Hansen upgraded to Buy

Chances are you've recently received a bill from this company, yet you've probably never heard of it. Founded in 1971, Hansen Technologies got its big break in the late 1980s when it won the contract to develop Telstra's new billing system.

Using this as a springboard and with some sensible acquisitions, Hansen now builds and manages customer care and billing software in 45 countries for a range of utility companies, including water, gas and electricity providers as well as telcos and pay TV operators.

Software companies are a dime a dozen, but Hansen has carved out a profitable niche. Whilst a handful of global enterprise application software developers like SAP and Oracle build complete systems that manage everything from the call centre to billing and HR, there are also hundreds of tiny businesses selling off-the-shelf products and countless in-house IT teams managing legacy software.

That's been great for Hansen because whilst it offers global reach and is capable of managing software for large corporations, it's small enough to maintain personal service. When a customer calls, they can still talk to the chief executive. And, unlike Oracle or SAP, Hansen doesn't spread itself thinly; it develops custom solutions and knows billing back-to-front, something its customers appreciate.

Heart of a business

This is a business where detail matters. And nowhere is that more evident than on the bill itself. Take your last electricity bill for example, perhaps charting your on- and off-peak consumption and comparing your electricity usage to your neighbourhood. Then there are the itemised deductions for overdue payments, ancillary services, network usage, GST and, if you're lucky, a credit or two, followed by the total.

This kind of bill is worlds apart from those quarterly envelopes that just told you how much you needed to pay. Hansen's software measures your consumption via smart meters and set-top boxes, calculates fees and billing information, presents the information visually on a bill, sends it to you and processes your payment.

This is software that sits at the heart of a business – its cash flow – and with high switching costs, customers almost never leave: although Hansen has more than 200 customers, you can count the number that have left over the past ten years on one hand. This is a business with significant pricing power.

Customers pay a monthly management fee with a contractual yearly increase. There are also consistent add-on service charges, driven by marketing. Each time Optus advertises a new offer, Hansen's software is updated and the client charged for the change.

Chart 2: Hansen customers

What does all this mean for potential investors? All up, about 75% of the company's revenues are recurring, and they come from a broad spread of utility companies around the world, so they have limited exposure to the economic cycle. But Hansen is still a software company, so it requires few tangible assets to operate. With little need for capital expenditure and captive customers, Hansen generates juicy profit margins of around 20% and converts it efficiently into cash.

Better yet, customers pay for development and growth. Hansen doesn't need to reinvest its earnings to grow revenues because, if a client wants an upgrade or new system, they pay for it upfront.

The downside is that although Hansen retains the intellectual property to reuse with other customers, most solutions are custom made. There aren't the same economies of scale here as there are in selling off-the-shelf software like computer games or Excel. That means margins are unlikely to increase over time.

Adding complexity

But that doesn't mean growth prospects are limited. The trend towards privatising utilities should help because growing product complexity and ballooning data from smart meters favours nimble billing software over stodgy legacy systems. When utilities are privatised, a new billing system is often the first thing on the shopping list.

Telcos and Pay TV operators, another key client group for Hansen, also face increasing complexity. Product variety is exploding, with bills now bundling fixed-line, mobile, internet and Pay TV. And the constant churn of products and special offers requires adaptive billing software and more frequent updates.

However, the customer captivity that gives Hansen its stability and pricing power cuts both ways: those reasons that make it hard for customers to leave also lock potential customers to its competitors.

Hansen only signs up 2–4 new customers each year, so growth is slow and mainly a product of the annual fee hikes. Organic growth, however, is still a respectable 5–7% and we think there's a good chance that figure understates the company's true growth potential.

Acquisition growth

There remains a real opportunity to grow through acquisition. Chief executive and 24% shareholder Andrew Hansen has proven himself in this regard, over the past decade purchasing a number of loss-making businesses cheaply and then stripping out costs and tapping their pricing power.

This highly fragmented industry offers plenty more potential acquisitions along the same lines. And as products become more complex, companies are recognising the benefits of 'selling' their in-house IT team to an external operator.

Despite Hansen's excellent track record, overpaying for an acquisition is one major risk. Given the company's clean balance sheet, there may be the temptation for management to bite off more than it can chew – although Andrew Hansen's large stake in the company means he's unlikely to go empire-building for the sake of it.

The loss of a large account is another risk, although the biggest customer only contributes about 10% of revenue. Large customers also have more negotiating power and therefore tend to be on lower margin contracts; so while a defection might hit revenue by up to 10%, profits would probably fall by less.

Finally, the 25% of revenues that are discretionary will be exposed to the economic cycle and customer spending decisions, with acquisitions and currency movements providing an added swing factor.

Great company, fair price

All up, though, the risks are bearable – so long as we can buy the stock at a reasonable price. So what's a fair price to pay for a business with prospects for steady organic growth and the possibility of supplementing it with favourable acquisitions, not to mention a clean balance sheet and shareholder friendly management?

The company generated revenue of $86m in the year to 30 June and a net profit of $14.8m, or 9.2 cents per share, with free cash flow being roughly the same. That puts the stock on a price-earnings ratio of 17 and a free cash flow yield of almost 6%, although a (fully franked) dividend yield of only 4% is paid.

Assuming annual organic growth of 5–7% over the long term, with room for cluey acquisitions to add to that, total annual returns could comfortably surpass 10% a year. So while Hansen isn't going to be the next REA Group, if you're after reasonable growth and a steady yield, there's a lot to like.

We're making Hansen a Buy up to $1.60, with a recommended maximum portfolio weighting of 4%. It may be worth starting below this limit, though, to allow room to increase the holding if the price falls. Bear in mind also that with several substantial shareholders, the stock is quite illiquid, so be careful of price spikes. If you're patient, you should be able to build a position more cheaply.

Note: We're adding 3,000 shares to our model Income Portfolio and 5,000 shares to our Growth Portfolio at $1.52 per share for a total cost of $4,560 and $7,600 respectively.