Description

Business description

1.      Aspen sells simulation software used by engineers in chemicals, engineering & construction, and energy companies to optimize manufacturing plants and supply chains and to design plant expansions and new construction.

2.      The company was originally created to commercialize intellectual property developed at MIT in the early 1980’s. Through the 1990’s Aspen rolled-up smaller adjacent software providers to cross-sell related products to its customer base. This M&A spree culminated with the acquisition of Hyprotech, which resulted in a 3-to-2 consolidation in the industry for core simulation providers (see the FTC’s 2004 antitrust complaint for more detail). After integrating its acquisitions and offerings from 2004-2008, Aspen launched a revenue model transition from license to subscription. This multi-year transition, which is nearing completion now, should improve revenue predictability and resilience during downturns.

a.       Note that the transition has distorted GAAP financials over the last 5 years, though, so management’s supplementary organic revenue metrics have been the main way to track recent business trends.

3.      Customers sign 5-6 year subscription contracts with 2-3% annual price escalators and one-way ratchets on volume (meaning mid-contract volume can go up but never down). These contracts have 98%+ renewal rates and generate ~90% gross margins.

Thesis summary

1.      High quality business: the bargaining power displayed in Aspen’s customer contracts comes from its competitive advantages:

a.       Large installed base with high switching costs – similar to other vertical market software providers, Aspen’s products are deeply embedded in customer workflows, have non-portable data, and require product-specific training.

b.      Network effect – engineers train on Aspen because companies use it, and companies use Aspen because engineers are trained on it, resulting in a winner-take-most outcome with ~80% market share in Aspen’s core Engineering suite (70% of revenue). Aspen provides free software to universities to feed this network effect.

c.       Intellectual property – Aspen recently forced a competitor into liquidation and bankruptcy through IP litigation.

d.      Small yet critical part of customer cost structure – customers generate high ROICs on Aspen software, which is a relatively small expense for them and contributes to price insensitivity.

2.      Long runway for growth: Aspen is ~20% penetrated with existing products at existing customers. Compelling customer economics, along with Aspen’s R&D and salesforce focus on cross-selling, will continue to drive steady uptake.

3.      Margin expansion: double-digit organic revenue growth + flat total costs = margin expansion. Aspen’s total costs (COGS + OpEx) have ranged within a 1% band every year since FY’11. We believe this wedge between revenue growth and cost growth will drive margin expansion beyond management’s 42-45% target range.

4.      Capital deployment: similar to software peers, Aspen converts revenue to FCF well and requires minimal reinvestment. Dissimilar to many software peers, Aspen deploys this FCF intelligently through share repurchases and M&A. The company is aggressively spending down balance sheet cash, including buying back more than 2% of total shares in the most recent quarter.

Inefficiencies

1.      Impact of oil price decline: AZPN sold off 30% with oil prices. A detailed examination of Aspen’s revenue exposure, combined with the high quality of business, suggests to us that this share price decline was unwarranted.

a.       Chemicals customers, ~26% of revenue, should see limited impact on end market demand and may even benefit from lower feedstock costs. Energy, ~37% of revenue, is primarily refineries that should see limited impact on profits given their spread-based economics. These customers must continue using Aspen’s software to keep plants running, which we view as likely given huge shutdown/startup costs for refineries. Finally, E&C customers, ~31% of revenue, comprise the most important risk to Aspen’s growth. Part of this vertical constructs chemical assets, which should see limited impact from lower oil prices. But part relates to construction of energy assets, of which a small minority relates to upstream assets. If we ignore the heterogeneity of E&C exposure and assume it is entirely oil price sensitive, we estimate the impact of a 1/3 reduction in contract size for renewing E&C customers (<20% annually) would be a ~2% revenue headwind.

b.      While we believe that revenue should be resilient to oil price declines, it is true that consensus does not forecast a big decline. In fact, the sole bulge bracket bank to cover Aspen, JPM, rates it a sell but still has revenue growing 8-11% over the next three years. This range around 10% growth seems correct, but is similar to Aspen’s recent growth of 11-14%.

2.      Expense sandbagging: over the past five years, management’s total cost guidance has ranged from 5% to 8% growth, which the sell-side duly incorporated into estimates. Aspen has delivered roughly flat total costs during this time period, though, leading to an average quarterly EPS beat of 33%. The sell-side continues to fall for management’s tricks, incorporating 8% cost growth guidance into estimates for FY’15. In 1H, total costs shrank slightly. Still, the sell-side takes management’s guidance for 2H, which implies 4Q total cost growth of 17% YoY (no 1x items, unusual comparisons, or rationale).

3.      Confusion around taxes / declining FCF: Aspen accumulated NOLs during its transition from license to subscription, leading to minimal cash taxes over the last several years. In FY’16 these NOLs expire, creating a YoY decline in FCF. We view this decline as a one-time reset unrelated to business fundamentals. However, the unpleasant picture of near-term declining free cash flow for what should be a growing tech company has drawn sell-side comparisons to stagnating tech giants such as Microsoft.

4.      Capital deployment / share count: Aspen has consistently bought back shares, has stated its intention to continue doing so, and recently announced a $450mm repurchase authorization (market cap is ~$3bn). Therefore, we model continued share repurchases. The sell-side models an immediate end to repurchases.

Valuation

AZPN looks expensive. Forecasting FY’16 costs based on history rather than extrapolating management’s sandbagged guidance and subtracting net cash brings down the FY’16 P/E from Bloomberg’s 26x to 20x. On FCF/share, AZPN trades at around 16x FY’16. For a dominant software business 20% penetrated in its TAM growing FCF/share around 20%, that valuation seems cheap.

In a base case we believe Aspen can grow revenue near 10% for the next two years and, with continued cost leverage, grow EBIT in the mid-teens. Assuming continued buybacks, this forecast results in nearly $2.60 of FCF/share in FY’17. Using a 22x multiple and adding back remaining net cash results in nearly 50% upside. If the company levers up to repurchase stock that would provide a nice upside to our forecast. In a worst case we believe AZPN will earn $2 of FCF per share in FY’17, and at a 15x multiple with net cash that would result in 20% downside. This bear case assumes 2008-2009 conditions and a fairly punitive valuation for a business of this quality.

Risks

Aspen’s high quality business narrows the range of outcomes. For example, during the worst possible conditions for this company in 2008-2009 with a deep recession and oil in the $40s, Aspen grew underlying revenue organically in the mid-single digits. Therefore, the most probable downside scenario is decelerating growth (from either oil prices or the law of large numbers) and valuation multiple compression. The current stock price provides a decent margin of safety in this state of the world.

Disclaimer:  We and our affiliates are long AZPN. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.

Catalyst

Free cash flow per share compounding at ~20% should generate acceptable returns and give us staying power. We may get some acceleration of returns in the form of multiple expansion if any of the inefficiencies outlined above are resolved with FY’16 guidance in May. The FY’16 numbers will be the first taxed, subscription transitioned, and oil impacted guidance, which should give a clearer view of ongoing profitability.