Last week accounting software provider Reckon started a new chapter, with shares now trading separate to the Document Management segment, which will be listed independently on London’s AIM exchange next month as “GetBusy”.
There are a number of aspects to the demerger to consider, the primary one being that it makes the core software segments, Business (SME accounting) and Practice Management, more attractive to potential suitors. We also see a dramatic increase in free cash flow over the next 18 months.
The Document Management segment included the US-based Smart Vault and UK-based Virtual Cabinet businesses. These businesses are in their early stages, so despite strong revenue growth, Document Management FY16 cash flow was negative $2.5m due to elevated software development and marketing investment. The demerger provides more flexibility to pursue strategies tailored to individual segments, and will also improve RKN’s financials.
As indicated in its FY16 result presentation earlier this year, management plan to dramatically reduce capital expenditure within the core business from FY18 (from 23% of revenues to around 15%). This follows a period of heavy investment to develop its SaaS SME accounting product, Reckon One, as well as to ‘cloudify’ parts of the Practice Management suite.
Meanwhile, RKN has nearly finished the multi-year process of moving all of its customers from perpetual licenses to subscriptions.The new fee structure nullifies part of the attractiveness of subscription-based SaaS competitors, and also sets the company up for recurring revenues to translate nicely to free cash flow with future capex reductions. It seems to have been a good move because Reckon actually maintained its 100,000-strong Business (SME accounting sofware) customer base in the face of explosive growth by larger rivals MYOB and Xero.
Effectively, free cash flow could more than double from $6m in FY16 to around $15m in FY18 as a result of the demerger and reduced capex. This compares reasonably well to RKN’s post-demerger enterprise value of $220m, which is the current market cap of $170m plus net debt of $50m. The corresonding free cash flow yield is about 7%, which is not bad.
But there’s more to the story on the valuation front. As followers of RKN might be aware, a commonly held theory is that RKN’s stronger Practice Management segment almost underwrites RKN’s market value (at the current share price of $1.52). This arguably implies a ‘free option’ over the more competitively-challenged Business segment.
To test this theory we discuss some of the specifics of each segment below.
 
Practice Management segment
Almost all accounting practices use Practice Software. RKN’s key Practice Management product, APS, dominates the larger end of the market with 70% share the top 100 accounting firms, including and 3 of the ‘big 4’ professional firms (PWC, Deloitte, and KPMG). Although it’s a mature business, APS clients are very sticky due to their larger the workforces and the deep integration of APS software with daily operations. APS clients have high switching costs.
Using FY16 figures we can estimate the valuation for the Practice Management division as a stand-alone (assuming capital expenditure falls to the targeted 15% of revenue):
 
 

Figure 1: RKN Practice Management valuation estimate
Source: StocksInValue
 
Business segment
The back of the envelope calculation above would imply the remaining enterprise has a market value of about $80m. To be a ‘free-option’, one would need to apply an aggressive multiple to the Practice Management business, say 20+ times instead of 15.
The reason for approaching RKN’s valuation by parts is that the Business segment’s future is highly uncertain, whereas the Practice Management should maintain its strong position for many years to come. The Business segment is worth somewhere between zero and a whole lot. In our view the market is probably getting it right at the moment, so we’re not in the ‘free option’ camp.
 

Figure 2: RKN, MYOB, XRO revenues (FY12 – FY16) *XRO has a March FY balance date; RKN and MYO have December balance dates
Source: Company financials
 
It is, however, comforting to know that RKN’s Business revenues have remained more or less flat despite exponential-type growth by Xero and MYOB. What this means is that competitor growth mostly reflects market growth, rather than customer migration from RKN to competitors. The addressable market for small business accounting software in Australia and New Zealand includes approximately 3 million SMEs, however around 2 million use accounting software, and closer to 1 million are paying users. There is a long runway for increasing adoption of accounting software as well as converting non-paying users of legacy products. Industry revenues could potentially double over the next decade.
Market growth has been driven by SaaS providers such as Xero and MYOB. RKN had limited opportunities in this market until earlier last year when essential Payroll functionality was added to its own SaaS product, Reckon One.
Importantly, increasing software adoption is largely occurring across more price-sensitive micro businesses (1-4 FTEs). Reckon One rates highly in terms of functionality in this market segment, which doesn’t require overly sophisticated software, and is marketed at a disruptive price point that will be difficult for larger players like Xero or MYOB to match.
The emerging risk for RKN is the increasing investment by larger competitors in artificial intelligence, with the aim of automating accounting functions and potentially assisting accountants with advising clients. RKN’s capital expenditure of $23m pales in comparison to Xero (NZ$120m), MYOB (A$56m), and US giant Intuit (US$250m), which is taking on Xero in its home ANZ market this year. The resulting functionality gap may be too much for RKN to bridge.
We’ll be keeping an eye on RKN to see if opportunity presents following the demerger. It looks fairly priced at the moment.
 

Figure 3: Adopted valuation metrics for RKN
Source: StocksInValue