Can accounting software be exciting?
I don’t have the opportunity to keep up with all of the IPOs as I would like. Far too many distractions and alternative demands on my time. And then again, who might have imagined that a company that essentially sells accounting software could be a hyper-growth story. I can’t claim that accounting was ever my favorite subject when I was forced to study it. And the other folks who were in the class with me all those years ago were even less interested in the subject. Most jocks at Wharton simply had other priorities at 8 a.m. three days a week. But that is a story for another time and place.
BlackLine (BL) is a company whose business is providing users with tools that help automate the closing process, reconcile accounts and provide tools for intercompany accounting and controls assurance. The company calls its technology continuous accounting which basically means that workflows are continuous as opposed to being driven based on specific data for a specific date.
Most recent IPO's these days, start by delineating the size of the market for which they compete and most of the time the market based on an analysis of the TAM is said to be very large. This company cites a Frost & Sullivan survey that defines the TAM as $17 billion - based on targeting more than 165,000 enterprises employing 13 million finance and accounting professionals worldwide. Honestly, suggesting that the TAM is based on 13 million seats strikes this writer as a gross exaggeration. On the other hand, these days that is how IPOs get done. If some recognized third-party consultant - in this case Frost & Sullivan - defines a market and populates it with every conceivable body under the sun, that allows underwriters to develop aggressive IPO valuations. There are other measures that have been used by other observers that calculate a TAM of $7.5 billion. But even if the penetration of the TAM estimate cited by BlackLine proves to be just 20%-30% there is still plenty of runway for this technology. BlackLine revenues for 2018 are estimated to be just $222 million.
Breaking into the financial space
All significant ERP vendors sell financials, or at least try to do so. The market has been dominated for many years by Oracle (ORCL) and SAP (SAP) which typically sell their financials integrated with their ERP systems. Workday (WDAY) has been trying to penetrate the market for financials now for the last several years. Microsoft Dynamics offers a suite of financial applications as well. The financials sold by BlackLine are not quite the same as the financials sold by many other vendors. They fit in a different category in that they are focused on resolving accounting requirements as opposed to resolving planning requirements. This may sound like a nuance, but it really is not in the current market.
SAP does not specifically compete in the space that BlackLine solutions address. In fact, BlackLine is “an SAP-Endorsed Business Solution for Financial Close.” About 25% of BlackLine’s installed base run SAP and this company has integrated its products closely with SAP’s other solutions.
I have expressed my reservations regarding Workday (NYSE:WDAY) precisely because I think it is very hard for anyone to displace the mainstream vendors in financials now that all of the companies have mainstream cloud offerings.
What Blackline sells is described by Gartner as a subsegment called Cloud Financial Corporate Performance Management. I have linked the Gartner study here for the convenience of readers. As can be seen, most of large organizations and a reasonable percentage of mid-size organizations are likely to be using solutions in this segment for consolidation and reporting by 2020.
In reality, this market segment has been around for quite some time and historically had been led by Cognos, Hyperion and Business Objects, now all owned by larger survivors such as IBM (IBM), Oracle (ORCL) and SAP (SAP), respectively. Much of the business that BlackLine and its peers are closing consists of current users migrating from on-prem to cloud solutions.
Gartner also rates vendors in the segment it calls Cloud Financial Systems. In that study, linked here, Oracle and Workday are rated as one and two respectively with SAP relegated to a niche status. That obviously is a gross mistake. Oracle and SAP run neck and neck in financials and Oracle is certainly not a niche vendor. One publication, with an article linked here, has recently run an article about why SAP apparently has such a poor rating in what is really the company's wheelhouse.
It is my guess, for what it might be worth, that SAP because of the Gartner ranking, is likely to feel it needs to take some bold steps to redress the playing field in Cloud Financial Systems. Acquiring BlackLine, which could be done for just more than $2 billion, would significantly upend the market structure in financials, probably an important strategic goal for SAP and one that I think cannot be gainsaid.
The market has been rapidly shifting from mature solutions that were deployed decades past and were on-premise, to cloud based on-demand solutions of the kind offered by BlackLine amongst others. While there are no statistics that delineate the growth of cloud-based corporate performance solutions, it certainly seems as though the market space has experienced and is likely to continue to experience rapid growth for the next few years, simply based on the erstwhile size of the on-prem corporate performance market segment.
Gartner rates BlackLine as the leader in its particular space, overall, although companies such as Host Analytics and Workiva are evaluated as strong competitors. Workiva is actually larger than BlackLine on a revenue basis, according to the latest data, and appears to be moving to fill in the holes around its go to market strategy. Host Analytics also are seen as having a suite of very useable and well supported products that can be used in complex use cases. It lacks much international presence.
