If you had to bet on one company to win the accounting software wars, you'd probably choose Xero. From a standing start in 2007, its cloud-based accounting software has revolutionised the industry and it now has nearly 500,000 subscribers across Australia and New Zealand alone. By contrast, second-placed MYOB has a mere 170,000 'online' customers (that is, not all of whom are using its cloud-based software).
With software typically being a scale business, companies who have a first-mover advantage like Xero can utilise their industry-leading revenue to outspend competitors on development and so maintain and even increase their dominance. This is particularly the case if there are network effects – such as with Microsoft's Windows and Office software – as this often leads to a winner-take-all situation.
Some people might pick MYOB, but we're fairly sure very few would choose Reckon. For those brave souls who did, a dividend cut and declining earnings in 2016 might persuade you to think twice. Yet we're about to recommend you buy the stock in any case.
More than just small business accounting software
Practice Management segment a gem
Document Management growing quickly
It's true that the company’s Business unit, which sells its small business accounting software products Reckon Accounts and Reckon One, is up against it. Competitors such as Xero, MYOB and Quickbooks Online have better products and greater resources too.
While Xero has offered a cloud-based product since 2007, Reckon finally released its version, Reckon One, in 2014. Unfortunately, it had to release a ‘redesigned from the ground up’ version a year later after Microsoft stopped supporting the platform on which Reckon One was written. Reckon One still lacks many of the features of its competitors, has far fewer compatible third-party apps, and only recently incorporated a Payroll module.
On the face of it, these weaknesses and the economics of the software industry would suggest Reckon customers are switching to competitors in droves. Yet they aren't and we think there are two main reasons why.
Firstly, even with the likes of Xero offering to convert your data for free, the costs of switching remain high. Reckon One is sensibly priced as the low-cost competitor in the industry, which means cost savings are non-existent should you wish to switch to, say, Xero. Moreover, no matter how many bells and whistles it may have, learning a new system and layout is daunting at the best of times. There’s even less incentive to do so when you’ll actually be paying more if you switch.
So in the absence of a price war, we think it will be easier for Reckon to convert its desktop users to Reckon One than for competitors to steal its customers.
Helping the company in this regard is the move to a subscription-based model. Instead of forking out hundreds of dollars every three to five years for the latest version, under the subscription model users pay a regular fee and automatically receive updates over the internet. With subscriptions now contributing 80% of revenue, this should help Reckon retain customers and switch them to its Reckon One product.
The subscription model also increases the lifetime value of each customer and, just as importantly, increases the size of the market (see Chart 1). For example, around half Xero's customers have never previously used accounting software and if the figures quoted by both companies' managements are accurate, there should be more than enough new customers to keep Reckon, Xero, MYOB and others happy (and their businesses profitable). Moreover, Reckon's low-cost strategy will help it exploit a niche targeting customers who don't want to pay up for MYOB or Xero.
Reckon One was recently launched in the UK and should be released in the United States in coming years. So while we think Reckon will struggle to catch Xero and others, we think it can maintain a fairly profitable business in this segment.
This brings us to Reckon’s Practice Management segment, which to us is the most attractive part of the company.
Accounting for around 35% of the segment’s revenue, Reckon Docs offers company registration and compliance services, assists in setting up trusts and self-managed super funds, employment contracts and other services. This business has grown revenue at 9% a year since 2011 and nicely complements this segment’s other major businesses, Reckon APS and Elite. These businesses offer practice management software for larger and small-to-mid-sized accounting firms respectively. Amongst other things, this software helps accounting firms manage clients and jobs, allocate employees, manage billing and debtors, and prepare clients’ financials and tax returns.
Here Reckon APS is the market leader. It offers the widest variety of features and is the only provider that can take data from almost any software provider – whether Reckon, MYOB, Xero, Quickbooks Online or others – and whether desktop or cloud-based and integrate it into an accounting firm’s software. This helps counter pressure from competitors who use accountants to market their small business accounting software with the idea of benefitting from network effects. For example, 70% of Xero's customers in Australia are obtained via its accountant partners.
