Fleetmatics-Is The Investment Case Just Blarney Or Is There A Real Pot Of Gold At The End Of The Rainbow For This "Irish" Software Company?

| About: Fleetmatics Group (FLTX)

Summary

Fleetmatics is one of the leaders in the vehicle monitoring and optimization space.

Despite its size, the company has a reasonable level of GAAP profitability and generates a significant amount of cash, with relatively strong cash flow margins.

The company was attacked by a dedicated short seller shortly after it went public and valuations are still apparently less than would otherwise have been the case.

The TAM of the vehicle management market is one of the largest and most undeserved in the enterprise software world.

Vehicle management software has one of the highest ROI's and the shortest time to benefit in the enterprise software space.

Fleetmatics: A mid-sized SaaS vendor that actually has a profitable business model!

I am reasonably certain that far less than 10% of the readership of this article has seen the show Finian's Rainbow. Perhaps a few more readers know the song "How are things in Glocca Morra" which is the most famous musical number of the show. It was far easier to watch when I was young than it would be today although it remains one of those classic American musicals that gets revived every so often. If anyone goes to see it, it requires lots of suspension of disbelief in order to get through the parts of it that don't have the music. Remember the show dates to 1947 and some of the themes are a bit grating for modern tastes.

The show ends with Finian having lost his hope of getting rich. But he goes in search of his own rainbow and all ends happily. The show is loosely based on several people going to look for gold at the end of the rainbow which is supposed to be allegorical. If I am going to look for a pot of gold, it needs to be tangible. The balance of this article will focus on whether or not the concept behind and the management of Fleetmatics (NYSE:FLTX) can provide a pot of gold, or at least a bar of the yellow metal to investors.

I really can't describe Fleetmatics as an Irish software company although it was founded in Dublin about a decade ago. These days it is a typical Rte. 128 software company headquartered in Waltham, MA and derives something close to 90% of its revenues from North America. The company remains domiciled in Dublin and receives substantial tax concessions from the Irish government because of its domicile.

It raised $133 million in its IPO back in the fall of 2012 with typical Big Bank underwriters. its shares were offered at $17 and popped to $22.30 the first day. The shares have not been without controversy. In 2013 the company attracted the attention of a research group called Prescient Point that essentially accused the company of aggressive accounting (shenanigans is what they called it). Some claims were that FLTX used a non-standard definition of churn rate and that the churn rate would inevitably inflate, that its gross margins were inflated by using lengthy depreciation periods for its hardware (telematic) devices, that it isn't a real SaaS company and that it capitalized commissions.

Taking each point individually: the company does capitalize and then amortizes commissions. That is not unusual for subscription revenue companies. Most of FLTX's customers use their product on a long term basis. Although as discussed below, there can be promotional pricing, for the most part, the company sells it products based on 3 year leases. If a lease is canceled or not paid, the capitalized commissions are expensed immediately. There is no evidence in the latest 10Q that this is happening.

Capitalization is meant to match expenses and revenues more accurately. The net of capitalizing and then amortizing these costs added about $600k to the company's net income in the just ended quarter. Many other SaaS vendors use the same methedology.

Salesforce (NYSE:CRM) the leading SaaS vendor also capitalizes commissions. At the current time, its balance sheet shows more than $400 million of capitalized commissions. It also expenses these over the life of an installation.

With regards to the devices themselves, for the most part the company retains ownership of the devices and charges customers a single price for the service that is provided. The company was using a 6 year estimated life for the telematic devices in 2013. It still is and has gone through 3 audits since time. Telematic devices are what they are, and they do what they do, and have been around for quite some time. The 6 year estimate for economic life of the devices seems quite reasonable under the circumstances. The company has never had to write-of the value of the telematic devices.

I am not too sure about what is meant by using non-standard churn rate metrics. The company's churn rate has remained consistent for several years. It has trended up in the last couple of quarters mainly because of the turmoil amongst the companies oil and gas customers. The CFO forecast churn to return to historical levels by the end of the year. The increase in churn forecast by Prescient has never actually happened. The company management appears very focused on churn rates and reports them in some detail each quarter.

