This is a discussion of ClickSoftware’s (NASDAQ:CKSW) business model attributes, such as the capacity to provide solutions that are integral to the businesses of clients and highly-valued by them, and attractive economic returns underpinned by low operational risk and steady growth in cash flow. The underlying issue is market mispricing. The analytical context is cash flow, driver of fundamental value. The article examines opportunity, investment risk, and uncertainty.
Business Model Defined
Business model is defined by the interaction and balance among three interconnected elements; value proposition (client benefit), economic returns (value metrics measure), and core competence (technological and management expertise). Enterprise success entails a healthy balance among the three elements. Below we discuss each of them.
Value Proposition (External Client Measure)
The value proposition refers to the benefit received by clients using CKSW’s products and services in exchange for payment, their degree of dependence on the product, and continuity as product users.
In this proposition value lies in the eyes of the clients and their acceptance is manifested by their willingness to pay once and to continue paying to ensure continuity in the benefits received.
- Client’s Business
CKSW’s products can and do transform the way the client’s own service chain works. The service chain is an integral component of the client’s business, which entails attracting, servicing, and retaining customers (customers are the clients of ClickSofware’s clients). Incidentally, CKSW’s client roster is impressive.
- Client’s Working Capital
Management of working capital is at the heart of the value stream of the client who needs to organize end-to-end processes and resources, and upgrade knowledge to deliver quality services to their own customers. Embedded in such value stream is ClickSoftware’s expertise and products. Becoming integral part of the client’s operations and shaping the clients’ value stream is a distinct and somewhat unique attribute of CKSW’s products.
- Client’s Strategies and Financial Performance
The benefit accrued lies in the optimization in the use of resources within the client’s chosen policy constraints (customer waiting time, internal costs, regulatory requirements, etc.). Optimization is the “best” result every service day --customers are happy, suppliers are happy, regulators are happy, service personnel are happy, and the CKSW client is happy with the outcome at the optimized cost.
For clients optimization is strategic, far reaching, and a continuous goal –it improves service quality, reduces costs, and enhances revenue growth (by improving the client/customer relationship, strengthening customer retention, and promoting customer expansion), enhances regulatory compliance, reduces capital investment (reducing service equipment idle time), and allows for controlled experimentation and policy testing.
The role of CKSW extends into the clients’ strategies as clients test their customer servicing policies and gain insight through experimentation and use of CKSW’s products. CKSW’s close consultative role with clients fosters information exchange and a mutually constructive dialog which leads to improvements in the clients’ businesses and in CKSW’s product development.
- Client’s Product Demand
Demand for ClickSoftware’s products is not unduly dependent upon increases in the clients’ sales volumes, or upon their industry growth. Instead, demand is driven by the basic and persistent need of the current businesses –the need of clients to preserve their own competitiveness in retaining customers, enhancing current returns, or preserving returns during periods of economic contraction.
Even during periods of economic uncertainty, or slow growth, the demand for ClickSoftware technology grows steadily as clients scale the technology curve based on attractive ROI due to expense savings, increased productivity, and enhanced customer experience and retention. Growth in demand is evidenced by continuing revenue growth exhibited by the company during periods of economic expansion, uncertainty, and contraction alike.
From this perspective the risk of sudden drops in product demand is contained, as clients place CKSW’s services high in their priority lists; a must do, continuously, almost irrespective of economic conditions or irrespective of conditions in their own industry.
Economic Returns (Economic Success Measure)
Economic returns are the financial representation of the performance of the firm in delivering the value proposition. The measure of economic success emphasizes cash flow and fundamental value. Likewise, the metrics chosen to measure economic returns unfold from cash flow and fundamental value. Particular attention is given to the business risk incurred in the ordinary course of business. Such risk is a modifier of certainty of future financial performance.
- Value Metrics
Attractive economic returns are buttressed by a reliable and growing stream of free cash flows (FCF) with an implicit return on invested capital (ROIC) greater than the firm’s weighted average cost of capital (WACC). Fundamental value is the present value of expected future FCF discounted at the firm’s WACC.
We now focus on return on invested capital (ROIC) because it is a comprehensive measure of efficiency in the use of capital.
ROIC = NOPAT / Operating Capital
- - NOPAT = Net Operating Profit after Taxes = EBIT (1 – Tax Rate)
- - Operating Capital = Net Operating Working Capital (NOWC) +
- Operating Long Term Assets (OLTA)
ClickSoftware’s ROIC is unusually high. Annualized ROIC for Q 6/10 is computed at 100%+. This means that revenues and the resulting NOPAT are high relative to modest investment in working capital (NOWC) and in fixed assets (OLTA). In other words, CKSW needs only minor amounts of capital investment per unit of NOPAT produced.
