Unwarranted Gap Between ClickSoftware's Market Price and Fundamental Value

This article discusses the continuing strong operating performance in the second quarter. It also highlights continuing strength in normalized operating free cash flow generation despite holding a substantial portion of the assets in low-yielding cash, and suggests stock repurchase as an opportunity based on real economic benefit. Also discussed is the major upside in value associated with deployment of surplus cash in an eventual acquisition, and the benefit in emphasizing free cash flow with investors and analysts as a key metric and as a driver of fundamental value.

Operating Performance

Second quarter results reflect continuing strong performance. Revenues were up 22%, pre-tax profits up 8% (y-o-y), despite a decrease in gross margins from 67% to 62%.

  • Revenue growth would have been 25% if we exclude $400 thousand, negative foreign exchange impact derived from the US Dollar strength.

  • Embedded in the pre-tax profits ($2.8 million) is a negative $600 thousand due the currency fluctuations mentioned above --$400 thousand decrease in reported revenues plus $200 thousand increased expenses.

  • The decrease is gross profit margins is explained by the expected low productivity involved in new product implementation. Margins are expected to return to the higher traditional levels over the next quarters as the benefits of the learning curve take hold.

Despite broad economic uncertainties, management reaffirmed 2010 guidance –revenues in the range of $71.5 - $74.5 million, representing 17% - 22% annual growth.

In the conference call, held after the earnings report, the CEO went through an extensive list of new deals and renewals. The take away is the strength of CKSW’s fundamental value proposition –growing demand for products that enhance the businesses of clients and their shareholder value. CKSW’s products enhance the clients’ relationships with their own customers and improve productivity. Reliable expansion in product demand contributes to un-interrupted growth in the client roster and in quarterly and annual revenues.

Continuing expansion of product platform capabilities, particularly ClickMobile and ClickRoster, strengthened CKSW’s industry leadership position and served to feed future revenue growth (See Gartner’s Magic Quadrant for Field Service Management, 6/17/10).

Shelf Registration

Management also indicated that the 15 million shelf registration (discussed in detail in a previous article) was intended to provide CKSW with sufficient flexibility for accessing funds in case of an acquisition opportunity. For all practical purposes, however, the company would first use the cash available in the balance sheet ($42.5 million), then available credit, and only finally the company would issue a minor portion, if any, of the amount available under the registration. The implication was that size of companies which could be acquisition candidates is relatively small, and that the amount available to CKSW from cash on hand and available credit would be largely sufficient to cover the price of any acquisition. This explanation put dilution concerns to rest.

Fundamental Value

Since the fundamental value of the stock is the net present value of the future streams of cash flows, and since the market value (or price) of a stock reflects the collective judgment of investors’ expectations about future free cash flows (FCF), then it follows that investors in CKSW are underestimating the future stream of FCF (other things remaining equal) and allowing the price of the stock (current price is $5.57/share) to be significantly discounted to its fundamental value ($8.0/share). Below we discuss some unappreciated strengths and suggest that increasing emphasis should be given to FCF, a key performance metric, and the engine behind fundamental value and of the organic growth in CKSW’s surplus cash (the article dated 1/1/09 describes the methodology behind FCF and fundamental valuation).

  • FCF = NOPAT minus increases in Operating Capital

  • Net Operating Profit after Taxes (NOPAT) = EBIT (1 – Tax Rate)

  • Net Operating Capital = (Net Operating Working Capital + Operating Fixed Assets)

  • Fundamental Value = PV of future free cash flows discounted at the Weighted Average Cost of Capital (WACC)

The updated fundamental valuation, based on FYE 12/10 guidance and various assumptions regarding future growth, is $8.0 per share. Our computations indicate that FCF is running at a normalized annual rate in excess of $6.0 million. It is noteworthy that such FCF is produced by only 42% of the firm’s assets devoted to business operations. The remaining 58% are non-operating cash balances that do not contribute to (operating) FCF and contribute only minimally to accrual net profits. The fundamental value --PV of discounted future FCF actually exceeds $8.0/share. This valuation is conservative. It does not include the benefit of available tax carry-forward.

