On April 14, 2010, ClickSoftware Technologies (NASDAQ:CKSW) announced the shelf registration statement for the offer and sale of $15 million shares at an estimated $6.72 for a total of $100 million. This article discusses the registration within the context of ClickSoftware’s historical performance and prospective stock value.
While the purpose of the registration is broad and generic, there is sufficient evidence to expect that the substantive reason behind the registration is the pursuit of acquiring companies in the same line of business. The registration represents an intermediate and necessary step in the implementation of such acquisition strategy.
Because of the size of the registration we would expect that the acquisition would represent a major expansion in substantive operations and clients to supplement rapid organic growth. The purpose is to increase the absolute dollar earning capacity (and sustain a high rate of earnings growth), to accelerate the rise in the price of the stock.
Historical acquisitions have been minor in scope and dollar amount. They have focused on filling gaps in the product suite (small and mid-size businesses), and on increasing the geographic footprint and low cost professional capability (India) for global deployment. These acquisitions effectively expanded the size of the addressable market, but were not intended, or could be expected to dramatically impact absolute dollar earnings growth over the short term.
To be clear, the company has been extremely successful in achieving organic fast growth in retained earnings on a relatively small dollar equity base. In 2009 CKSW’s $42.7 million in equity book value grew 63% YOY principally due to $12.51 million in 2009 net profits. CKSW’s efficient use of capital has been able to support high rates of growth without debt or external financing, while increasing surplus cash.
An acquisition of the magnitude of the announced registration, relative to current business, would potentially represent a leap in absolute dollar earnings capacity. The $100 million registration size roughly represents one half of the current enterprise value. Such a leap would be subject to implementation execution, and would be expected to drive a step-up in net operating profits after taxes (NOPAT), free cash flow (FCF) generation, enterprise value, and in the value (and price) of the stock. The methodology of these calculations and terminology has been covered in earlier articles on this site (ClickSoftware Technologies: Smallcap Value Investment).
Pro-forma calculations, under various assumptions, suggest that the acquisition could result in a major improvement in ClickSoftware’s stock value (PV of future FCF) in comparison with the value under the current scenario (growth without the acquisition). Click to enlarge
In other words, the acquisition could accelerate the rise in the price of the stock to a fundamental value in the order of $15.00. This is a notable improvement from the current calculated fundamental value of $9.00. Such a value improvement is subject to various risks – investment risk, operations risk, and financing risk.
Investment risk is significant due to the potentially large size of the acquisition. It is reasonable to expect that because of the business and market knowledge CKSW is well positioned to assess market opportunities and to appropriately valuate the acquisition, negotiate terms and pricing, and close the deal.
One issue of concern is the capital efficiency of the acquired company and its impact on the combined business. In previous articles we have discussed the high efficiency of CKSW in the use of capital. Such efficiency, measured by low requirements in operating fixed assets (OFA) and in operational working capital (OWC) relative to revenues, was highly beneficial in supporting fast revenue growth without debt financing, while growing surplus cash balances. In other words acquiring a relatively inefficient user of capital would hamper the ability of sustained fast revenue growth without debt, and/or generate surplus cash.
Operational risk entails the integration of the existing and the acquired businesses, namely segmentation of clients, and realignment of processes, roles, accountabilities, metrics, and skills. It is reasonable to expect that a disciplined and well-organized firm, like CKSW, would be able to properly execute with a keen eye on value metrics – revenue growth, NOPAT and OWC.
Financing risk encompasses the weighted average cost of capital (WACC). This is the rate that discounts FCF to PV. The difference between such PV and the amount of capital invested in the acquisition represents contribution to shareholder value (increase in the value of the stock). We foresee that CKSW chooses to finance the acquisition only with equity (and surplus cash), rather than debt. This seems in line with the financially conservative nature of CKSW’s management. The price of equity based on current P/E is reasonable. Very conservatively we use WACC at 11% for pro-forma calculations.
Resources, Skill, and Challenges
- Value Proposition (Client Benefit) --The growing roster of clients and successful deals clearly supports the extent of the value provided by CKSW in the eyes of clients. The firm’s client focus and core technical competence is at the center of the intersection of value provided and client benefit received (see previous article).
- Economic Equation (Value Metrics) -- By necessity the mentioned acquisition will impact efficiency in the use of capital going forward and future performance, as measured by the changes in the relative weights of value drivers of the combined entity. In other words, the acquisition of a relatively more intensive user of capital can actually result in larger Dollar earnings for the combined entity, but also in lower return in capital deployed. This scenario may ultimately hamper the ability to maintain high rate growth without increasing levels of debt (see previous article; CKSW: Rapid Growth and Efficient Use of Capital). This issue is critical in the achievement of the desired growth in the stock value, discussed above.
- Core Competence (Management Skill) -- At a high level, management skill balances an existing base of expertise and resources with market growth opportunities to achieve stock price growth. At this juncture acquisitions seems to be a chosen alternative. Such acquisition will reinforce ClickSoftware as the industry leader and pre-empt gains from existing competitors and new industry entrants.
The greater business mass of the combined entity will require realignment in the way management allocates resources and manages business. Greater business mass means more of everything, and potentially different – clients, products, human resources, development projects, geographic locations. The purpose of the expanded business remains the same but size alone, increases the complexity of the business, particularly when client teams, or product development teams, must include associates reporting into different supervisors. Clients, processes, roles, accountabilities, metrics, and skills, will need to be realigned.
By itself the announcement to register shares is not necessarily good, or bad. The presumption that a larger number of shares will necessarily drive down share value is premature and lacking necessary additional information. In this article we have discussed a contextual framework of facts, challenges, and reasonable expectations regarding prospective performance and the ability to achieve purpose; the acceleration in the rise of enterprise value and in the price of the stock.
The envisioned transaction represents a watershed event in the life of the company; a rather unique event in its history. Success will depend on the efficiency in integration and operational execution. Success will also be driven by various aspects of the acquired business such as clients, products, skills, and particularly its efficiency in the use of capital, discussed above.
An acquisition will require skills, such as corporate assessment and valuation skills, that do not fall neatly within the firm’s daily bread-and-butter activities. Likewise, execution will entail realignment of roles, skills, process, accountabilities, and metrics, to deal with a sudden and expanded business mass – in scope of operations and in financial measures.
From this perspective, faster and higher gains in the value (and price) of the stock are in the promise of an acquisition. Financial track record, expanded resources, and management capabilities, support the view that the company has the capacity to maintain client focus carry out a major acquisition successfully.
Historically, management actions have shown to be thoughtful, conservative, and well balanced from a risk and reward point of view. Management’s significant ownership in ClickSoftware provides an appropriate alignment between the interest of management and that of stockholders in general.
Disclosure: Author long CKSW