Description

I am recommending that the shares Click Commerce Inc (symbol: CKCM) be sold short, or, if in the event that CKCM is currently in your portfolio, I recommend you sell. The company “provides software designed to help companies streamline their trading partner interactions and automate compliance-related activities.” The provider of logistics software continually boasts of the company’s strong revenue growth and earnings generation, but in fact, the company has generated no growth without the help of acquisitions and the lack of earnings quality has caused the company to generate cashless earnings throughout the year. The lack of organic growth combined with very poor quality of earnings is the cornerstone of my short thesis.
As a quick overview of the company, CKCM has four revenue reporting lines: 1) Product license, 2) Maintenance and hosting 3) Consulting and implementation services, and 4) Subscription. The company positions it self as a “software as a service” provider and 86% of revenue in the most recent quarter falls within the last three revenue lines, which are deemed as service revenues for the company. Over the last 4 quarters the company has generated 1.06 in EPS and currently trades at approximately $26. The company has a market cap of approximately $310 million. The company’s book value is approximately $28mm but once goodwill and intangibles are removed, the company has a negative tangible book value. The company trades at approximately 6 times sales. Certainly, the company is not being supported by its book value, and below I will explain why the company’s multiples of sales and earnings should not be relied upon. In a nut shell, the company has no organic sales growth, no cash generation, and a very high likelihood that they are manufacturing earnings.
Below I will outline my evidence that CKCM’s growth in revenue over the last year has been solely the result of three acquisitions during this fiscal year and it is likely that the company has had negative organic growth during this time. Additionally, the company’s earnings growth is not mirrored by a growth in cash generation and CKCM has in fact generated negative cash flow from operations over the three quarters of this year. Lastly, two of the company’s recent acquisition targets were venture capital portfolio companies of CKCM’s second largest shareholder who was a large VC investor in CKCM as well. This potentially raises a conflict of interest during the negotiating process of these acquisitions.
1) No organic revenue growth; top line growth the result of acquisitions.
Over the last three quarters CKCM has stated the following with regard to sales growth. In the first quarter earnings release on May 5, 2005, CKCM stated “Click Commerce Year over Year Revenues up107%.” On the August 8th CKCM’s press release stated “Company’s Year over Year Revenues up 115%.” The most recent press release on November 3rd stated, “Total third quarter 2005 revenues . . . represent [ed] a 130% growth over third quarter 2004 revenue.”
In 2005, CKCM has made three acquisitions. In the first week of February, CKCM acquired two companies. Channel Wave for total consideration of $5.3m and Optum for total consideration of $30.8mm. In the last week of May, CKCM acquired Xelus, for total consideration of $2.7mm. These acquisitions are responsible for the year over year growth that the company loves to promote.
The true effect of the acquisitions on revenue growth is revealed when you examine the mandatory disclosure regarding business combinations that is in the company’s 10-Q. In the notes to the financial statements, Note 4 provides information where the company “presents the consolidated operations as if all the acquisitions had been made on January 1, 2004.” This mandatory disclosure shows that company revenues, without the help of acquisitions, are actually declining.

Pro Forma Revenue as if all acquisitions had been completed Jan 1, 2004; Three month period ending:
In thousands of $, March 31, June 30, September 30,
2004 2005 2004 2005 2004 2005*
Revenues 15,503 13,027 16,243 14,352 18,430 16,205
Net Income (4,209) 2,646 65 2,290 (2,063) 3,787
Basic net in -0.42 0.23 0.01 0.20 -0.40 0.33
* In the 3rd quarter of 2005, CKCM made no acquisitions so pro-forma revenue was not reported, reported results used instead


In each quarter of this year, pro-forma revenues have in fact declined. A very different visual then the company’s quarterly earnings press releases would have you believe. Year over year pro forma revenue growth was -13.5% in Q3 2005, -13.2% in Q2, and -19.0 % in Q1. The company is not growing organically, the growth headlines that the company loves to promote have been bought, not organically generated. The above pro forma revenue chart clearly illustrates this.
This onion can be sliced in a different way that reaches the same conclusion; CKCM’s revenues are not growing. I think the following exercise helps clarify that revenues, net of acquisitions, are flat at best for this company. I wanted to attempt to see if I could predict what CKCM would report for revenue knowing only the following. 1) The previous year’s actual reported total quarterly revenue, 2) the dollar value of monthly acquired revenue of the three acquisitions in 2005 (derived from the 10-q), and 3) the amount of quarterly draw down in deferred revenue as taken from the statement of cash flows.
The chart below details this exercise and again illustrates the company is not organically growing. I will walk you trough the September quarter in the chart below. For the quarter ended 9/30/2004 CKCM reported total revenue of $7.0mm. Using that number as our baseline, we then add three months of Optum and Xelus monthly revenue (3*$2.1mm=$6.3mm) and three months of Xelus’s monthly revenue (3 * $0.5mm = $1.5mm). Lastly we add in the deferred revenue draw down of $0.892 mm. In total, we have $15.6mm as our predicted total company revenue assuming NO growth of either the organic business or the acquired business. This prediction is only 3.0% different then actual reported revenue. Again, in this rough model, which has a high level of accuracy in all three reported quarters, we have assumed ZERO growth! And in every quarter the model has been highly accurate. By simply doing a sum of the parts (last years sales + acquired revenues) while assuming zero growth, our prediction is very close to actual reported results. This implies again CKCM is not growing.