High ROIC largely results from the characteristics of the firm’s operating cycle (NOWC) and investment cycle (OLTA). These characteristics are structural, rather permanent, and inherent in the way CKSW does business with its stakeholders, principally clients, eco-system partners, suppliers, employees and associates.
Deferred revenues are particularly important sources of operational working capital. They originate from the terms of selling agreements between ClickSoftware and its clients, and related accounting rules.
investments in long term assets (OLTA), such as product development and asset acquisitions (investment cycle), also support outsized revenues and resulting NOPAT.
The combination of high NOPAT and relatively modest Operating Capital used results in robust free cash flows (FCF) and strong stock fundamental value.
Fundamental Value = PV of future FCF discounted at the WACC
- FCF = NOPAT – Net Investment in Operating Capital
- WACC = Cost of Equity (CKSW has no debt)
Normalized figures show the following:
Revenues $ 72.0
NOPAT $ 11.3
NOWC $ 2.6
OLTA $ 10.0
Operating Capital $ 12.6
ROIC 90 %
FCF $ 6.1
Enterprise Value $221.0
WACC 11 %
Stock Fundamental Value $ 8.2/sh.+ (conservative estimate)
Stock Market Price $ 5.5 - $5.7/sh. (recent range)
(Amounts in millions, unless otherwise noted)
Note: Assumptions and estimates underlying fundamental value are deemed conservative in order to obviate the need for an extraordinary performance, or a goldilocks economy, for the achievement of an attractive investment return.
A corollary of ClickSoftware’s efficient financial profile is the robust generation of FCF that is capable of supporting growing requirements in NOWC and in OLTA (due to sustained growth in revenues) and growing surplus cash balances, without any use of debt.
- Business Risk
Steadiness in the growth of Revenues, EBIT, and Earnings before Interest, Taxes, Depreciation, and Amortization ((EBITDA)) suggests a low level of operational risk –a low probability that unexpected events may derail from the current course or cause cash flow to be inadequate to sustain the operating needs of the business (and to sustain fundamental value).
Fiscal Year 2006 2007 2008 2009
Revenues 32.43 40.02 52.26 61.12
EBIT 1.75 1.36 6.28 11.13
Dep. & Amort. 0.44 0.62 0.75 1.03
EBITDA 2.19 1.98 7.03 12.17 NOPAT 1.67 1.34 4.65 11.13
(Figures are in millions of Dollars)
The chart suggests steadily upward sloped trend lines underlying the figures presented, including NOPAT, a principal determinant of the fundamental value of the stock. NOPAT represents the source of funds that supports not only net investment in Operating Capital, but also generate FCF, a determinant of fundamental value.
Supporting the metrics are real business activities involving a dispersed source of CKSW’s revenues around a large number of clients and around the world’s geography, and the relatively modest requirements in Operating Capital. Low risk is also characterized by transactions of a relatively small size that are constructed and delivered based on controlled processes resting on product modularity (grouping configuration by commonality of function), process modularity (linkage configuration by effectiveness of sequence), and accountability modularity (role configuration by functional specialty).
Buttressing low risk and underpinning predictability in revenue growth (and in NOPAT and in FCF) is the high priority placed on CKSW’s products by clients in their spending budgets. Such priority and strength of demand is exhibited in periods of economic expansion and during economic softness and uncertainty alike.
Implicit in the robust and steady cash generation is a strong debt servicing capacity. This attribute has important implications on two fronts; on the ability to potentially carry significant levels of financial debt to finance an eventual acquisition, and on the opportunity to reduce the cost of capital (WACC) by adopting a capital structure that includes not only equity, but also a moderate level of debt (this would also need to take into account the availability of tax loss carryovers).
Financial risk is also low since the company does not carry any financial debt. Instead it has abundant liquidity due to excess FCF, which steadily feeds into large surplus balances on the balance sheet.
Core Competence (Internal Organization Measure)
Core competence encompasses the alignment of organization, skills, technology, and processes to deliver the value proposition and achieve economic returns.
Core competence is the effectiveness of the firm in allocating resources internally. It is discharged through the institutional skills and experience embedded into the firm’s main-stream processes that are essential to its purpose. Core competence entails knowledge, specialization and technology (See Gartner’s Magic Quadrant for Field Service Management, 6/17/10).
By its internal company nature, core competence is difficult to assess directly. However, a history of successful financial performance, technical progress, and industry leadership, suggests that ClickSoftware’s internal organization is a value chain capable of sourcing prospect opportunities; orchestrating the market coverage directly and through the resources of partners in the eco-system, responding to a range of client needs, integrating sets of products and needs into a high value system, achieving client interface customization driven by client specification, and delivering high utility value.