Underlying fundamental value is the company’s business model which exhibits an extremely high Return on Capital Investment (ROIC) due high net operating profit with relatively minor use of operating capital.
- ROIC = NOPAT / Net Operating Capital

Annualized ROIC, based on 6/30/10 results is extremely high; way in excess of 60%. It is not apparent that this strength in performance, and in the model itself, is fully appreciated in the investing marketplace.

Principally resulting from the strong FCF is the growing level of cash balances --from $24.2 million on 6/30/08 to $42.5 million on 6/30/10, even after $5.9 million were paid for three acquisitions in 2009.

Strong Free Cash Flow using only 42% of Total Assets

Financial statements for the second quarter, 2010, show that 98% of the pretax income (or EBIT) was generated by 42% of total assets; and that 2% of pretax income was generated by cash balances representing 58% of total assets.

Profit and Loss statement for the second quarter ending 6/30/10:

  • Net Income from Operations (pretax) = $2.7 million (98%)

  • Interest (pretax) = $0.05 million (2%)

  • Net Income Before Taxes = $2.8 million (100%)

Balance Sheet as of 6/30/10:

  • Operating Assets (Devoted to the business) = $31.1 million (42%)

  • Cash, Cash Equiv.and Long Term Invest. = $42.5 million (58%)

  • Total Assets = $73.6 million (100%)

The take away is that in addition to the strong FCF generation described above, major upside lies in the productive use of surplus cash to effectively transform 42% of the company’s total assets that yield approximately 1% into field service management operating assets that produce ROIC way in excess of 60% (or at the minimum exceed the hurdle of the cost of capital, estimated at 10% - 12%). This upside does not seem to be reflected in the market price of the stock.

Acquisition Upside

Deploying $42.5 million in surplus cash into Operating Assets would dramatically increase Net Income from Operations, FCF, and fundamental value. An acquisition with a ROIC return similar to that in the existing business would multiply fundamental value and boost the price of the stock. Even in the ROIC of the acquired business was lower than the existing business’ ROIC, fundamental value (and the price of the stock) would be improved provided the acquired business’ ROIC exceeds 0% - 12%, estimated cost of capital.

Stock Repurchase

A controlled stock repurchase would take advantage of a depressed stock price to create economic gain and enhance shareholder value given the substantial discount of the price of the stock relative to fundamental value.

Using $5.57 in cash to purchase a share with an $8.00 fundamental value represents a potential 44% gain, which is significantly greater than the cost of capital.

During the interim period while a search of a suitable acquisition is conducted, a stock repurchase program should be appealing given the high level of surplus cash relative to the total assets of the firm, the predictability of continuing growth in revenues, earnings, and FCF; and the economic opportunity to realize economic gains given the gap between value and price. The program would support the price of the stock and the attractiveness of any secondary offering.

Summary

The operating performance of ClickSoftware continues to be very strong; including 2Q10 results and reinstated FYE 12/10 guidance.

Operating FCF generation is also very strong. It supports a fundamental value of $8.0 per share. This is noteworthy when considering that only a minority of the company’s assets (42%) are devoted to business operations. Underlying its fundamental value is the company’s business model which exhibits an extremely high ROIC due the powerful combination of high net operating profit (read NOPAT) and relatively minor use of operating capital.

It is apparent that these strengths are not fully appreciated in the marketplace. On this basis the discount in the market price relative to the stock’s fundamental value is unwarranted.

Further, there is considerable upside in the value and in the price of the stock that should follow from the deployment of surplus cash into productive operating assets, or in stock repurchases, or into sensible acquisitions.

Emphasis in FCF as a key performance metric should assist investors and shareholders in understanding the strength of ClickSoftware’s intrinsic business model; a fast grower and an efficient user of capital; and its strong capacity for returning capital to investors.

Disclosure: Hold a long position in CKSW