Again, I am not exactly sure as to what is meant by the assertion that Fleetmatics is not a true SaaS vendor. The company's most recent 10Q describes its products and their architecture in a bit of detail. The architecture of the Reveal platform and other company products is consistent with analytic platforms used by many other SaaS vendors. The application does not reside on-prem but in the cloud. To me, that is the essence of a SaaS business model.

Prescient Point has an unfortunate business model which encourages it to pan stocks it has already shorted and to benefit both its own positions and the positions of its subscription clients who get a couple of days of a heads-up regarding the companies that it intends to pan in the press. The report on Fleetmatics, which is lengthy, detailed and incredibly polemical and distasteful was issued on September 19, 2013.

I personally have disdain for the style of and business model of these kinds of services. I simply have a predisposition against any kind of polemical "research." Some of the "facts" and the aspersions in the report have self-evidently been proven to be inaccurate over time as detailed above. One might go further but at this distance in time, what would be the benefit?

But that being said, there were a few issues raised in the Prescient Point report that I will explore in some depth because regardless of the source, the issues that were raised such as churn, economic life of the devices, competition and pricing are real and have had and will have a significant impact on the results of FLTX operations going forward.

At the time of the Prescient Point "report" the shares were at $38. By the middle of May 2014, the shares had reached a low of $27 a decline of 29%. Over that same time span from Sept. 19 2013 until the middle of May 2014, the IGV software index increased by 4%. So, regardless of the validity of the Prescient Point research, its report was most probably a factor in retarding the progress of FLTX share price performance. Overall, since Sept. 2013, until June 23, 2016, the IGV has increased by 38% and FLTX shares are up 16%. Over the 3 years since the end of 2013, the company will have grown revenues by almost 100% according to the current analyst consensus forecasts for 2016. Over that span, reported non-GAAP EPS will have grown by 115%. I suppose whatever else is true, the shares are significantly less highly valued than they were when Prescient Point began its negative presentation.

To an extent, and just from a 30,000 Ft. view, the expression "nice work if you can get it", seems appropriate. It is, I think, nice not to have to be right on the facts but to get the alpha one seeks on the stock. Most companies with that kind of growth rate and with increasing margins that FLTX has achieved would have been far more likely to have seen significant share price appreciation absent the pal cast over the shares by the Prescient report.

Since May 2014 the shares recovered significantly and more than doubled to reach almost $62/share at the end of November of last year. The shares subsequently declined to $36 in the midst of the tech panic of earlier this year and also because the company issued light Q1 guidance of EPS of about $.34 compared to a prior consensus estimate of $.39. The Q1 revenue guide of $79 million compared to the prior consensus of $80 million. Not helping matters was commentary by CEO Jim Travers to the effect that the company is willing to offer discounts to win some large deals.

The shares fell 12% in the wake of the Q4 release and conference call. In the end, it turned out that the company had front-loaded sales hiring which increased Q1 expenses but the front-loading had little impact on the full year forecast. In other words, much ado about minutiae.

The Q1 earnings release issued on May 4, 2016 was almost exactly in-line with prior guidance and the company reaffirmed forward guidance for both the current quarter and the full year. The shares appreciated in the wake of the earnings release and are now at $44.

The history lesson was interesting but really what are the prospects for the business going forward?

Fleetmatics basically provides software to optimize the operations of the vehicle fleets of small and medium size businesses. It also an enterprise product that it has sold to companies with thousands of vehicles in their fleets. It is currently an underserved market and the solutions of Fleetmatics and its competition have very high ROI's. Unlike most other kinds of software, the installation of vehicle optimizing software is going to show measurable returns almost immediately. Most operators of vehicle fleets are going to have to deal with some common problems including excessive overtime by drivers, excessive vehicle wear, suboptimal vehicle routing, unproductive worker behavior, unsafe driving and unauthorized vehicle use. There are perhaps other ways of dealing with these problems than by using trackers and quantitative analysis, but installing sensors in vehicles is cheap, quick and relatively painless. Most fleet owners use some kind of manual process to address scheduling issues which, by its nature has to be sub-optimal.

The question as to how large the potential market might be is vexed. Fleetmatics has data from an organization called Berg Research that show 94 million potential vehicles and a 14% penetration of the available market. In the countries in which FLTX operates the target is said to be 54 million vehicles with a 17% penetration rate. In its report, Prescient says that the market potential for the solutions sold by FLTX is wildly inflated. FLTX uses the Berg research to derive the market size. It seems a reasonable approach.

