|Shares Out. (in M):||207||P/E||19.8||17.4|
|Market Cap (in $M):||6,467||P/FCF||19.8||17.4|
|Net Debt (in $M):||2,388||EBIT||575||627|
|Borrow Cost:||Available 0-15% cost|
SS&C Technologies is a software company hiding both secular and cyclical challenges behind endless acquisitions, 44 in total since 1995. With the anniversary in Q3/2016 of its largest acquisition ($2.6 billion for Advent Software), we believe that the façade of organic growth will soon be dismantled, and investors will not respond kindly.
Latticework did an excellent job describing SSNC’s business in a bullish write-up earlier this year (3/22/2016) – so refer to that for more detail. In brief, SS&C Technologies provides software products and software enabled services to financial services providers throughout the world. Over 90% of revenues are said to be recurring in nature. Those revenues are tied to portfolio management and accounting, with fees typically tied – at least in part – to assets under management. The remaining revenues include software and services for trading/treasury operations, application software, and loan management/accounting. The market for financial services software is relatively competitive, but high switching costs make the customer base somewhat “sticky”. SSNC competes with both large-scale and local players that are privately held, as well as with internal IT departments at large financial services firms. Approximately 50% of revenues are derived from alternative asset end markets, or hedge funds, private equity, and fund of funds. As readers are well aware, much of this customer base is facing unprecedented redemptions and/or the need to renegotiate its own fees downward. It seems unlikely to us that this pressure can be more than offset by increased services resulting from the Dodd-Frank Act which has been in effect for over six years.
Investment Thesis: Organic Growth is actually negative, likely due to the secular pressures in SS&C’s end markets; that negative growth will become obvious to the market in the next quarter.
In Q4/2015, SSNC reported organic revenue growth of just 50 bps, well below expectations. At that time, management insisted that the recently-acquired Advent products were more than making up for the difference and that “the problem is, it’s not counted as organic. It will be counted as organic starting in July of 2016 and that will naturally help our numbers too”.
We believe that this was entirely misleading.
Remarkably, however, the combined businesses grew an estimated +9.2% in the third quarter of 2016, just as the Advent revenues rolled into the organic growth number. As a result, SSNC reported organic growth of +4.5% - below Street expectations, but well ahead of where the two combined businesses had been trending over the previous four quarters. So how did they do it?
For context, we highlight the Company’s revenue recognition policy that “The Company’s payment terms for software licenses typically require that the total fee be paid upon signing of the contract. Maintenance services are typically due in full at the beginning of the maintenance period” while “professional services and software-enabled services are typically due and payable monthly in arrears”. In other words, 1/3 of revenues are paid up front and 2/3 are paid monthly after services have been rendered.
A change to how the Company discloses its revenue mix renders it difficult to calculate (a) days of deferred revenue relative to prepaid products and services only, and (b) days of receivables relative to post-paid products and services only. Furthermore, the allocation of what’s called a “deferred revenue haircut” in the Advent acquisition makes it clear that the two revenue streams are not as distinct and clear cut as the revenue recognition language suggests. As a result, we look at net days of deferred revenue (days of deferred revenue less days of accounts receivable).
What we find is that the combined Advent/SS&C companies historically displayed a very consistent, albeit seasonal trend, in net deferred revenues. That trend began to deviate significantly after the merger, and just as Advent-only revenues began to see accelerated growth (+7.5% in that same Q4/2015 wherein organic growth was just 0.5%). That +7.5% growth in Advent-only revenues may have been encouraging were it not for how it was achieved – i.e. by the aforementioned draw down of deferred revenues.
Excluding that balance sheet draw down, we estimate that the two combined businesses’ revenue (excluding other acquisitions) declined by 2.3% in the first three quarters of 2016. Moreover, an additional $50+ million will need to be drawn down in order to meet organic revenue growth expectations for Q4/2016. This would leave an astonishing one day of net deferred revenue on the balance sheet for a business that purportedly gets paid upfront for approximately one third of its revenues. Driving revenue growth through balance sheet draw-downs is simply not sustainable.
Valuation & Risk Reward
SSNC is currently trading at approximately 12.5x EBITDA, but looks more favorable on a P/E basis at 17x F2017 ‘adjusted earnings’ (this favorability is due to 4.1 turns of debt as of Q3/2016).
The bull case, as laid out by latticework and others, is that “organic growth should remain stable at 4% the next 4 years” which, combined with meaningful capital deployment should result in an 18x multiple on 2018 EPS of $2.50 or $45 /+40% in a year.
More modest assumptions around capital deployment, but similar assumptions around organic growth, argue for $2.15 in F2018 EPS (consensus), or $39/+22% in a year. It is no wonder, then, that 21% of the float is owned by hedge funds and there are 10 buy recommendations on the shares (2 holds, 0 sells!).
The problem with this picture, though, is that that if organic growth remains stable it will be negative 2.3%, and there is nearly nothing left on the balance sheet to plug this hole.
Bulls have argued that in the 2008/09 time frame, organic revenues declined only 5-6%, demonstrating the resiliency and inherent growth of the model. But posting negative growth in today’s environment should call that resiliency, and premium multiple, into question.
F2017 expectations call for revenue growth of +8.9%, of which we estimate 4% is expected to come organically. We conservatively estimate organic revenue of 0% for 2017 (on stated organic revenue of 2-3% in 2016), which is far from the 5-10% organic growth algorithm management claims. Using our assumption for 0% organic plus 4.9% inorganic, we see 2017 EPS of $1.80 (versus the Street at $1.93). At a more modest multiple of 11x EBITDA and 13x earnings we see downside of nearly 30% to the stock.
As this target assumes flawless execution on cost synergies, there is further downside should the company underperform on some of those goals against a tougher revenue back-drop. While no execution risk is embedded in our estimates, we do highlight that revenue growth at Advent may be moderating since the acquisition by SS&C.
Without getting too far into the technicalities of deferred revenue haircuts, we highlight that the remaining amount under the Advent haircut was $51.2 million at 12/2015 and management indicated that “90% of it will be gone by the second quarter”. However, at Q2/2016 the total haircut balance was $20.9 million, not the anticipated $5 million. While a piece of the excess pertains to Citi and Primatics, we believe they account for $9 million at the absolute most. The unexplained $7 million could signal implementation delays at Advent.
SSNC faces a number of risk factors that have plagued stocks -- hedge fund crowding, heavily adjusted EPS, financial leverage in an operationally levered asset, and trust in a CEO/founder for his capital deployment acumen. If history is any indicator, even our double digit EBITDA multiple may prove to be too generous when the Company’s negative organic growth rate comes to light.
Catalyst & Risks
Q4 earnings release and conference call.
The above analysis involves detailed forensic work to account for both the deferred revenue haircut on the Advent acquisition (the adjustment for which we believe is legitimate) and the impact of other acquisitions on the balance sheet and P&L (which we exclude). We believe that it is precisely the need for such forensic work that has served to obfuscate results in YTD2016. However, with the balance sheet “cookie jar” almost out, SSNC will need to either miss the fourth quarter, guide down F2017, or both. It is difficult to imagine an acquisition, nor an accounting “trick” of such magnitude that would allow the Company to continue talking down organic revenues while still not talking them down enough.
Having said that, the CEO’s material wealth is tied to SSNC’s stock price and he has every incentive to make the numbers work. And to quote that CEO on the Q2/2016 earnings call: “So we're not really trying to manipulate those numbers, those numbers come in where they -- where it's best for our customers and same thing with Citi…”
Q4 earnings release and conference call