Oracle gets a substantially lower grade within the MQ as can be seen. Oracle’s success in the space is a function of its ability to migrate its base of Hyperion users to its cloud solution. It has thousands of these users and most of them will remain with Oracle based on many considerations beyond just inertia. I have linked here to an alternative view of Oracle's technology and ease of use in this space. The article, written by a systems integrator who has a practice built around Oracle, claims that the account reconciliation service offered by Oracle has key features that have allowed it to convert users from both BlackLine and Trintech to Oracle. As the writer states, his firm does not have a BlackLine implementation practice and thus the information is necessarily skewed toward Oracle. At the end of the day, the author still describes BlackLine as a strong choice for this particular application.
Trintech, a company said by the management of BlackLine to be their closest competitor, is shown by Gartner in the Visionary quadrant, which basically suggests comparable technology but less of an effective sales and marketing effort. The company is said by Gartner’s user survey as having the lowest level of customer satisfaction.
I think that in viewing what is available on the subject it seems fair to conclude that BlackLine is at least amongst the top companies in most elements of its market and that the market itself is growing rapidly as users continue to migrate from on-premise to cloud at a steadily increasing rate. There is plenty of TAM available for BlackLine and some of its other competitors over the next several years. The issue for investors to determine is going to be whether or not BlackLine can execute effectively after its recent stumble and whether users favor integrated suites or best of breed solutions. Given that SAP is absent from the market, it is likely that there will be plenty of target for best of breed solutions.
An examination of BlackLine’s speedbump
BlackLine has been a public company for a bit less than a year at this writing. The shares rose by 40% the first day, and continued their upward path for some time thereafter. The shares ultimately reached a high of $36/share before it cratered by as much as 20% in response to a conference call that highlighted a couple of corporate weaknesses.
Q2 itself was quite strong for the company on a headline basis and growth accelerated slight reaching 46%, compared to 45% in Q1. Revenues were a bit above the top of the prior guidance range. EPS which was a loss of $0.03 non-GAAP was substantially greater than prior guidance as well. The company also was able to improve CFFO as well, in terms of year-on-year comparisons, although that was a function of the recognition of its liability for common stock warrants and a change in deferred taxes. The growth in deferred revenues, and thus bookings, were both disappointing. The company also saw a disappointing growth in the number of users which rose by 21% year on year.
As a result of these weaknesses, the company chose not to raise its revenue guidance for the full year. Indeed, since Q2 results were above expectations, it might be said that guidance for the balance of the year is less than had been anticipated. It also lowered billings targets for the balance of the year. Although, apparently, that had more to do with an acquisition the company made last year of Runbook. It should be noted that the company does not normally guide bookings and this guidance was apparently a one-off - it was part of the mea culpa about the company's stumble. Adjusted for the Runbook acquisition, the growth in billings is expected to be around 30% for the full year, with some seasonality between Q3 and Q4. Despite issues with revenue growth, the company did raise its EPS estimates noticeably for the full year, to a point where it is possible that the company will achieve non-GAAP break-even in Q4.
Like many companies of this nature, the sales strategy has consistently been to land and expand. Last quarter the expand part of the equation was lower than it usually is, with the dollar based renewal rate of 114%, down from 117%. Was it because of stumbles in the company’s sales process? Certainly, satisfied customers with strong sales relationships are more likely to expand their installations consistently, quarter after quarter. Providing clients with long-term relationship managers is going to be one of the changes in the selling motion made by BlackLine.
Since early August, when BlackLine announced its "stumble," the shares have recovered, although there has been no specific news about any remediation of the problems cited by the CEO. At this point, the shares stand just 7% or so below the levels they reached just before the earnings release. Needless to say, it would be easier to be more enthusiastic about the shares if there was some evidence that the company had solved its problems.
In addition to the weakness related to account management and user satisfaction, management called out issues with regard to customer support and other issues regarding the lack of success of a strategic product called the Intercompany Hub (ICH). The ICH is a rather complex piece of software that allows companies to build a "clearinghouse" in which they can settle transactions between subsidiaries and insure that transfer agreements are appropriately recognized. The product was initially introduced three years ago and is supposed to be a major growth driver for BlackLine. In Q2 it was unable to sell any deals involving ICH, a substantial disappointment.
Just looking at the link that is provided here suggests some of the complexities involved in setting up an ICH. Inevitably, sales cycles will be longer, and may well lead to protracted negotiations before signing deals. BlackLine mainly has had a history of selling small deals with an ACV of around $50,000 - although these small deals morph into much larger installations over time. The ACV for a typical ICH installation will almost surely be several times that level, although there is no data yet as there has been but a single reported sale.
Apparently, this functionality has heretofore not been something offered by other vendors in this space and BlackLine at this point is being somewhat of an evangelist in creating a market that automates the functionality for inter-company closes. Creating a market is challenging work, can be expensive and the cadence of creating a market always is difficult to forecast.