3/30/2005 6/30/2005 9/30/2005
Total Q Revenue, last (a) 5272 6208 7036
Optum&Channelmonthly revenue(*) 2110 2110 2110
# of months of Acq rev in Q 2 3 3
Sub Total (b) 4220 6330 6330
Xelus per month revenue(#) 500 500 500
# of monts of Acq rev in Q 0 1 3
Sub Total (c ) 0 500 1500
Draw of Def Rev (c) 880 2494 892
Predicted Rev (a+b+c+d) 10372 15532 15758
Quarterly Reported Rev 10925 13349 16205

* $2,110 is calculated as follows: Channel Wave was acquired 2/2/2005 & Optum was acquired 2/7/2005. Therefore the revenues of the two acquisitions were included in two of the three months in Q1 2005. The difference between the pro forma revenue in q1 2005 of $13.0mm and actual reported revenue of $10.9mm represents the revenue generated in the month of January by the two acquired companies. Thus total monthly revenue of the two targets is $2.1mm.


# $500 is calculated as follows: Using the same technique used in the above footnote, Xelus was acquired on 5/27/2005. One month of Xelus revenue is included in CKCM's q2 revenue. The difference between pro forma q2 revenue of $14.3mm and actual reported revenue of$13.3mm represents 2 months of Xelus revenue. Thus, Xelus' monthly revenue run rate is approximately $500 thousand.


I believe the two separate methods have shown that the company’s core business is not growing and the top line growth the company is reporting is the result of acquiring businesses. This in itself would not be bad if the company could then convert the acquired revenues into not only net income, but more importantly into cash. Below I am going to show how the company has generated cashless earnings in the nine months of this year. The earnings that have been generated have been of the lowest quality and have not resulted in positive cash flow generation.