The international market which is just slightly smaller than the addressable market in North America is clearly less penetrated and it has become an area of some focus for this company. In Q1, international represented 13% of revenues for FLTX up from about 10% in the year earlier period. The CAGR in terms of available vehicles overall is said to be 15% through the end of the decade. The question revolves around how many vehicles are really fleet vehicles that might be a market for telemetric devices. Berg appears to be the leading research company in terms of the telemetric market.

But investors do not really have to accept that the market is quite so large in terms of the potential for FLTX to grow. At the end of Q1, the company had 737,000 vehicles subscribed to its service up from 709,000 vehicles in the prior quarter. The company goal is to increase the sub total to 1.2 million by 2020, which implies adding about 125k vehicles a year. Regardless as to how the market is precisely defined, there appears to be more than enough runway given current penetration rates to achieve that goal and to perhaps exceed it.

I think a more significant question is one of competition. This is not a market that has very visible competitive moats. Fleetmatics spent just 6% of its revenues on R&D which is significantly below what many observers might think necessary to produce an adequate level of product differentiation. The company's long term model is for R&D spend in the 8%-10% range. Some of that reported "underspend" is the impact of software capitalization but software capitalization at $1.7 million last quarter is not substantial. The company has started to ramp R&D spend. R&D spend increased by more than 40% in Q1-2016 on a GAAP basis. The company is rolling out a couple of new products including "Work" which is field service management software, "Log" which is essentially an electronic driving log and "Routist" which as its name implies is a solution that optimizes vehicle/driver routes to minimize costs and improve productivity. Log demand is likely to be stimulated by the new mandate for Electronic Logging Devices that was recently enacted. Are these newer products enough to create a competitive moat? Probably not entirely. There are lots of competitors offering lots of solutions. At some level the combination of solutions that Fleetmatics offers is likely unique but then so are the offerings of some of the other larger companies in the space. Everyone seasons the stew a bit differently but the product is still ultimately stew.

I do expect that FLTX will continue to expand its product line over time. It is the only way it can raise ARPU (Annual Revenue per Unit) which will be key to growth and profitability. But this is a very fragmented market and is likely to remain so. According to the Berg study there are 9.2 million vehicles equipped with telemetric devices. FLTX has an installed base of 737,000 units and it is the market share leader. And it is market share leadership and marketing resources that are the real competitive moat for this company. Because it is larger than its competitors, it can afford to invest more in sales and marketing. And it seems to have a more efficient approach in terms of marketing spend than many of its competitors. Marketing is focused on Digital Advertising, and on the other typical components of a telesales model. Cash Customer Acquisition Costs have been stable and while they can reflect seasonal trends, cash acquisition costs actually declined in North America last quarter. More marketing and more efficient marketing is more likely to be a competitive moat than are specific product features in such a crowded market space.

There has been some commentary amongst analysts and article writers other than Prescient that the software applications in this space are "primitive." I am not to sure what makes an application primitive. I suppose on the same basis most "factory" software is primitive. Obviously calculating MPG statistics is not terribly high-tech. It has been available in vehicles themselves for years. What makes the software useful, however, are the correlations and analytics that are drawn from the collected data. The analysis of big data sets and the use of that analysis to drive operating decisions is one of the core tendencies these days in the enterprise software space. Collecting, classifying, correlating and analyzing big data sets may not sound like that much but it is far more useful way to derive value from an IT investment than anything else.

I really do not think there is a material correlation between the lines of code, the complexity of algorithms and the potential share value of Fleetmatics shares. Let's just say for the sake of this discussion that there are many companies in the space and most of them have some kind of solution sets that will improve the operational performance, improve the safety and optimize the economics of fleet use. If there is a secret sauce, it isn't that FLTX has invented some pearl without price but that it has put together a set of capabilities that customers find to be competitive and that it markets those capabilities quite efficiently and successfully.

