Ultimate Software: Expensive And Dilutive
Summary
- ULTI is not particularly profitable. It is dilutive. It doesn't beat the risk-free rate. And it is trading at a significant premium.
- ULTI's current P/E - 564 - trades at a significant premium to both market averages as well as its own historical multiples.
- Worse, there is significant optimism embedded in ULTI's shares. With a forward P/E of 46, ULTI has a price-implied one-year earnings growth expectation of over 1202%.
- If its earnings yield is significantly less than the risk-free rate, in my opinion, it's not worth the excess risk of its shares.
The Ultimate Software Group (NASDAQ:ULTI) is a company offering web-based payroll and workforce management software. It is a company that's not particularly profitable. It is a company that is dilutive. It is a company trading at a significant premium. Finally, looking at its price-implied earnings growth assumption, it is a company with a significant amount of optimism embedded into its price.
With an earnings yield that doesn't beat the risk-free rate, in my opinion, investors would do well to avoid it.
First, let's talk about dilution.
Share Dilution
ULTI has diluted its shares significantly, diluting shareholders over 25% in the last decade alone.
Source: YCharts
As my readers know, one of the first things I look at when I analyze a company is its history of share dilution. When a company issues additional shares, an existing investor's ownership stake in the company is reduced. This harms investor returns and should be avoided.
To demonstrate how dilution harms returns, I'll use the following thought experiment.
1. I'll assume that the next ten years resemble the last ten years, and ULTI increases its share count by 25%.
2. I'll assume ULTI manages to double its revenue in that same period.
Even with that revenue growth, because it diluted its shares, shareholder return would be muted. To demonstrate just how much, let's assume you buy 100 shares of ULTI today at ~$54 when it has 30.57m shares outstanding.
Source: Author's Compilation
As I said, we'll assume that over the next ten years ULTI doubles its revenue. And, let's say, that because ULTI investors love to reward revenue and nothing else, the stock price reflects that. Your risk has paid off!
But ULTI has issued 25% more shares, so now there are over 38m shares outstanding.
Source: Author's Work
Holding all else constant: instead of your shares being worth $108 per share, because of the dilution, they're now worth a little over $86 per share. Even though the company doubled its revenue, revenue per share has increased from $30 to only $49, instead of $61. Instead of your share of ownership being worth $10.8k, even though you made the correct directional call, now, simply because of management's decision to dilute those shares, they're only worth $8.6k.
A valuation increase doesn't guarantee a share increase if management dilutes them. Instead, because of its dilution, your return is muted.
The situation is worse when we consider its poor earnings history.
Profitability
While ULTI has enjoyed consistent sales growth over the decade, its earnings are not keeping pace. Indeed, net income is at around the same level that it was at in the early 2000s.
Source: YCharts
In fact, its revenue and net income are actually negatively correlated, demonstrated in the correlation analysis in the chart above. It's hard to see how ULTI will grow its profits in the future if the sales growth above doesn't lead to similar earnings growth. Without some significant operational cutbacks, ULTI may not be able to improve its bottom line.
This failure to grow its bottom line is worse when we consider that it diluted its shares by over 100% over that period.
Optimism
In the above, I've focused on the quality of the company - its profitability and its dilution. But reviewing the quality of the company is only half the battle. We also need to review the quality of the stock.
Given the quality of the company as discussed above, investors like myself might expect ULTI to trade at a discount.
We'd be wrong.
ULTI's current P/E - 564 - trades at a significant premium to both market averages as well as its own historical multiples. For market averages, the Kansas City Fed finds, high P/Es have negative consequences for shareholder returns (emphasis added):
[...] high price-earnings ratios have been followed by disappointing stock market performance in the short and long term. Specifically high price-earnings ratios have been followed by slow long-run growth in stock prices. [...] The P/E ratio varied mostly between 5 and 27 from 1872 to 1998, averaging only 14 for the entire 127-year period. The P/E ratio moved above 27 in mid-1998 and has since stayed above that level. In June 2000, the P/E ratio was slightly above 29. While this value was lower than a year earlier, when the ratio was close to 36, it was still high by historical standards.
That means that ULTI trades at over 15x historical market averages even at its highest (36). Further, it's trading at more than double its 5-year historical P/E.
Source: Morningstar
Worse, with a forward P/E of ~46.92, ULTI has a price-implied one-year earnings growth expectation of 1202%. In my opinion, that means that there is simply too much optimism embedded in its shares.
Finally, ULTI's EV/EBIT is 170.29. If we take the reciprocal of this, I get an earnings yield of just 0.58%. Compare that 58 basis points with the 225 basis points provided by a two-year t-bill. With an earnings yield less than the risk-free rate, in my opinion, it's not worth the excess risk of its shares.
Conclusion
I caution investors against buying shares of ULTI. Even assuming ten years of excellent price-linked revenue growth, an investor's reward may very well be muted if it continues diluting its shareholder base. It is a company that's diluting its shares; it is a company that has failed to translate sales growth into bottom line growth; it is a company trading at a significant premium, with a significant amount of optimism embedded in the price of its shares. Further, its earnings yield doesn't come close to beating the risk-free rate.
For certain companies - let's say, a brand new biotech, I might be willing to consider paying an earnings premium. In the case of ULTI, I would not suggest investors take on that risk.
This article was written by
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (7)
Full disclosure, I’m also a long term holder and beneficiary of ULTIs’ great success during the past 15+ years.
Overtime it’s been easy on SO many occasions to reach the “sell now/over valuation” conclusion of the author.
I agree much of this authors “generic” analysis as it applies to ratios and valuation measures.
What the author fails to provide is an understanding as to what separates (for 20 years) ULTI from other pioneer SaaS providers (leadership at CEO level, best of breed culture recognized by Fortune, Forbes, etc, profitability, growth over long term, client stickiness, best customer service, consistent r&d deliverables, etc).
These are a few of the characteristics that set apart competitors in the gladiatorial world of software services.Where I believe the author strays is a failure to acknowledge the “best of breed growth companies” concentrate on executing the above first and if successful the market rewards with premium valuations.
In the long run successful growth business’ shift focus toward incremental gross and net margins as the business mature.
This is not the case for a company growing annually at 20%+ for past 20 years that barely serves 10% of its domestic market; and that doesn’t even considering global growth prospects of an excellent SaaS provider.Like Medguy; I see $300+ (not in a straight line of course) as ULTI crosses the $1billion sales threshold this year ($941mm in ‘17) enroute to $2 billion!ULTI’s priority concentration on excellence in hiring, training and retaining talent, customer service and putting shareholders (like me) third in line has been rewarding.
