In their heyday, newspapers made wonderful businesses – and were a particular favourite of Warren Buffett. They were often regional monopolies; readers had few other options so they could raise prices without risking the loss of customers. Expenses were funded by a sticky subscription paid upfront, which made for steady cash flows; and they consumed relatively little capital, and so offered high returns on equity.
Of course, the internet has put paid to the monopoly part of that, and the rest has collapsed in a heap. But there are other businesses around now that have similar characteristics to the newspapers of old – but whose customers might find it harder to move elsewhere.
Enter Hansen Technologies. The company makes billing and customer information system (CIS) software, which manages the customer relations and billing cycle needs of telcos and utilities. If you’re an Optus or Energy Australia customer, Hansen prepares your monthly bill.
The company needs almost no capital to operate – it’s just a collection of geeky software engineers, laptops and the odd roof over their heads. Employee salaries make up two-thirds of total expenses.
Capital light business model; lots of free cash flow
Annuity style revenues and captive customers
Customers fund growth and R&D
This has a couple of benefits. The first is that Hansen doesn’t need to keep reinvesting profits in upgrading expensive equipment, so free cash flow over the past five years has matched net profit almost one-for-one.
Compare this to, say, Qantas, which must constantly upgrade its aircraft using last year’s profits (if it should be so lucky). This leaves little cash to distribute to shareholders. Hansen, on the other hand, can direct its cash flow to shareholders or use it to make acquisitions.
It also means the balance sheet is squeaky clean. As of December, the company had net cash of $24m and a book value of around $50m after deducting intangibles associated with acquisitions. Most of the cash, though, isn’t necessary for operations, leaving Hansen with capital employed of around $25m and a return on that capital of more than 100%.
The other benefit of running a software business is that it’s immensely scalable. Hansen gets paid according to the number of end-customers being billed using its software – and at the last count Hansen’s 500 or so employees were billing more than 100 million of them a month.
Hansen doesn’t have as much operating leverage as other software makers like Microsoft – whose operating systems are built once and then copied millions of times – because a large portion of Hansen’s software is tailormade for the customer’s specific needs. Still, as it adds customers – and its customers add customers – a little more revenue from each additional sale falls to the bottom line because revenue can grow more quickly than expenses, thanks to its relatively fixed cost base.
Keep the code
Like a newspaper subscription, when a customer wants a new billing system they pay for it upfront. This shows up as $18.1m of unearned income on Hansen’s balance sheet, which reduces the company’s working capital needs.
An upfront payment model is also a valuable source of funding for growth, because it means Hansen doesn’t need to make costly investments in staff or infrastructure before it gets new business – the customer gives Hansen the cash first, so the company has rarely needed bank debt or capital raisings to grow. We saw this merrily in action in the 2015 financial year when a few large upfront payments for future projects caused free cash flow to double to $29m, compared to just $17m in net profit (see chart 1).
What’s more, Hansen owns the intellectual property developed as part of upgrading the customer’s software, which can then be used elsewhere when building a different customer’s system. In other words, Hansen’s customers aren’t just funding the company’s growth – they’re also funding a goodly proportion of its research and development expenses.
For a company with few tangible assets that’s printing money, its value lies in its future cash flows. The question then becomes how wide is the moat that defends those cash flows.
Imagine that you’re Energy Australia’s chief executive and someone offers you a new billing system for 10% less than the cost of your current model. Would you bite?
Keep in mind that it can take a year or two for a utility to install new billing software (or six years, as Origin Energy recently discovered). Also remember that Hansen’s software is a pillar of your cash flow management, marketing and customer relations departments.
The new software might save you a few pennies, but if there are any stuff ups during the change over, you’re going to have cash flow problems and three million grumpy customers – not to mention an uncomfortable dose of career risk. And who's to say Hansen won't add some functionality in a year or two's time to tilt the value equation back into its favour.
Hansen isn't just selling software, it's selling a service relationship; and of its 200-plus relationships, only a handful of customers have ever left. They may not be happy with Hansen every minute of every day, but it’s a big deal for a utility to change billing software providers. That doesn’t mean things can’t change if a truly superior offer comes along, but it does mean that there’s a lot of continuity in this business.
With this in mind, Hansen has significant pricing power – it has an operating margin of 25% – and these sticky customers also ensure highly recurring revenues. At least 70% of Hansen’s income is recurring, including things like yearly contracted payments, licence fees and support services.
Hansen is a rare breed: it has the high returns on capital of a software maker, but the customer captivity and pricing power of a utility. The share price, though, is up 132% since we first upgraded the stock a year and a half ago. The investment case is definitely shifting.
So what returns might shareholders earn from here? Management expects revenue of around $148m for the year to June, with earnings before interest, tax depreciation and amortisation of around $44m – a 70% increase on 2015.
If those goals are met, net profit should reach around $27m using historical margins, or 15 cents a share. We expect free cash flow to be roughly the same, putting the stock on a free cash flow yield of around 4% using 2016 estimates, although the dividend yield is only 1.6%.
Unfortunately, the customer stickiness associated with billing software applies equally to Hansen’s competitors, making it hard for Hansen to pry customers away from them. Acquisitions have been the main source of growth over the past five years and it’s only fair to assume organic growth of 4–6% over the long term due to contractual price increases and the odd new customer.
As a result, we only expect total annual returns in the high single digits – though more smart acquisitions could push that above 10% (with 2017 shaping up nicely thanks to a tentative agreement to buy PPL Solutions). Still, that’s a fair return for a high-quality software company and we continue to recommend you HOLD.