FLTX has been working with GM to integrate its software with OnStar to produce a solution that could be sold on a non-exclusive basis with GM as the OEM customer. So far nothing has developed from the announcement. I think that investors at this point should not expect anything to really happen with regard to potential OEM deals until they are actually announced. The larger and more significant a deal is, the longer it will actually take to close, for the most part and by their nature, OEM deals of any size are amongst the most complex and contentious deals to negotiate.

The thought here is that many vehicles can be equipped with the telemetric device as standard. Many vendors in this space give away the hardware in any event. Whether or not Fleetmatics can benefit from any potential OEM deals remains to be seen. I suppose given current forecasts, OEM deals should be considered in the nature of langiappe for this company.

The other significant component of the business outlook for this company is churn. Obviously the economics of a SaaS model can only work if subscription renewal rates are high. FLTX sells most of its product to the mid-market, i.e. users with between 50-500 vehicles. It sells primarily on a 3 year lease arrangement although other terms can be made available depending on the situation. Under the circumstances it is going to have some churn. I was actually surprised that its gross churn is only running at 2.85% in this last reported quarter.

It is standard for subscription model software company's to report some kind of churn statistic when they report numbers although the churn statistic is rarely part of the earnings pres release. Some SaaS companies actually report renewal rates which include the value of any upgrade that renewal customers buy.

Until recently, when Fleetmatics started to introduce more products renewal customers could only renew and hence it uses a churn rate which reflects the cancellation in the installed base that it has received within a particular quarter. There is no "correct' or standard methodology in reporting churn.

CRM, the largest SaS vendor reports the renewal rate for the leases that expire in a particular quarter. Lately the renewal rate for CRM has been between 91%-92% which has obviously been considered acceptable by most analysts and investors.

This company uses another method in which it analyzes the number of its users in each quarter who were scheduled to renew but did not renew. In Q1, Fleetmatics management reported that gross churn was at an elevated rate 2.85% compared to 2.42% in the prior reported quarter. The increase was a function of the problems in the oil & gas industry which has accounted for 6% of installed units for Fleetmatics to this point. For the rest of the installed base, the churn rate has remained consistent. The company's CFO, Stephen Lifshatz forecast that churn would return to normal levels by Q4. Basically a 2.42% churn rate is equivalent to a 90%+ renewal rate and that fits with this company's business model.

This company does have an enterprise product offering for users with fleets of more than 500 vehicles. Enterprise is clearly not a big seller for this company. It has 737,000 vehicles under management with 37,000 customers. That is just less than 20 vehicles per customer. But the point is that enterprise users are likely to have lower churn rates than some of the tiny customers who often go out of business or simply can't pay their bills. As the company expands its portfolio of solutions, I might speculate that its products will appeal more to the enterprise market and this will serve to diminish churn. For enterprise customers, the renewal process is typically about acquiring more functionality for a consistent price.

Management did not discuss its Enterprise offering on the last call-or at least not explicitly. I think that enterprise could readily be a growth driver for this business and I believe that the larger the proportion of the installed base that is enterprise, the lower the churn will be. The company announced that its CEO, Jim Travers, would be stepping down at the end of this year. He is to be replaced by Jill Ward who has been President and COO since she joined the company last year. Perhaps the transition will see more emphasis placed on either or both enterprise sales and additional product development programs.

The company has forecast that its sales will grow by 20% at the mid-point of its guidance range and that non-GAP EPS will be in the range of $1.72-1.76. Needless to say, analyst estimates are smack dab in the middle of those ranges. Cash generation is rising faster than earnings and based on the constituents of cash flow in Q1 that trend is likely to continue.

Next year the analyst consensus forecast revenue growth is lower at 17.6% while EPS is forecast to rise by 20%. Those are unlikely to be well analyzed numbers. The space is almost certainly growing at more than 20% and FLTX is almost certainly retaining or increasing its share. The company has not yet provided guidance for its 2017 expectations.

Next year the excess churn in the oil & gas space is likely to abate and the company has 3 relatively important products that should be contributing significantly to revenue. It seems likely that 2017 growth will be equal to or greater than the growth in 2016.