Investor communications provide a glimpse in the inner workings in ClickSoftware. One can not help but get the impression that management is very engaged in the business, active in the marketplace, and very much in touch with clients and deals; that the complexity of managing through the resources of partners in the eco-system has been simplified into an effective process with clearly defined purpose, roles, accountability, and rewards.
It is also apparent that management has constructed a conservative business model were revenues and earnings are supported by high cash content and operating risk is low. Likewise, management has also adopted a conservative style in investor communications manifested by a disposition to under-promise and over-deliver.
Business Model Balance
A report card would have sufficient basis for providing a very high passing grade to management for worked done and progress made. The company provides great value to clients who actually want, need, and greatly depend on ClickSoftware for their own businesses, and are willing to speak once and again with their wallets.
Resulting from close client following, growth in revenues and earnings is robust and steady during good and bad economic times. In terms of shareholder value metrics ROIC, FCF, and Fundamental Value are all strong measures, with no indication of letting up. In other words, ClickSoftware’s shareholders capital is used very effectively and steadily produces outsized returns. (Everyone wishes that the company would be ten times its size, with commensurate enlarged value metrics).
Business risk is low; the revenue stream is diversified in terms of clients, geography, and increasingly in product range. Again, growth in revenues and earnings is strong and steady, and risk is within the competence of management. Notably, high ROIC does not require a high level of business risk.
Neither of the value proposition or economic returns would be possible without ClickSoftware’s strong core competence. The circle closes nicely. The three elements of the business model orchestrate to work together and mutually reinforce each other. Management has created a low risk business, propelled by leading technology; that produces both, solutions that clients value and high economic returns to shareholders.
Low investment risk and high pay-off potential suggest an attractive investment opportunity. Low downside investment risk is due to the sizeable discount between market price ($5.50 - $5.70/sh., current range) and fundamental value ($8.00/sh.). High pay-off is the return measured by the gain when the market price meets fundamental value. (Investment risk is the pain due to the relative size of the financial loss from entry price level).
This investment proposition rests on the premise that market does in fact misprice the ClickSoftware stock. To be clear, this is not the same as saying that the market always, or never, misprices a stock, or any stock. This is to say that in recent times the market exhibits a negative bias in ClickSoftware’s stock. This bias is of persistent duration (e.g. weeks if not months at the time) and substantial discount (amounting to as much as 30% of fundamental value, or 45% of market price).
There are a number of plausible reasons that could be offered in explanation for the mipricing; like insufficient interest in small caps by institutional investors, or low market liquidity. Ultimately, the reason behind specific misalignment, in this case, is unknown. In reality nobody knows why it exists. There is no prescription for correction. Instead, there is uncertainty regarding the circumstances and the timing behind a move of the price of the stock to approximate fundamental value.
What we know, however, is that eventually market prices approximate fundamental values and that investment risk decreases as the discount to fundamental value grows.
A telling episode of mispricing in action comes to mind during the 3Q earnings announcement last year, when severe drops in the price of the stock accompanied by a major volume spike followed disclosure of what would otherwise be deemed to be a solid performance. The announcement reflected a strong performance; something like record revenues and record operating profit, strong client wins, substantial revenue growth, and guidance of about 15% in revenue growth for the year (remember the gloom and doom in the market at that time). The market turned the announcement into a severe cut in market cap.
Market expectation for outsized positive surprises to guidance, in revenues or earnings, does not seem to be borne by the nature of ClickSoftware’s organic business activity or by the application of accounting rules. Neither is geared to producing major spikes. There are no cyclical revenue downturns that provide easy comparables for upcoming periods of upswing in product demand. In fact, ClickSoftware’s revenue growth is predictable, guided; and accrual accounting contributes to smoothing earnings.
Instead of jerky performance, ClickSoftware delivers reports of sustained revenue and cash flow growth. To be clear, they represent absolutely solid economic returns, fully supportive of a strong fundamental value. Evidently, the market disagrees.
This investment proposition also presumes an accurate estimation of the stock’s fundamental value. By necessity, estimation of future performance and related value necessitate assumptions and judgment. From this vantage point, the methodology used in this analysis has proven to be a reasonably good estimator of fundamental value elsewhere. It has have been extensively applied and tested in value estimations in small and large caps alike, in various industries, and at different points in the economic cycle. In this particular exercise estimates are deemed conservative and not reliant on unfettered optimism.
Where does this leave us?
One may consider this proposition valid, but remain uncertain about how or when the mispricing will be corrected.
Two thoughts attributed to Charlie Munger seem well suited for uncertainty. Read them carefully; read them twice.
….. You are looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.
…….you don't make money when you buy stocks. And you don't make money when you sell stocks. You make money by waiting. And so the biggest, the single biggest advantage a value investor has is not IQ; it's patience and waiting. Waiting for the right pitch and waiting for many years for the right pitch.
Disclosure: Author is long CKSW