This company has a variety of other relatively new product initiatives that have helped drive revenue growth. These include Smart Close and Transaction Matching as well as its new hub product. While the lack of success with ICH last quarter was a disappointment, it seems reasonable to expect that some of the elongated sales cycles closed during the September quarter.
The issues with regard to user success appear to be more organizational than a factor of any quality defects or problems with the core technology. The company has been focused on letting it be a “hunter." Apparently disturbing the relationship between customers and their sales reps lead to some level of customer dissatisfaction, and apparently, in turn that has led to be a less expansion on the part of newly installed users.
Management commentary touched on most of the normal ways to deal with the problem. Better salesforce training, meetings, enhanced satisfaction metrics and tracking are all part of the mix. Management attention to user success appears to be as high as that I have seen in any other company and should lead to improved cohort metrics going forward. I would be surprised to see the company not make significant headway to resolving its sales execution issues in the balance of the year.
Taking a look at BlackLine’s own financials
Overall, the company is making noticeable progress in terms of reaching GAAP profitability. And despite the miscues in terms of sales execution, the company is improving operating expense ratios at a very rapid cadence. Last quarter, gross margins remained a bit above 75%, the same as the prior year and marginally below the profitability of the prior quarter.
Overall, the company improved its operating expense ratio from 104% last year in Q2 to 94% this year on a GAAP basis. Sequentially the expense ratio improvement was around 270 basis points compared to Q1. The sales and marketing expense ratio showed a 600-bps improvement year on year and research and development costs dropped by more than 400 basis points as a ratio. These results were significantly better than had been guided just a quarter before.
Management said that hiring during the quarter was back-end loaded. This will have the effect of moderating the further improvement in expense ratios in the second half of the year. The company, like most businesses in this space, provides non-GAAP guidance. Through the first half, the company had a non-GAAP loss of $.0.09 per share. The company is now anticipating that it will report a non-GAAP EPS loss of $.06 at the mid-point in the quarter that will be reported in early November and that the loss will be around $.04/per share in Q4. The company has had a consistent history of significantly exceeding its EPS forecast in its four quarters as a public company and this suggests that it could well report break-even non-GAAP results in Q4.
Analysts are projecting substantial top-line growth deceleration, both for the balance of the year, consistent with management guidance and then through 2018. That is perhaps consistent with the company’s bookings guidance which is for only 30% growth after adjusting for the small acquisition made earlier this year. On the other hand, the guidance was apparently set excluding any potential from major transactions and particularly transactions that might be dependent on the company's ICH solution. Basically, the CFO said that the company is ”adapting to longer sales cycles, because strategic deals have become a bigger part of our business and growth strategy and today make up more of our pipeline than 12 months ago.” On that basis the company has chosen not to raise revenue guidance and has moderated its expectation for EPS improvement compared to what it could have been. It would only take a modicum of success in enterprise deals for the company to significantly exceed expectations - and that is one reason to be optimistic about share price performance going forward.
The shares of this company are not particularly cheap and investors need only to have blinked before their opportunity to buy a significant dip was gone. At the moment, the company has 52.2 million outstanding shares, yielding a market capitalization of $1.77 billion. With about $105 million of cash, the enterprise value is just less than $1.7 billion. Over the next 12 months, it is reasonable to expect revenues of a bit over $200 million. That computes to an EV/S of 8.1X. That ratio is on the high side of other valuations of companies achieving hyper growth - although not totally an outlier.
The company is not likely to generate either any significant level of earnings or significant CFFO over at least the next 18 months. Investors who buy these shares do so for growth and for the potential for this company to be purchased, which at least to this writer, is not insubstantial. No one buying the shares today is doing so because of expectations for a significant level of either earnings or free cash flow at any time in the near future.
The company’s financials are not heavily influenced by stock based comp. That expense was a bit less than 5% of revenues last quarter compared to 5.3% in the year earlier period. Despite the significant hiring described by management, Q2 stock based comp was flat sequentially.
Sentiment is fairly mixed on this name with a bit more than half of the analysts covering the company rating it buy or strong buy. The shares have an average price target of just $37. Valuation is a problem for many analysts and presumably investors, just as it is for this writer.
I think the outlook for this company is excellent. It is a clear best of breed and its customer roster which includes such names as Coca-Cola (KO), Costco (COST), SunTrust (STI) and Kimberly Clark (KMB) is impressive at this point in the company’s history. I think the demand environment for what this company sells is likely to be strong and the management seems acutely aware of what it needs to do to execute at a high level and gain market share.
There is an old saying from Texas about the money running out before the deals do. That really refers more to real estate, and scratch any Texan and one finds a fully versed real estate speculator trying to stretch the last dollar of leverage. But that can be true in equity investments as well. I'm not going to buy these shares at this price at this time for no other reason but that there are other opportunities I would like to chase more. If the shares pull back, and if they do so because of some spurious or over-blown concerns, I would elect to make a commitment. But not today, at this price.
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.