So it’s not surprising that the number of paying users (or ‘seats’) for Reckon APS has grown from 42,000 in 2011 to 90,000 at 30 Jun 16 (see Chart 2), a compounded annual growth rate of 19%. Like in the Business unit, the move to a subscription model has increased the size of the market for practice management software. Reckon has also won market share from competitors such as MYOB and CCH: it now has four out of the top five accounting firms in Australia and 70 out of the top 100 firms in Australasia as customers.
This software is a critical part of accounting firms' businesses and so switching costs have traditionally been high. While the move to a subscription-based model has lowered them due to the reduction in upfront licence and consulting fees, APS remains the market leader, meaning the bigger accounting firms are already getting most of the features they would receive if they instead switched to the cloud. In addition, the bigger the accounting firm, the greater the switching costs in both time, money and employee training to move to a competitor even if the cloud-based products offered by Xero and Intuit (owner of Quickbooks) weren't inferior, as they are currently.
Still, we expect this segment to migrate to the cloud eventually, which is why Reckon is investing in developing APS Cloud. While it could mess up the transition, it has even more favourable dynamics supporting it here than in the transition to Reckon One.
Rounding out Reckon's business is its fast-growing Document Management segment, whose Virtual Cabinet and SmartVault products allow professional firms to store documents securely and share them with clients. As well as exploiting the move to a paperless office in their home countries of the United Kingdom and United States respectively, there should be ample opportunities to cross-sell these products to Reckon’s existing customers in Australia and New Zealand.
After buying SmartVault in January 2016, Reckon is cranking up its development spending here as well, to integrate the two businesses and produce a cloud-based document management solution.
Increasing amortisation from the increased development spending here and in other segments – Reckon capitalises and amortises this expenditure over three to four years – and rising marketing expenses will depress headline earnings in 2016 and potentially beyond. These are necessary expenses, of course, and there is a risk that the hoped-for increase in revenue doesn't eventuate and/or the development spending remains elevated rather than returning to more 'normal' levels of around 14% of revenue in 2018 as management has suggested.
|Six months to 30 Jun||2016||2015|| /(–)
|U'lying EBITDA ($m)||21.1||20.2||4|
|U'lying NPAT ($m)||10.7||9.9||8|
|U'lying EPS (cents)||9.4||8.7||8|
|Interim dividend||2 cents, unfranked,
ex date 16 Aug 16
The impact of these expenses means we think the best way to value Reckon is by looking at each segment separately.
The Practice Management segment's dominant market position and good growth prospects make it the most valuable part of Reckon. Given its quality, we've applied a multiple of 12 to its $12m in operating profit to value it at $145m, or around two-thirds of Reckon's enterprise value.
Small, fast-growing businesses like the Document Management section are always hard to value, particularly when their earnings are being reinvested to help them grow. Its $7.3m in revenue over the past six months is 46% more than in the first half of 2015 but its has of course been helped by the acquisition of SmartVault. We estimate it will generate around $15m in revenue in 2016 and for valuation purposes assume a more moderate growth rate of 15-20%. Other listed cloud-based software companies with similar revenue growth rates are selling for around three to four times revenue so using a similar multiple for Reckon values this segment at around $50m. However, this could vary widely depending on how it performs in coming years.
This leaves us paying around $30m for the Business unit which recorded $15m in operating profit over the past year. If we're wrong and this segment does fade away, then it could be worth less than this or even zero in a worst case scenario. However, management has a history of running the business for the benefit of shareholders – the CEO and Chairman own around 17% of the company between them – and so we'd expect losses to be cut and excess capital to be reallocated to other segments or returned to shareholders.
On the other hand, if things go well and this segment increases its earnings then it could be worth much more, in turn potentially pushing the value of Reckon beyond our suggested Sell price.
All in all, while there are risks, we think there is a margin of safety at current prices. As ever we suggest you buy in stages to take advantage of any price falls and we recommend keeping to a maximum portfolio weighting of 3%. With those provisos, we’re upgrading Reckon to SPECULATIVE BUY.