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A head in the clouds? by Roger Montgomery

Whoever said accounting was boring has not followed the progress of Xero, MYOB or Reckon over the past year, or considered how technology is disrupting the billion-dollar accounting software market and potentially creating huge winners and losers.

Xero shares have soared almost fivefold this year, capitalising the cloud-based software provider at a staggering $3.7 billion. And like many internet hopefuls, Xero doesn’t make any money.  It lost $17.1 million in the half to September 2013, is yet to have positive free cash flow as it reinvests for growth, and serves 4 per cent of small businesses in Australia.  It has some very smart and well connected backers including Sam Morgan who sold TradeMe to Fairfax and who I can say from personal experience is one of the smartest digital-age operators in Aus/NZ.

MYOB on the other hand has been passed between private equity firms, the last sale for about $1 billion in 2011, and is a rumoured Initial Public Offering (IPO) for 2014. One wonders whether Xero’s nosebleeding valuation might spur MYOB to come to market sooner rather than later.

Then there is Reckon, the subject of today’s report, capitalised at $288 million, and under pressure with a one-year total shareholder return (including dividends) of minus 6 per cent. Price falls have put the well-run Reckon on the cusp of value territory and strengthened its case for a prime spot on portfolio watchlists for long-term value investors.

On paper, Reckon looks ideal for this market. Accounting software provides high-margin, recurring revenue and good earnings visibility, and the company has a handy forecast 4.3 per cent dividend yield. Such stocks have attracted valuation premiums this year given earnings uncertainty in many sectors.

But Reckon faces three key challenges. Short term, it must overcome the loss of its licensing agreement with Intuit Inc for QuickBooks and Quicken desktop products, which ends in February. It has rebranded QuickBook and ReckonBooks and says there has been no effect on revenue so far.

The medium-term challenge is development reinvestment and heightened industry competition. Reckon used to go head to head with MYOB in the lucrative accounting software market. Now it’s up against the impressive Xero, which is growing rapidly off a small base, a larger MYOB, and US accounting software giant Intuit.

The long-term challenge (depending on your definition of “long term”) is becoming a key player in cloud-based accounting solutions. Reckon has taken its time to compete in cloud-based software, but at least has a product, Reckon One, which is yet to earn revenue and is still in Beta testing.

Cloud-based solutions could seriously disrupt the accounting software market. Consider a micro-business owner with fewer than five employees. Its owner pays hundreds of dollar for accounting software upfront, struggles to understand it, and only uses a fraction of its functionality.

The micro-business then meets its accountant, who reconciles and lodges the accounts, provides retrospective advice, and perhaps a few ideas for the coming year. The desktop accounting software means the accounts are kept and maintained by the business, then shown to the accountant -- an old-fashioned way to work in an interconnected world.

In theory, with cloud-based accounting solutions, the micro-business pays a small monthly fee and, thanks to the internet, discusses the accounts with its accountant in real time, via the cloud. The accountant or business adviser can provide strategic advice and potentially earn new fees. Like all great innovations, cloud-based accounting software solves problems for different stakeholders.

For the micro-business that struggled with desktop accounting software, or kept its basic accounts on an excel spreadsheet, cloud-based accounting has great potential. It’s a reason why one investment bank earlier this year dubbed Xero the “Apple of Accounting”, such is its disruptive potential.

The other attraction is market size. With 500,000 micro-businesses in Australia thought to use spreadsheets to maintain their financial accounts, and more than a million small businesses, there is scope to grow market share in a large, fragmented business-services market.

The other appeal of cloud-based accounting software is the business model, scalability and sustainability. As an online product, it offers companies a “capital-lite” business model that can be quickly taken to new markets. Xero has already entered the challenging US and UK markets and has less than one per cent share. Even a few percentage points is a big deal given the size of those markets but keep in mind the price of the shares currently anticipates many millions of customers, which Xero does not yet have.

Sustainability comes through the “stickiness” of accounting software. In terms of a sustainable competitive advantage it’s referred to as switching costs.  Larger businesses cannot function without the software and they tend to stick with the same product for longer periods because of the high perceived cost/inconvenience of switching to a new provider. The benefit to the business of the inconvenience to the customer, is the ability to charge rising prices.

The experience of other industries – print media is a good example – shows the damage technology-based insurgents such as Xero can inflict on incumbents like Reckon over time. The insurgent typically has an early-mover position that is hard to catch, and vastly lower costs. Strong cash-flow growth lets it reinvest heavily to accelerate growth and consolidate its market position.

The fear is the accounting software industry will eventually boil down to two players: a market leader that has a significant gap between it and the number two player, and is light years in front of the third.  Several other industries disrupted by web-based rivals have developed this way. With four strong competitors, the number one and two spots in accounting software will be hotly contested.

Understanding these industry dynamics is critical when assessing Reckon. Backing incumbent companies in industries that are increasingly digitalised can be a high-risk strategy. And with so much competition on the way, investors should ask: are Reckon’s best days behind it?

Reckon has plenty of challenges, but never write off exceptional companies. The key question is whether its valuation reflects these changing industry dynamics and if “market noise” about cloud-based computing and Xero has created a buying opportunity in Reckon.

There is still a lot to like about Reckon. Its A1 quality rating reflects growing Return on Equity (ROE) from 23 per cent in FY05 to almost 40 per cent in FY12. Reckon has been A-rated for a decade and its performance judged exceptional for most of that time.

The balance sheet is strong: net-debt-to-equity was 20.7 per cent at the end of FY12 and considered low risk. The number of issued shares fell from 132 million in FY11 to 128 million in FY12 after a share buyback. At least Reckon believes its shares are underpriced.

The market expects Reckon’s high ROE to continue. A consensus of eight analysts has the ROE dipping to 35 per cent in FY13, then rising to 41 per cent in FY14 and FY15 – still an exceptional return and a belief that Reckon can defend its market position and maintain high returns on shareholder funds. Of course it pays to remember that analysts are, as a group, overly optimistic.

Reckon’s market position will be hard to shake. As mentioned earlier, small and medium-size enterprises usually take a lot of convincing to change service providers – and the SME market can be a deceptively hard one to crack. That Reckon has so far suffered no revenue fallout from the ReckonBooks re-branding shows the strength of its customer relationships and brand.

Moreover, it has 600,000 registered business customers, 100,000 repetitive customers who buy a range of solutions annually, and it partners with more than 6,000 accounting practices. Far from being crunched by cloud-based computing, Reckon could deliver an internet-based software package, assuming it gets its product right, to a large existing customer base, and target new markets.

Its software is popular with established small and mid-size enterprises. Cheaper cloud-based accounting software might have more appeal to micro-businesses with a founder and perhaps a few staff, which are a key target market for Xero, but the same market might be limited in terms of what they can afford to pay, which in turn, could limit that company’s pricing power.

Skaffold forecasts Reckon’s intrinsic value will rise from $1.51 in 2013 to $2.10 in 2014 and $2.31 in 2015. Always seek companies with large forecast increases in intrinsic value, for the share price usually follows it higher over time.

At $2.11 and after meaningful share price declines, Reckon is right on value territory, but long-term investors might want to wait for even lower prices to ensure a sufficient margin of safety and carefully assess the intensifying industry competition.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!