Solera Holdings (SLH) produces software used in the auto insurance and collision repair industry. Solera's offerings allow customers to estimate the cost of auto repairs, automate the claims process and monitor trends in their business. At core, the company's software is an enormous database of information related to auto repair, including product and labor costs and inventory management. The company serves 1,500 insurance companies (40% of fiscal 2011 revenue), over 35,000 collision repair facilities (36%) and 7,000 independent assessors (10%). In addition, the company serves 30,000 automotive recyclers (14%).
The company generates the majority of its revenue and profit in the EMEA region, principally in developed Europe. Sales in EMEA represent about 60% of the total with 82% of that revenue coming from Europe. The U.S. comprises the remainder of revenue at about 40%. Operating profit margins in each region are similar although EBITDA margins in the U.S. are somewhat higher.
Solera has managed to grow the business quite nicely since 2006, when the core of the business was purchased from ADP (ADP). At the time, the business was only marginally profitable while today the company produces forecast profits in the range of $120 million per year, including the impact of intangible amortization. It is clear that Solera has done an excellent job in keeping costs under control while growing revenue. Recently the growth profile has moderated which has likely been the reason for weakness in the stock.
One of the big questions in valuing the company is the nature of its intangible assets. To review, Solera's intangible assets are mostly customer relationships and software and database technology. Street analysts produce estimates excluding intangible amortization, implying they don't believe the acquired assets have reinvestment needs; essentially, they are more akin to goodwill than real assets.
In my view, the assets are real and have constituted, to some extent, a buy versus build decision. In addition, the assets are not free in the sense that each year the company must reinvest in its software development and its sales apparatus. The industry is competitive with a number of solutions available. A lack of investment over many years would see competitors pull away. If investment needs for all players were in fact lessened over time, then a new fear would arise: competitors could lower prices to gain share while still building shareholder value.
Given the view on intangibles the company's shares are quite overvalued based on an economic profit model, in my view. However, it will likely take some time for the market to recognize that the long-term returns on the stock from the current starting point will be low. That is because I expect the market will continue to view intangible amortization as free money - something I have seen play out in other industries.
To play devil's advocate, if the intangibles are really like goodwill, then assuming a 3% real growth rate for ten years, fair value of the shares is in the $35 range. For the current market value to be correct, growth would need to be in the 5% range. That is if the company can reinvest at its IRR excluding intangibles to create that growth. In reality, the company has been highly acquisitive and will likely not be able to generate that level of growth organically. While I expect acquisitions produce a better IRR than the cost of capital, they are likely not at the company's existing IRR.