Stock based comp is not explicitly part of the business outlook. But it is something that plagues some readers and investors. Needless to say this company does use stock based comp. It is located in Greater Boston and could not hire any talent if it did not. Stock based comp was up by 84% on an annual basis last quarter although at $8.3 million it is just a bit over 10% of revenues. It is about 1/3 rd of operating cash flow and a greater percentage, obviously, of free cash flow. The company has significant provisions for depreciation-primarily from the telemetric devices it installs in the cars of users and for the amortization of deferred commissions. These items, and stock based comp have been the most important elements in the growth of cash flow in the just past Q1. Adjusted EBITDA as the name suggests, eliminates the depreciation and amortization amounts from that calculation.

FLTX already has a decent business model that ought to improve some at scale. It has a leading market share in its space and it has made some interesting new product launches that might bolster growth and improve churn rates. Its largest competitive moat is likely the use of the web as its primary sales platform. The market space is more than a bit fragmented and likely to remain so. What is the business outlook for Fleetmatics? Sunny to partly cloudy-some thunder in the distant past.

Risks:

In looking at the risks identified by the Prescient report, the major item that is currently outstanding is pricing. As mentioned above, while Fleetmatics may be the market share leader, the best statistics show it has but 9% share of the installed base. It is not the 600 lb. gorilla in the room and it will face price competition from smaller vendors seeking to establish their own footholds. Users currently have offers from competitors who charge $16.95/month per vehicle. Fleetmatics pricing these days is pretty aggressive as well. There is a freemium option with basic functionality that costs nothing. Currently, Fleetmatics it is running a promotion for Reveal, its main product offering that includes 6 months' free service and a "free" telemetric device. My impression is that the "special" is quite pervasive. It is likely that the Fleetmatics Reveal platform does have more functionality than the products that cost half as much. Fleetmatics pricing scales significantly based on the feature set required by the user organization. For the most part, the market appears to be bifurcated between vendors with basic functionality and other vendors who have their own sets of unique features. Pricing and price competition are not likely to be eliminated in this market anytime soon. That being said, even with the highly aggressive promotional pricing, Fleetmatics has been able to achieve consistent gross margins and has met its target for net sub ads while maintaining a consistent cost for customer acquisition. The pricing risk is real and it is the one part of the Prescient analysis worth following carefully. Pricing is a risk and it is going to remain a risk for the foreseeable future.

While the market potential seems to be very large, I have to imagine that at some point, some of the smaller vendors will combine or simply give up the ghost of trying to compete without scale enough to make any significant level of cash income. Of course the real cure for the level of price competition in the market these days is for Fleetmatics to have a broader product footprint. It is likely that it will take a few years before the company will be in a position where it will have adequate functional differentiation to be able to lessen its reactions to price competition and to improve its gross margin realizations.

The other issue or risk I see is the tradeoff between growth and profitability. Many readers on this site and more than a few commentators want companies to accomplish the impossible; i.e. to achieve hyper-growth and GAAP profitability at the same time. In the distant past, I remember when John Chambers of Cisco (NASDAQ:CSCO) told a conference call audience that he was surprised that analysts and shareholders weren't calling on him and Cisco management to spend more on sales & marketing given the economics of the situation. He basically was saying that he wondered why investors were so focused on short term EPS and not focused on growth and market share. It was then and remains today a reasonable question and one that needs to be understood in analyzing what might be termed hybrid investment opportunities.

Hyper-growth and GAAP profitability are more or less mutually exclusive. Veeva (NYSE:VEEV) is one of the exceptions to that rule, to be sure and there are doubtless other outliers with which I am not familiar. But for the most part, growth above some significant percentage rate is usually negatively correlated with GAAP profit margins. The management of this company has chosen to focus on what may be considered as a moderate growth objective while also trying to pursue some level of GAAP profitability.

Such goals can be significantly more difficult to accomplish then might seem to be the case because of management trying to accomplish what can be two diametrically opposed objectives. Rather like the Fed and its dual mandate. In the end, trying to pursue two non-correlated goals can lead to dysfunctional decisions and I see that as a potential risk for this company.

One theory in the software business suggests that companies in new spaces such as vehicle operation optimization need to do what it takes to promote a land and expand strategy and to maximize market share and thus eviscerate the potentials for competitors. This isn't the time to discuss the merits or demerits of that strategy in any detail, but when I look at this company I am forced to wonder if rather then maximizing growth FLTX is attempting to achieve a "reasonable" margin while leaving lots of revenue potential on the table.

