41 cents on every Dollar invested; 41% is over four times 10%, estimated cost of capital (WACC).
Economic Value Added (EVA) to shareholders after paying for the cost of capital invested is $9.26 million [(41% -10%) x 29.88].
- Growth is 27% in 2012 --IR 66%, ROIC 41%
The firm grows rapidly due to the large percentage of NOPAT invested into OC.
Growth is driven by 41% ROIC and 66% Investment Rate (66% x 41% = 27%).
- FCF is $10.74 million in 2012 -- NOPAT $12.35 million; Increase in OC $1.61 million.
FCF is substantial; 10% of revenues. On an ongoing basis cash generated is sufficient to support substantial reinvestment, dividend payments, and a robust surplus cash cushion without using debt.
High ROIC, rapid growth and strong FCF is the real ClickSoftware story.
ROIC, a sticky attribute, results from two basic conditions; industry structure --where rational pricing allows reasonable economic returns to participants, and the firm's unique competitive advantages among participants. A persistent high ROIC indicates favorable industry conditions and strength in the firm's competitiveness.
Rapid growth is enabled by high IR. A strong FCF stream discounted at WACC yields an Enterprise Value containing substantial shareholder value added.
The real story also resonates in terms of Net Income and EPS. Table 1b shows that Net Income, after the R&D conversion, is $12.71 million, vs. $7.48 million under GAAP; EPS, after R&D conversion, is $0.39 per share, vs. $0.23 per share under GAAP.
Commentary by Moshe BenBassat, Chairman and CEO, and Shmuel Arvatz, CFO, shown below (source: here) is a relevant complement to the metrics discussed above.
- Investments in cloud operations, R&D, and sales and marketing establish the groundwork for accelerated growth -exceeding 20% annually; in 2013, 2014, and possibly beyond.
- Strategy is focused on three major initiatives:
- New Territories --Building local presence in Latin America and Eastern Europe to support acceleration of sales.
- Enterprise Mobility --Accelerate sales to prospects preferring to start with mobility solutions; to increase the potential to sell optimization products. In 2012, 80% of new customers also purchased mobile solutions. The Mobility pipeline is rather recent, and now a "huge" number.
- Cloud-based Offerings -Emphasize the sale of cloud-based solutions (new division). Current revenues are not very significant, but will grow fast. The cloud-based solutions pipeline is in the tens of millions.
- For 2013, the company expects revenues in $120 to $125 million range, or 20% to 25% growth. The second half of the year should show improvement in profitability with gradual payoff of current investments.
ClickSoftware's 2012 key value metrics; ROIC, growth, and free cash flow, are extraordinary.
Strategies are in synch with financial results, with resources available, and with growth expectations. New product offerings strengthen competitiveness and expand the size of the market opportunity.
Business risk embedded in the strategy, operations, and finance, remains well within the core competence of the firm.
The conversion of R&D expenses into tax-advantaged capital expenditures sheds a bright light into the real strength of the business, adequacy of strategy, and cleanliness in execution.
The R&D conversion enables the view of the real company -Will the Real ClickSoftware Please Stand Up?
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.