The risk management property of redundancy is rarely caught in the financial media flow, which is a shame because it’s extremely useful in investing. A simple awareness brings risks and opportunities previously ignored into focus.
Redundancy is the excess capacity or capability that enables systems to withstand or exploit volatility. It gets little air time in finance probably because the concept seems boring. The state or condition of a business is simple to understand and seemingly there’s not much debate to be had on these matters.
Indeed, projections and where one sits against consensus usually takes centre stage. Recall earlier this year the buzz around BHP and its dividend. Now debate rages on how the bad debts cycle unwinds for banks.
Powers of prediction are revered because resolving complexity in economic systems is difficult. Commentators largely compete on this basis but too often it gets in the way of more important information.
As a starting point what’s more useful: someone’s out of consensus view of a business’s earnings next period, or a description of how the business is positioned to cope with unusual events on the upside and downside? This is an important distinction that ties into how we perceive risk. The hierarchy in analysis matters.
For example, commodity-type businesses like our banks have the opposite of redundancy due to high levels of debt, and will remain exposed to negative shocks at this point in the cycle regardless of whether the next reported earnings are better than expected. In this context an investment strategy based on out-predicting consensus can bring one to miss the forest for the trees.
The first point of call should be to identify layers of redundancies that can fuel compounding growth. The key ingredients are:

  •        Net cash balance (ideally) or at least highly manageable amounts of debt
  •        Pricing power
  •        Above-average management that are aligned with shareholders
  •        Industry capacity
  •        A reasonable share price

Time is often the friend of businesses with the above attributes, and in the presence of volatility they’re more likely to grow stronger. In a sense redundancy can be viewed as an aggressive stance, rather than a waste of excess capability.
So, let’s compare two companies that pass this qualitative filter, which are enterprise software providers Technology One (TNE) and Objective Corp (OCL).
TNE’s and OCL’s software are integral components of their customer’s (local governmnts, utilities, financial services, healthcare providers) IT infrastructure. Although TNE is much larger with a market capitalization of $1.7bn compared to OCL’s market cap of $160m, both share similar characteristics and have followed remarkably similar trajectories since starting out in 1987.
TNE has a broad offering covering a business functions ranging from asset management and financials to enterprise content management (ECM) and human resources, while OCL specializes in ECM, collaboration and process management systems. Essentially they digitally capture, manage and exchange business-critical information, in many cases for customers with specific regulatory requirements. Both compete with much larger global players including IBM, Oracle and SAP.
Due to the deep integration and mission critical nature of enterprise software the industry is characterized by high switching costs and sticky customers. TNE and OCL have enjoyed retention rates above 98% for the last decade.
Returning to the concept of redundancy, both companies have maintained net cash balance sheets since listing in 1999 (OCL) and 2000 (TNE). On 31 December OCL reported net cash of $20m and TNE reported net cash of $45m at its 31 March balance date.
The strong balance sheets provided a capital buffer for management to aggressively invest in R&D and make strategic acquisitions  to capitalize on the recent shift from on-premises systems to cloud and mobile. Over the last five years R&D expense averaged ~20% of revenues for both companies (totaling ~$50m for OCL and $180m for TNE), around double the industry average rate, to move their product suites to the cloud.
According to tech industry research house Gartner only 15% of businesses currently use office and human capital management systems from the cloud. According to TNE management, product cycles for on-premise systems has typically been around 10 years due to the complexities of updating and the reluctance of switching systems. Upgrades of on-premise systems usually occurred only when fully depreciated or perhaps with a change of management. The advent of cloud delivery, however, should support elevated technology refresh activity.
An advantage OCL and TNE have over more cumbersome competitors such as SAP and Oracle is their software doesn’t require burdensome customization by third-party consultants such as Accenture. Uniform and configurable software delivered over the cloud means OCL and TNE can rollout upgrades with little to no costs of distribution. This means they are highly scalable.
As customers move to SaaS revenues will increasingly reflect recurring subscription fees less perpetual licenses for on premises systems. Recently both companies reported the proportion of recurring revenues exceeded 50% of the total.
Both OCL and TNE are led by respective founders Tony Walls (who maintains a 68% ownership stake) and Adrian Di Marco (12%).
With much of the (fully expensed) R&D spend on cloud products complete, the dollar amount of R&D is expected to plateau, while revenues are expected to grow at 10% – 15%, leading to margin expansion and stronger earnings growth with OCL and TNE expected to compound earnings respectively at ~40% and 16% over the next three years.

Despite the similarities their treatment by the market is starkly different. OCL is currently trading on a modest FY17 enterprise value to EBITDA multiple of 10.7x, while TNE looks a little expensive.

FY16

FY17

FY18

OCL

TNE

OCL

TNE

OCL

TNE

EBIDTA

9.5

57.6

13.5

66.2

16.7

76.6

EV/EBITDA

15.2

28.2

10.7

24.5

8.6

21.2

Written by Jonathan Wilson, Analyst.