Previous articles estimated the fundamental value of the ClickSoftware (CKSW) stock. This document discusses market noise and investing execution from the perspective of investor opportunity. It also suggests management actions to realize value.
Underlying investor opportunity is the large disparity between fundamental value ($13.00/share) and price ($8.40/share). Value is driven by the firm's track record -- return on invested capital of well over 100% during each of the last three years, easily exceeding 10% weighted average cost of capital; and revenue growth averaging 22% per annum in the last five years. Embedded in these metrics is low business risk.
Low business risk is characterized by the combination of market and product leadership, client and revenue diversification, steady revenue and EBIT growth, no debt, and high liquidity. Focused operating activity entails risk well within industry specialization and management competence.
At a basic level, low risk reflects the high priority of ClickSoftware's products in the eyes of clients -- that enhance their ability to deliver service quality and customer service to their own customers, and enables the clients' own value performance. Such high priority by clients translates in steady and growing product demand, even during periods of macro-economic weakness, like 2008 - 2009.
Fundamental Value Metrics
- ROIC (Return on Invested Capital) = NOPAT / Operating Capital
- NOPAT (Net Operating Profit after Taxes) = EBIT (1- Tax Rate)
- EBIT (Earnings Before Interest and Taxes
- FCF (Free Cash Flow) = NOPAT - (Changes in OC). [As approximation FCF = CFO (Cash Flow from Operations) minus Depreciation & Amortization]
- OC (Operating Capital) = NOWC (Net Operating Working Capital) + OLTA (Operating Long-Term Assets)
- Operations Value (OV) = Present Value of prospective FCF, growing at g, discounted at WACC
- WACC (Weighted Average Cost of Capital)
- Enterprise Value (EV) = OV + Non-Operating Assets
- Equity Value (Fundamental) = EV - Debt
- Stock Value (Fundamental) = Equity Value / # Shares
- EVA (Economic Value Added) = (ROIC - WACC) OC
ClickSoftware's May 2, Q1 Earnings Report triggered a substantial drop in the price of the stock (from $10.62/share at May 1 closure) in the days and weeks that followed. Arguably, the market took as a negative various management actions directed to sustain accelerated growth, which caused unexpected increase in operating expenses, reduced EPS, and dampened expectations.
An intrinsic investor would argue that the management actions directed toward sustaining rapid growth were absolutely necessary and in fact represented an overriding and perhaps overdue priority, particularly given high ROIC. Thus, the compression in the stock price is considered to be out of synch with the metrics supporting the value of the stock.
It is likely that macro-factors in addition to the new Q1 information, also contributed to the drop in price. All in all, expectations were lowered despite the fact that as part of the Q1 information the company also reiterated previously provided year 2012 guidance -- revenues in the approximate range of $100 to $105 million, representing about 15% to 21% growth over 2011. This is particularly significant given management's favorable track record in meeting and in exceeding guidance.
The sizeable discrepancy between value and price suggests a preponderance of market participants who rely on other-than-fundamental information for short term profits (and informed investors who miss-value the stock, including those giving excessive weight to recent new information relative to robust historical metrics).
In other words, the aggregation of trading events that have the effect of expanding the short term value-price discrepancy, characterized as financial noise, is substantial. While the trading patterns of noise traders and intrinsic investors are different in purpose, frequency, and trade size, increased stock involvement by intrinsic investors is an important driver in the closure of the price-value gap.
Under the fundamental view that price and value converge over the medium term, and that there is sufficient confidence in the value estimate, short term price compression provides an opportunity to invest at lower cost. The larger the gap becomes -- between value ($12.50 - $13.00) and price ($8.40), the greater is the potential investor return.
Fundamental Investing Execution
Embodied in the value-driven investment proposition is process discipline; from identification of investment prospects, to due-diligence and analysis (adequacy of the value estimation framework), reasonableness of assumptions in value estimation, and execution (purchasing, holding and re-sizing position through volatility, selling). Below are highlights.
- A fundamental value estimate based on ROIC, growth, and business risk. Low business risk increases the certainty in FCF and adds confidence in value estimates.
- Acceptance of market noise, reflective of non-fundamentally-based (and frequent) trading and trading based on biased interpretation of new information. Investor returns depend upon the firm's internal performance and on noise; both influence the price of the stock.
- Size of the bet --in harmony with intrinsic investor confidence in his or her value estimate and with the win/loss probabilities implicit in the value-price gap. Investor risk decreases as lowering market expectations compress price, and the opportunity to buy the stock at lower prices expands. Expanding the size of the investment gathers force in those cases when the investor "knows enough to know" that mispricing translates in odds that are overwhelmingly on his, or her, favor.
- A medium or long term investor horizon -- to allow the marketplace to close the value-price gap. Expansion of the price-value gap can be as pronounced on the way down, as contraction can be on the way up. Growing intrinsic institutional investor interest is the fuel to defining the ranges of value and to raising price toward value.
Managing for Value
What can management do to enhance value and close the value-price gap?
Below are some suggestions.
- Manage for long-term shareholder value creation. ROIC and growth (and FCF) are determinants of shareholder value. Assess management initiatives based on their impact on value. Balance GAAP accounting information disclosure with relevant intrinsic value metrics. [GAAP accounting is not "user friendly" to intrinsic investors. EPS is an overused and oversimplified measure of performance (ignores efficiency in the use of operating capital)].
- Maintain sustained rapid growth as a top management priority. High ROIC dictates rapid growth, even if it increases (reasonably) operating expenses and decreases in ROIC.
- Beware of acquisitions that are "accretive to earnings". This regards a recent company presentation where management discloses that is seeking appropriate M&A candidates, as one among many initiatives, to accelerate growth. Acquisitions are a reasonable and welcomed, provided FCF of the combined entity increases relative to total capital employed. (The Street practice of referring to the attractiveness of M&A on the basis of earnings accretion is misleading at best -- EPS may go up but FCF may not; if FCF does not increase value does not increase either regardless of EPS).
- Understand institutional intrinsic investors; communicate clearly. Intrinsic investors represent a steady force in determining value and contributing to stock prices converging with value. They need the right information to estimate value; value metrics is the language of intrinsic investors. Align investor communications to attract intrinsic investors.
From the investor perspective, the firm's intrinsic metrics performance supports a value of $12.50/share to $13.00/share. Current stock prices represent attractive potential investor returns, given the value-price gap.
"Knowing enough to know" is the source of investor confidence in the adequacy of value estimates and in fundamental investing execution.
From the firm's management perspective, managing for value is the way to create value for shareholders; focus on FCF and in the efficient use of capital. Emphasizing ROIC, growth, and FCF in communications with intrinsic investors is a corollary.
Intrinsic investors represent an important segment among market participants. They set value and pursue value realization over the medium and long term.
Disclaimer: The material presented here is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion. Views and opinions in this article may be wrong. The analysis, including financial computations, presentation, and views, do not necessarily conform to any sanctioned or accepted standards. Presentation and computations entail a probability of error, which is entirely possible. I am not an investment management professional; please do not rely on this material, do your own due diligence.
Disclosure: I am long CKSW.