MYOB under the spotlight

Some time after our last review of MYOB, on 25 Apr 06 (Hold – $0.945), one of us happened to meet someone who worked in the company’s Sydney office. As ever, the conversation turned to business matters and the employee’s description of chief executive and largest shareholder Craig Winkler as ‘totally ethical’ was particularly striking. Recent events at the company have given us the opportunity to test that opinion.

Black marks

The tagline on the cover of MYOB’s 2007 annual report asks readers to ‘Look at us in a different light’. It doesn’t tell us which light, though, so we naturally approach the company sceptically. The outright rejection last year of an unsolicited $1.90 cash bid by private equity firm Archer Capital earned management a black mark; a one-page announcement, released months after the bid was rejected, said the offer was inadequate and little else. Perhaps shareholders would have appreciated the opportunity to have their own say on the matter.

A second black mark was earned when the company tried to issue 1.2m options (with an exercise price of $1.63) to Mr Winkler with relatively few hurdles. The proposal was rejected by shareholders, with MYOB’s second-largest shareholder, Guinness Peat Group, reasoning – quite correctly in our opinion – that management was being greedy by issuing options at that price if they really believed the stock was worth more than $1.90.

Hell-bent on expansion

In our last review, we wrote ‘if [the expansion plans] turn sour the company will only suffer a glancing rather than critical blow’. That glancing blow occurred when MYOB’s products failed to get much market share in Europe, and the UK and Irish businesses were sold to larger competitors for a total of $70m.

It seems obvious that MYOB should focus on Australia and New Zealand, where it’s market leader and makes 80% of its revenues, rather than be the also-ran in other markets. But the company seems hell-bent on expanding in Asia, especially China. It hasn’t been profitable there yet, and we wouldn’t punt on it being profitable there any time soon. All the factors that keep potential competitors at bay in Australia work against MYOB when it moves into other markets where it lacks the leadership position.

Business strength

So management deserves some scrutiny. But ultimately the business matters more. Its strength in Australia is undeniable, with a quadrupling in adjusted net profit since 2005. We’ve adjusted for MYOB’s aggressive approach of capitalising software development costs by starting at the earnings before interest, tax and amortisation (EBITA) line then subtracting the year’s development costs, and working down to an adjusted net profit. We think these figures are more useful than the headline profit.

And while adjusted net profit has grown significantly since 2005, as the table shows, it’s remarkable that the capital invested has barely changed over that time. It’s indicative of a very good business, which is generating a growing stream of free cash.

The $65m MYOB has recently borrowed to pay a special dividend shouldn’t worry shareholders. After selling the UK and Irish businesses, the company has net cash of roughly $16m, and this is a business that could support a little debt.

In good company

So what’s the company’s value? At an underlying historic PER of 26, the market appears confident that earnings will continue to grow rapidly for the next few years. It would be a stretch to plan for another quadrupling of earnings, but the possibility can’t be dismissed. A miracle such as the Asian business becoming profitable would help the cause. The danger, though, is that management doesn’t learn from its European experience – it could be pouring more money needlessly down a hole.

We’re not rushing to upgrade MYOB at the moment. If you want to ride the software gravy train, we prefer Infomedia – its business is of lesser quality, but its low share price more than compensates. Current MYOB shareholders shouldn’t fret though. They’re in the good company of some well-known value investors. HOLD.