Much has changed during this time: New products, new clients, new employees, new achievements, new challenges. The investment thesis, however, remains the same, only strengthened by performance. Meanwhile fundamental value estimates have risen and the promise of high investor return remains as bright as ever.
Inherent in the investment thesis is low business risk. Risk is discussed in two parts: Business risk related to workforce management and service optimization, and investment risk, which in addition to business risk includes stock market price volatility.
The context of analysis is free cash flow and risk as drivers in fundamental value. The investment thesis is presented as the rationale supporting a fundamental value estimate, the expected outcome.
Management effectiveness is assessed as the causal force in the realization of a business model that delivers a value proposition to clients and produces attractive economic returns to shareholders.
This article provides a view regarding the attractiveness of ClickSoftware as an investment, and the role of conviction in holding for the long haul in the face of volatile price action.
Business risk is the probability of a negative outcome. Risk implies volatility in earnings an uncertainty regarding future cash flows. Uncertainty increases the cost of capital to the firm and decreases fundamental value. At the extreme, cash flow volatility may cause insolvency and bankruptcy.
Two components define business risk: Operational risk and financial risk.
Operational risk is volatility in the (metrics reflecting) core activities of the firm. It results from the relationships between the firm and its stakeholders such as clients, employees, strategic partners, suppliers, etc. These relationships involve benefits, obligations, and risk.
Operational risk can be assessed by means of the metrics shown below:
- EBIT (Earnings before Interest and Taxes)
- FCF (Free Cash Flow / Revenue)
The table shows the following:
- Steadily upward trajectory in Revenues and EBIT.
- Stability and strength in EBIT / Revenue margins. This ratio, along with increasing absolute EBIT, suggests that the CKSW’s value proposition is strong and that it supports strong product pricing.
- A blip in Cash Flow from Operations and in FCF in 2009 is explained by the three acquisitions in that year (here). They expanded the balance sheet and depreciation and intangible amortization charges.
- Efficiency and stability in FCF / Revenue. This ratio suggests high cash content in sales and high efficiency in the use of capital.
As an aggregate, Revenues, EBIT, and FCF, evidence reliability and sustaining power even during periods of weak aggregate demand.
Having said this, the assessment of ex-ante risk, based on historical performance, is not a script for future events. Prospective risk includes events not envisioned in this current analysis that can be disruptive to the business model as it is currently organized.
An example of such disruptive event is discontinuity in management. This generic example can take a variety of forms, each with its own degrees of uncertainty regarding prospective performance.
Another example, perhaps closer to home, is the disruption brought about by the business acquisition, currently on the cards. Beyond the general purpose of gaining business mass and leapfrogging current growth, there are a lot of unknowns on this potentially major undertaking - unknowns regarding size, impact on the nature of business and on the business model, on the investment thesis, and more.
There is no way of telling their likelihood of occurrence, or about the probability of positive resolution. Mitigating these risks, however, is a track record of stability in management employment (re: management discontinuity risk) and history of deliberate, and careful selection of the strategic acquisitions made in 2009 (re: prospective business acquisition risk).
All in all, business risk is relatively low.
|ClickSoftware (CKSW) Table --Selected Metrics|
|(Amounts in millions of US$, unless otherwise noted)||FYE 12/07||FYE 12/08||FYE 12/09||FYE 12/10 Estim.||4-Yr. Avg.|
|Revenue Growth (y-o-y)||23%||31%||17%||19%||22%|
|EBIT / Revenues||3%||12%||18%||18%|
|Cash Flow from Ops.||4.91||8.54||7.55||12.00|
|CF f/Ops.Growth (y-o-y)||-13%||74%||-12%||59%||27%|
|Free Cash Flow||4.29||7.79||6.15||10.00|
|FCF / Revenues||11%||15%||10%||14%|
|FCF Growth (y-o-y)||-18%||82%||-21%||63%||26%|
|Debt Service Obligation||0.00||0.00||0.00||0.00|
|Cash (& Market.Secs.)||24.70||32.00||34.97||50.00|
Financial risk derives from the use of debt. Figuratively speaking, financial risk is superimposed on the firm’s operational risk. It is additive and to some extent, discretionary. In contrast, operational risk is intrinsic to the business.
Financial risk is dependent on debt servicing capacity. It is the likelihood of default that Available Cash Flow to Service Debt will not be sufficient to meet upcoming Debt Service Obligations.
Available Cash Flow to Service Debt = EBIT + Depreciation – Taxes Paid - Uses in ONWC (Operating Net Working Capital) - Uses in OLTA (Operating Long Term Assets)
Debt Service Obligation = Debt Interest + Debt Obligations Due.
For simplicity sake, and because fine-tuning is unnecessary, we take Cash Flow from Operations as a shorthand approximation of Available Cash Flow to Service Debt.
The table confirms what we intuitively know, that ClickSoftware financial risk and likelihood of default are insignificant (and decreasing) due to substantial cash flow, no debt and growing surplus cash.
Given the favorable metrics shown in the table, the question remains: Why is ClickSoftware’s business risk low, and why ClickSoftware does not use debt?
The reasons underpinning low risk are implicit in the nature of the business as expressed by the strength of the business model. In essence, it means predictable revenues and earnings and ample operational cash flow able to cover all operational needs and generate surplus cash.
- Value Proposition
Strong client benefit is derived from using CKSW’s products and services. Such products and services, ingrained in the clients’ processes, are defining features in the clients’ relationships with their customers and on the clients’ own operational and financial performance.