2) Terrible quality of earnings: Zero cash generation.
Deferred Revenue Draw Down
In the nine months of 2005, CKCM has reported net income of $9.6mm but the cash flow statement shows that over this same timeframe the company has generated negative cash flow from operations of $-1.2mm. Cash flow generation has lagged reported net income by $10.8mm over the nine month period. Last year this was not the case. Over the same period in 2004, the company’s net income was $3.4mm but cash flow from operations was a POSITIVE $1.7mm, representing a much smaller “deficit”. In 2005 the company has lost its ability turn net income into cash. It is my belief that this is the result of the company “manufacturing” EPS by drawing down on its deferred revenue balance and by aggressively accruing expenses.
On the balance sheet the company’s deferred revenue account has gone up on an absolute basis from $5.1mm to $10.9mm, but again this is the result of acquisitions. The cash flow statement shows that deferred revenues have been drawn down by $4.2 mm. The company has acquired deferred revenue in its three 2005 acquisitions. But as evidenced by the deferred revenue being a “use” of $4.2mm on the cash flow statement in the first nine months, the company has not replaced these deferred revenues with new sales. On the 3q conference call CKCM’s CFO, Mike Nelson said, “deferred revenue was down 10% because a primary component of that are maintenance renewals, which are still on an annual basis, with January renewals.” But if this is true, it is not evidenced by the Q3 of last year when deferred revenues actually increased from $4.2mm to $5.1mm. The company made no acquisitions in the Q3 of 2004. So, the seasonal affect that Mr. Nelson seems to be referring too with regard to a draw down in deferred revenue was not evident last year.
I believe it is possible that the company is acquiring deferred revenues but is “burying” their matching expenses in the “intangible assets” line of the balance sheet. This year, the intangible assets line has increased from $2.9 mm to $20.2mm. The intangibles are largely amortized over periods of 5 to 7 years depending on the acquisition. In the nine months of this year, CKCM has “used” $4.2mm of deferred revenue which represents a draw down of 28% of the pro forma deferred revenue account. [$4.2mm used in operations divided by $15.2 (4.2 +11.0 deferred balance as of 9/30/2005) = 28%] Over this same period CKCM has amortized only 12% of its acquired intangibles assets. Thus, I believe it is possible that the company has received an earnings boost by drawing down on its deferred revenue account by 28%, yet only expensing an estimate 12% of the matching expenses. This situation I describe would help in generating the type of cashless earnings that CKCM has reported.
As one last point about revenues, I would like to quote from the company’s 10-Q about revenue recognition. The 10-Q states “revenue is recognized in a multiple-element arrangement when company-specific objective evidence of fair value exists for all the undelivered elements in the arrangement, but does not exist for one or more of the delivered elements in the arrangement . . . the company defers revenue for the fair value of its undelivered elements . . . and recognizes revenue for the remainder of the arrangement fee attributable to the delivered elements.” Wow, what a mouthful! The reason I point this out is I believe it gives the company much discretion in when they recognize revenue. As a result, it makes it easier to change the timing of top line results.
Accrued Expenses
The other “use” of cash that has prevented CKCM from generating positive cash flow this year is the company’s accrued expenses. The cash flow statement shows two “accrued” lines, accrued compensation and accrued expenses. Both of these have had a significant negative affect on cash flow generation. Year to date the company has increased “accrued compensation” by $3.6mm and has increased “accrued expenses and other current liabilities” by $1.7mm. In other words, the company has paid cash to employees and paid for expenses, but has yet to recognize the expense on the statement of income. “Delaying” expenses to future periods would artificially increase EPS, and also results in the type of cashless earnings we see in CKCM’s statements.
The combined effect of pulling in acquired deferred revenues from previous periods and delaying costs by accruing them rather then expensing them have greatly help CKCM “manufacture” earnings. In fact, the combined effect of “deferred revenue”, “accrued compensation”, and “accrued expenses and other current liabilities” are almost entirely responsible for the cash flow deficit. Of the $10.8 mm that cash generation trails earnings, 88.8% of this can be explained by these three accounts. These three accounts have helped manufacture EPS.
Not only has the company been unable to grow organically, the company has not generated cash flow from operations and I believe it is likely that the company has used “financial shenanigans” to help manufacture artificial EPS growth.
3) Relationship of second largest share holder and two previous acquisitions.
In my research I also became aware of the fact that CKCM’s largest shareholder, Insight Ventures, that has a 7.17% position in the company, was a venture capital investor in CKCM prior to the company’s IPO. The reason I think this is note worthy is that Insight VC was also a venture investor in Optum and Xelus. It strikes me as unusual that CKCM is acquiring companies in which their second largest investor has a material financial interest. I certainly know of no impropriety with regard to these deals, but I do think it is note worthy and worth pointing out because a potential conflict of interest could exist.
4) Catalysts
a. The major acquisitions that have helped generate the top-line growth occurred in the 1st quarter of this year. As the company anniversaries the acquisitions, the perceived top line growth will disappear. The headlines that the company loves to promote showing 100% revenue growth will change to headlines showing no year over year growth. The company certainly could attempt to keep the game going, but as the company gets bigger, it will be more and more difficult to prolong. The acquisitions would need to get bigger and bigger.
b. The company is in their audit quarter this quarter, and if my hypothesis is correct, it will be difficult for the company to continue to accrue expenses and manufacture earnings.
c. As the market gains an understanding of the fact that this company is not growing organically and has continually generated cashless earnings I think it is likely multiple contraction will occur.
5) Conclusion
CKCM trades at a multiple of over 6 times trailing revenue. This may be an appropriate multiple for a company that has strong sales and earnings growth. But as I believe I have pointed out in this piece, the company’s growth is acquired and the earnings are manufactured. Cash generation is not reflective of net income as the company runs a large cash flow deficit. Once you peal back the onion and see that there is no growth and that earnings are manipulated, I feel it would be more appropriate that this trade at a multiple similar to other zero growth software companies. My best estimate of this, approximately 1 or 2 times sales. This implies a fair price in the single digits.
All of what I have outlined above can easily be “seen for yourself” in a matter of seconds, I point you to the Statement of Cash flows on page 5 of the most recent 10-Q, filed 11/14/05. Please observe the big discrepancy in the “Net Income” and “Net Cash (used in) operating Activities” lines, and observe that deferred revenue and accrued expenses are what have caused this. Secondly I point you to page 15 of the same document; it is here that the lack of pro forma revenue growth can be observed. Perhaps my analysis is wrong and management could point out the failure of my logic; but alas, management does not return phone calls!

Catalyst

1) anniversary of acquisitions that generated misleading growth
2) Audit quarter will limit potential of continued financial schenanigans
3) As market realize company is not growing organically, and that earnings are manufactured, multiple should contract