Hansen: Beyond the headlines

Hansen Technologies isn't a software company – it's a utility company that happens to deal in software. A few days ago, we explained why the company's recent profit downgrade was a minor irritation, not a disaster (see Hansen's first blunder). We won't go over those points again here but suffice to say that the issues are mainly temporary or already solved. 

The stock has fallen another 10% since then and it's now hovering around our Buy price. If, like me, you prefer boring cash generators to glamorous tech stocks, then Hansen may be for you.

Hansen makes billing and customer information system (CIS) software, which manages the cash flow cycle and customer relations needs of water, gas and electricity utilities, telecos and cable TV providers. If you're an Optus or Energy Australia customer, Hansen prepares your monthly bill.

Prisoners of software

Here's the great thing about Hansen: the company's customers are more accurately described as detainees. 

Hansen's software is responsible for collecting consumption data, calculating fees and billing information, producing bills for customers, processing payments and managing debt collection. It essentially becomes a utility's cash flow engine.

The level of complexity means that for a utility to install new billing software, the process can take a year or two – or six, as Origin Energy discovered when it tried to switch from Hansen's main competitor, Gentrack. Changing providers also frequently carries a seven-digit price tag. Any mistakes during the transfer and the utility faces cash flow problems and a customer relations nightmare, so executives don't like to tinker.

With this in mind, it's no surprise that Hansen's customers are ‘sticky'. They may not be happy with Hansen every minute of every day, but the risk and cost associated with switching providers is so high that only a handful of Hansen's customers have ever left the company in its 40-year history. What's more, that stickiness is likely to increase further as software requirements become more complex.

Sticky customers are good for two reasons. The first is that it gives Hansen significant pricing power and an underlying profit margin of 19%. Annual price escalations built into its contracts also ensure steady – albeit slow – organic revenue growth.

Sticky customers mean a high proportion of recurring revenues, too. Around two-thirds of Hansen's income is ‘annuity-like', including yearly contracted payments, licence fees and consistent add-on service charges. Each time Optus offers a new promotion, for example, Hansen's software is updated and Optus is charged for the change.

The rest of Hansen's revenue is from one-off projects and support services – say, building a special feature for a customer. This discretionary income component is arguably the key risk when investing in Hansen, as it can bounce around significantly from one year to the next. Management expects flat revenue in 2019 due to a decline in one-off project revenue, despite continuing growth in underlying recurring revenue.

You've seen how the share price reacted to last week's news but it could be worse. During a recession, it's conceivable that 30% of Hansen's revenue would evaporate if utilities delay upgrading their systems. Over the long term, however, the ebb and flow should even out, and what's left is a steadily rising tide. 

Growth ahead

Unfortunately, while those rusted-on utility customers all but guarantee that Hansen will be doing more business 10 years from now, it is equally difficult for the company to dislodge customers from competitors.  

Nonetheless, Hansen is likely to benefit from a worldwide trend towards privatising and deregulating utilities. Roughly a third of utilities worldwide still use outdated internally developed billing systems that are more than 10 years old. Privatisation and deregulation tends to encourage product variety and more price points, which demands flexible billing software. The increasing complexity should encourage utilities to switch to third-party billing providers, so they can benefit from their specialised expertise and economies of scale. 

Hansen's organic growth rate is in the mid-single digits, but the company has added to this by making sensible acquisitions. Over the past five years, revenue has grown at around 25% a year while earnings per share have risen a more subdued but respectable 10% a year. 

Cash flow

While Hansen is best thought of as a utility service for utility companies, it still enjoys the trappings of running a software company. 

Hansen's main expense is paying its software engineers, so the company requires few tangible assets to operate. Hansen doesn't need to reinvest its earnings into updating old equipment and factories, so profits convert efficiently into cash – over the past five years, Hansen generated a cumulative net profit of $90m and free cash flow of $93m. 

Better yet, Hansen doesn't need to reinvest its earnings to grow revenues because when a customer wants a new system, they pay for it upfront – and Hansen retains ownership of the software and intellectual property developed as part of building the system, so ideas generated for one customer can often be used to enhance products for other customers.

Time to buy

This is how we see Hansen: a core business of sticky, slow-growing recurring revenue – spiced up with one-off project sales – that comes from a broad spread of utility companies around the world with limited exposure to the economic cycle. 

Hansen's long-term outlook has changed very little from last week. What has changed is its share price. 

Management expects underlying earnings per share of 19.0 cents in 2018 – up 24% compared to last year – putting the stock on a forward price-earnings ratio of 16 and a forward free cash flow yield of around 5–6%. The company also offers a fully franked dividend yield of 2.0%.

Earnings probably won't grow much next year if one-off project revenue falls, but we expect earnings per share to grow around 5–7% a year over the long term. At today's share price, total annual returns might come in around the 10% mark, which we think is a fair return for a business of Hansen's quality.  

Hansen has defensive utility customers held captive by high switching costs, it has pricing power, and plenty of free cash flow to fund acquisitions, buybacks, or dividends. Add to this high returns on capital, decent growth prospects, negligible debt, and management owning a 20% stake in the business.

With the stock fractionally below our Buy price, we're happy to start building a position slowly and we're upgrading to BUY.

Note: The Intelligent Investor Equity Growth Portfolio and the InvestSMART Small Companies Fund own shares in Hansen Technologies. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in Hansen Technologies.