Description

Short MANH @ $46.25 / $3.2b mkt cap / $3.1b TEV

Manhattan Associates (MANH) is a supply chain management software company in the early stages of downward EPS revisions followed by multiple contraction driven by 1) declines in high margin professional services revenue driven by cloud adoption and constrained customer budgets, 2) continued secular pressure in majority of their customer base (retailers), 3) need to increase pace of spending in order to drive adoption of their recently released cloud products.

Stock has always been expensive, but that was because investors were willing to reward the steady EPS growth and margin expansion experienced over the years. However, after 7+ years of double digit+ EPS growth, I expect EPS to be down in CY’18 / 19 and for the multiple to meaningfully contract to a below market multiple as investors stop paying a historical 30x multiple on non-recurring services revenue. I see CY’18 EPS / CY’19 EPS of $1.78 / $1.72 (vs. street $1.98 / $2.09) as 1) license revenue growth decelerates given the sale of cloud products, 2) operating expenses increase in an effort to market their cloud products, 3) gross margins on non-maintenance revenues continue to compress as customers continue to pause and pushback on excessive pricing. Applying a 16-18x multiple on CY’19 earnings yields a $28-$31 stock / 33-40% downside in a year.

Over earning on services revenue

MANH’s services revenues can be broken into three categories:

1.       Maintenance revenue: rights to updates / upgrades of purchased perpetual license revenues (~1/3 of services revenue)

2.       Professional Services: help implementing the software

3.       Change management services (consulting): help re-architecting a customer’s warehousing operations

Of the above, only #1 deserves a ‘vertical software’ multiple since it’s the only real recurring revenue stream. Stability of #2 will decline in the coming quarters as cloud products require less professional services for implementation + benchmarking other SaaS companies’ professional services gross margins shows meaningful over-earning in this bucket. #3 is important, but faces stiff competition with professional IT services companies like Accenture / TCS / INFY etc, some of whom are building specific MANH practices to go after this opportunity.

Assuming 90% GMs on the maintenance revenues implies professional services / consulting revenues are earning mid 40%s GMs. This is extremely high given most SaaS companies are break-even or ~10% GMs on professional services work. Furthermore, best in class IT services vendor Accenture has GMs in the 30% range, which is also substantially below MANH’s blended margin rate.

Why the multiple breaks

The reason MANH has traded at a 5-year historical average of ~30x PE is due to the steady top and bottom line growth + premium investors were willing to pay for the quality of the asset. This year marks the first year EPS has been guided to flat after several miss / guide downs throughout the year. The business is unlikely to inflect positively next year since we are still in the early stages of retail customers feeling the pain from AMZN + cloud products have only recently been launched and the impact is yet to be felt. In order for MANH to outperform from current levels, the multiple needs to expand which seems unrealistic since it’s already trading at 20x+ EV/recurring revenue.

As margins begin compressing and EPS begins trending negative in CY’18 I think investors will be forced to re-evaluate the valuation framework and the PE multiple will continue to compress on top of numbers that get revised downwards.

Key risks

Biggest risk is a take out by a larger software player (ORCL/SAP/IBM/MSFT). I think the near term risk of an acquisition is relatively low given the structural challenges around the services revenues + challenging end markets. Likely becomes a more compelling target <$30.

Catalyst

2018 guidance

Quarterly earnings