Clients need ClickSoftware’s products to stay competitive in servicing their customers and to reduce expenses and enhance productivity. Their need for CKSW’s products is permanent, in times of economic expansion as well as during times of slow growth. The importance attached to CKSW’s products by clients is top-of-mind and high priority.
The (working capital and investment) processes of ClickSoftware encompass relationships with its clients, associates, suppliers, and other participating stakeholders. These relationships entail agreements, actual or implicit, regarding exchange of materials, knowledge, services, capital, and technology, and regarding terms of payment and flow of cash. Embedded in such relationships and agreements is benefit and risk.
Contributing to stability in many of the relationships mentioned is a diversified roster of star clients and strategic partners. Many of them are recognizable names of substance and importance in their particular spaces.
Management, employees and associates, represent the intellectual force behind product creation, delivery, maintenance, and client retention. By all indications, such force is not only expanding in numbers, quality and stability, but also gaining in market traction and space leadership.
Clients, the ultimate source of revenues, EBIT, and FCF, are, by and large, well established and creditworthy enterprises. Among the clients are PG&E, SoCal Edison, Anglian Water, Hewlett Packard, Bell Canada, Deutsche Telekom, and Vodafone. Many belong to industries, like utilities and telecom that are somewhat resistant to economic slowdown. Alliance partners include SAP, IBM, Accenture, Ascom, Capgemini, and Microsoft (here).
- Economic Equation
Financial results and performance metrics (some examined in this article) point to consistent creation of value while delivering the value proposition to clients. In other words, the allocation of ClickSoftware’s resources in support of the value proposition yields attractive economic returns for shareholders.
The economic equation reflects pricing power based on the benefit of the service provided. A strong value proposition embeds a strong client benefit and a strong competitive stance. These translate in healthy margins, low capital utilization, and attractive equity returns.
Important in the assessment of economic performance is the relatively low level of risk inherent in CKSW’s business. Complementing low business risk is low financial risk due to the absence of debt. Such absence of debt results from strong operational cash flow generation, which supports all operating requirements (even during periods of fast growth) and generates surplus cash. Low risk and no debt are conducive to low cost of capital and strong fundamental value.
- Management Effectiveness
This is the causal element in the performance of CKSW. It involves overall business direction and execution, from organizing the firm, developing technology, and managing strategic relationships, to allocating capital, nurturing core competence, and maintaining risk within management’s risk-taking ability.
The management of ClickSoftware deserves very high marks.
Beyond delivering sustained growth, prudent risk-taking is focused on core-business activities, supported by core-competence skill, and leading to recognized leadership in the workforce management and field service optimization space. Worth noting are efficient use of capital and a deliberately constructed powerful moat.
Management is an effective force in the achievement of both, the value proposition and attractive economic returns.
Investment risk is the loss content due to permanent impairment in investment value. In this article, permanent impairment signifies a major shortfall in the investment thesis underlying fundamental value estimate.
Summarily, ClickSoftware’s investment thesis is predicated on low business risk, rapid secular growth in revenues and FCF, efficient use of capital that self-finances growth, and a strong moat hinging on product leadership and a leading ecosystem of strategic alliances. The latest calculated fundamental value estimate is $10.27/share (here). To be clear, fundamental value is based on a future stream of FCF discounted to present value.
Investment risk is influenced by business performance and by market driven price action. ClickSoftware’s business performance and low risk connote stability. Meanwhile, stock price volatility adds to investor uncertainty.
Recent history includes events (here) where ClickSoftware reported good financial results, in line with the secular growth history, and issued attractive guidance. Surprisingly, the stock recorded a major price decline. In other words, events representing performance in line with the investment thesis can well cause a negative market price response.
From this perspective the qualitative drivers of ClickSoftware’s business model, and the investment thesis, are very steady. Customary reports regarding quarterly results, current achievements, or upcoming strategic initiatives (here) do not alter the essence of the business, or the drivers in the business model, or the investment thesis. Instead those changes generally represent in-line performance, ongoing client achievements, or strategic progress, which reinforce the investment thesis.
Conviction in the investment thesis is more than helpful - it is necessary in long term investing. Conviction affords rational staying power and backbone support in the investment decision, particularly in the presence of unwarranted stock price action. Implicit in long term investing is time; a long time horizon if necessary as long as the investment thesis remains intact.
Conviction rests in knowing the business, part and parcel of long term investing.
ClickSoftware’s business risk is relatively low. Both, operational risk and financial risk are low. Business is steady in the upswing and returns are high. High return in invested capital (ROIC) and high capital efficiency underlie high business returns (discussed in detail in previous articles), a prelude to attractive investment returns. The combination of ClickSoftware’s low business risk / high return represents an attractive investment opportunity.
Management effectiveness gets very high scores for constructing the secular growth story, and for working hard in maintaining it vibrant and alive.
Investment risk, however, connotes substantial market volatility in the path toward attaining fundamental value, the expected outcome. Volatility feeds anxiety, which flourishes on random and often punishing market action. Meanwhile conviction provides solid grounding and the rational steadying hand.
Trading on ClickSoftware stock for short term gains falls outside the scope of the investment thesis presented in this document. Trading volumes are relatively modest and trading margins relatively wide. Buying ClickSoftware stock is like buying a rare piece of art for a life-time of enjoyment and appreciation. For short term trading, a high volume, narrow trading margin, commodity-type security will do.
Time is a friend of good businesses.
ClickSoftware is a great business: Low risk / high reward and worth owning with conviction for the long haul.