Businesses are not science projects. One doesn't get to run an experiment with controls to determine which strategy is correct and which is inappropriate. My own view is that the growth opportunities in the Fleetmatics space is such that it might well support faster growth than the 20% CAGR that this company has planned for. The risk, if you will, is that by not maximizing market share there is the potential of letting some other vendor become a real competitor. So far that has not happened but it is a risk that might emerge at some point.

Valuation

Valuation for Fleetmatics occupies a middle ground. The company has a current enterprise valuation of $1.5 billion. Sales this current year are projected at $343 million. So the EV/S is 4.5X. Not incredibly cheap, but not over-extended given that all of this company's revenues are recurring in nature and given its 20% growth rate. The P/E for this year based on the consensus estimates of 13 analysts is 25X. The P/E based on 2017 estimates is 21X.

Last year, operating cash flow came to $91 million or 43% of revenues. My comments about growth vs. profitability might be seen through the strength of this metric which is conspicuously an outlier for a company of this scale. I should also point out that being domiciled in Ireland means that cash taxes are nil effectively and are likely to remain so for several more years. The company, does, however accrue a 12% non-GAP tax rate. The free cash flow margin last year was 24% as defined by this company. (the company acquired a company for $32 million which is not reflected in free cash flow. It also capitalized $4.7 million of internal use software costs which is a use of capital.)

Cash flow continued to show strong trends despite the seasonal nature of Q1 operations. Operating cash flow increased by 36% in the quarter. The major contributors to the increase was a substantial jump in stock based comp, a jump in depreciation and a significant change from a loss to a gain in unrealized foreign currency gains.

This company does not forecast any component of cash flow. Just using the company's forecast for EBITDA growth, might produce an operating cash flow estimate of between $120 million and $125 million. Overall, as a guess, the free cash flow margin for this year might be 20-21%. This would produce a free cash flow yield of about 4.5%.

For what it is worth, given the company's current customer base, its subscription revenue model and its significant profitability, I believe that this company could well be an acquisition candidate either by companies in the motor vehicle industry or companies in the software world. The recent pace and valuation of transactions is such that the appreciation potential of a takeout would not be insignificant.

Summing Up:

  1. Fleetmatics is the leading independent company in the vehicle tracking and optimization space. The technology employs GPS sensors and software to provide analysis of all major operating metrics for vehicles in fleets.
  2. The company leases all of its products and hence all of its revenues are recurring
  3. The company was attacked by a "short" focused research firm shortly after it went public in 2012.The shares have underperformed some of the time since that analysis, which, for the most part, has proven to be grossly misleading and inaccurate.
  4. The company's track record, including projections for the balance of 2016 have seen revenues double and EPS increase by 115%
  5. Although Fleetmatics is the market leader in its space, the market as a whole is very fragmented with literally dozens of competitors. Fleetmatics' market share of 9% tops the other vendors, but the company hardly enjoys a commanding lead in the space.
  6. The space as a whole is expected to grow by at least 15%/year through the end of this decade. The solutions that customers buy have one of the more readily quantifiable ROI's and the shortest time to benefit of any solutions in the software space.
  7. Fleetmatics has recently introduced 3 new solutions that for the first time give the company some real cross sell and up sell capabilities.
  8. It seems likely that these new solutions coupled with geographic expansion are likely to bring growth for 2017 above the currently published consensus.
  9. The biggest risk to the company's business outlook is pricing at exceptionally low levels on the part of some marginal vendors. So far, despite extremely low prices being offered by down-market competitors, Fleetmatics has been able to hold its own with gross margins relatively comparable to prior periods and with customer acquisition costs also holding at consistent levels.
  10. The company has a significant opportunity to move up-market with its enterprise version of the Reveal platform. This would open the door to sustained growth above 20% and would likely help in lowering churn.

Fleetmatics has a reasonable valuation given its growth and profitability. It is also evident that the company is a significant potential acquisition target. Given the company's relatively reasonable current valuation coupled with the higher valuations that recent acquisitions have brought, the appreciation potential of such a transaction would be quite substantial and is likely to begin to carry some influence on the company's valuation.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FLTX over 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.