Manhattan Associates: Too Expensive? Not At All

| About: Manhattan Associates, (MANH)

Summary

Manhattan Associates trades at quite the premium to the market.

There are valid reasons for it: operating leverage, debt-free balance sheet, double-digit revenue growth.

While it looks like another overvalued stock that has been pushed up too high irrationally, this one is a keeper.

Do you like owning companies that consistently thrash earnings expectations? Firms with high, protected margins and substantial operating leverage? While we're at it, how about no debt and minimal capex needs? Sounds like a perfect company - does it even exist?

Manhattan Associates (NASDAQ:MANH) checks all those boxes for investors. This supply chain solutions company has been a beacon of operating excellence for years, and has become the go-to destination for major companies when it comes to improving their operations. Of course, a company with such a stellar reputation is obviously going to be expensive - 33x 2017 consensus earnings. Can the quality of the company be reconciled with the price?

Walk Back Through History

Revenue has grown at a steady 14% annual pace between 2011 and 2015. Gross margins were steady, but the company has benefitted from significant margin expansion. Substantial leverage exists in this business model. The company generated $64M in additional revenue, which only drove $30M in additional operating expenses. In other words, for every additional dollar the company earned only cost the company less than fifty cents. Incremental operating margin is 50%+, which is what drives the long thesis at Manhattan Associates. 2016 looks to maintain that operating margin growth:

"With the solid Q1 results, we are expanding our goal for 2016 full year operating margin expansion over 2015 to a range of 75 basis points to 100 basis points, providing for an additional 25 basis point upside as we continue to incrementally invest in innovation, marketing awareness programs and infrastructure in 2016."

It is important to note that current margin guidance points to a slight contraction in incremental operating margin - either operating leverage contracts or the company is sandbagging guidance somewhat. Given that the company has a history of flogging both guidance and analyst estimates (the company has beat expectations on the bottom line quarterly for the past three years, which has always been above guidance), history tends to point towards the former.

Now, it isn't all sunshine and roses. Fellow Contributor Terrier Investing does an excellent job of laying out the reasons why the company might suffer somewhat during a downturn. The company primarily operates on a licensing/maintenance model, and as such, most of its revenue is not recurring (i.e., software renewals) but is instead based on professional consulting, maintenance, and other services that are driven by recurring customer projects or investment plans.

If there was a significant downturn here in the Americas, I don't doubt that Manhattan Associates would have its growth path dented, which fundamentally impacts the bull thesis. Operating leverage works both ways, and a contraction in revenue would have an adverse effect on Manhattan Associates' results.

As a balance to that risk, Manhattan Associates continues to benefit from the extreme levels of competition in the markets it serves. Margins have been under extreme pressure in the traditional retailer group (PetSmart (NASDAQ:PETM), Tesco Corporation (NASDAQ:TESO), Cabela's (NYSE:CAB) as a few examples of Manhattan Associates retail customers) and there has been significant focus on cost cuts.

Long story short, the pie isn't growing, so the market is now all about extracting your piece of the pie as efficiently as you can. Traditionally, return on investment in supply chain management has been high across most industries, and it has been a go-to method of driving operating margin improvement in a cost-focused environment. Competitive forces here are unlikely to abate any time soon, and Manhattan Associates, as the firm with the best reputation in the space, will continue to get significant contract wins.

Reconciling The Price, Is It Still Attractive?

Buying a company at 33x TTM EV/EBITDA is enough to make any investor's head spin when placing an order, and by and large, many are likely to shrug off the company completely, no matter the forward outlook. For growth seekers with a bullish slant on the industry, the stock still appears to be a reasonable buy. Technicals are favorable, and investor interest will persist in the company (notwithstanding economic shock) because of the extensive operating leverage coupled with a lack of gearing on the balance sheet in my opinion.

Growth stories are often accompanied by debt, which isn't surprising given the advantage given to first movers, but those seeking growth won't find that risk here. Avoiding the overleveraged portfolio landmine is critical to healthy long-term returns, and the crystal clean balance sheet ($115M in cash, no debt at the end of Q1 2016) ensures the company can endure almost any downturn.

Street consensus is for $618M in revenue in 2016 and $677M in revenue in 2017 - in line with management guidance, and represents a continuation of the high single/low teen revenue growth that has become a consistent characteristic of Manhattan Associates coming out of the recession. If operating leverage continues at the current pace, operating income will run $210-220M in 2017.

A 36% tax rate and flat share count puts earnings at $1.82-$1.96/share - on the low side of current earnings consensus. Consistent deployment by management of free cash flow towards share buybacks (2-3% in retirements annually), pushes earnings per share towards the high end of consensus estimates. 32x forward earnings isn't cheap, but earnings quality is quite high and continued growth in future years is going to have an outsized impact given the operating leverage.

It isn't a stretch to model the company growing into its multiple by 2020: 9% revenue growth from 2018-2020 pushes revenue towards $875M by the end of the decade. Earnings per share would likely approach $3.00/share in 2020 given a continuation of margin trends. Even a contraction towards a more normalized historical trading multiple (25x) puts the shares as just a weak buy at current prices. If you're more bullish on leverage or revenue growth, the story quickly shifts into a solid buy.

Conclusion

If you're a believer in the firm's story and its ability to continue to execute, I can see the desire to continue to accumulate a position in the company today. The company still makes for an attractive M&A opportunity for any of the big players in the industry looking for both solid GAAP profit and a leg up in the industry, and downside risk is light. While the company is exposed to risk in down markets given the nature of its business model, the equity did outperform the S&P 500 in the 2007-2009 period, and would likely do so again today given the balance sheet quality. While there are many high-flying duds out there trading at outrageous multiples, I don't believe Manhattan Associates is one of them.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.