As Donald Trump approaches 100 days in office, it appears that more time is required for his administration to implement the stimulative policies he has promised. Irrespective of any policy changes, we believe the underlying strength of the US economy and its wealth of high-quality small- and mid-cap businesses will continue to provide attractive investment opportunities. Software developer Manhattan Associates is one of them.
Baby or bathwater?
Every January, despite efforts to stoke post-Christmas consumption with hefty discounts, many retailers experience cash flow problems and some go out of business. This year, the shift towards online from bricks-and-mortar stores accelerated faster than anticipated. Given that plenty of shops are struggling in an already tough competitive environment, media and stock-research reports about the performance of retailers have been alarmist.
The predictable negative headlines and sentiment provided us with a long-awaited opportunity to invest in Manhattan Associates, a technology company that produces software helping to optimise retailers’ inventories. It has been on our watch list of high-quality companies since our first visit to its Atlanta headquarters during a research trip in March 2015.
Picks and shovels
The US retail supply chain is being disrupted – and this is happening fast. Indeed, even boutique retailers are becoming distribution centres themselves. As large and small players alike compete for shoppers across channels, we prefer to invest in the enabling technology rather than the brands on offer, which can easily fall out of favour with consumers.
In Manhattan Associates, we are not investing in a single consumer brand exposed to competition but a business that is both enabling and benefitting from the growth of omni-channel sales, the ability to deliver goods to consumers in-store, online or at click-and-collect desks in the most cost-effective way. Its software helps retailers optimise what is their most valuable and risky item of working capital – their inventory.
Manhattan began in 1990 as a supplier of warehouse-management software and systems for large retailers. It quickly became successful, generating sticky, recurring revenues and consistently producing gross margins above 55%. The company also aligned itself with a long-term secular growth opportunity: throughout the past two decades, Manhattan has evolved into a provider of market-leading supply chain technology, with particular expertise in retail. The company nevertheless maintains a well-diversified customer base, with 40% to 50% of its revenues derived from non-retail sources.
Manhattan’s solution enables customers to manage inventory in real time by identifying which warehouse can most cost-effectively shift goods throughout sales channels. Eddie Capel, the company’s CEO, believes that it would take four years for multinational software corporation SAP to develop similar functionality. In addition, since 16 of the top 20 global apparel retailers use Manhattan’s software (including market leaders like Walmart), this provides an edge on competitors such as IBM, which can’t cite existing customers as referees. Manhattan’s system can plug into any incumbent enterprise resource planning (ERP) system, such as SAP or Microsoft Dynamix, making it compatible with the information architecture of most businesses. Combined, these competitive advantages provide Manhattan with a broad economic moat for the foreseeable future.
Some Wall Street analysts fear that weak sales will force retailers to defer investment in their supply chains. Even if this happens, our view is that the stronger ones will still need to upgrade their omni-channel support systems in the near future to deliver goods to customers wherever and however they choose to receive them. Manhattan believes that 62% of retailers plan to implement or improve 'buy anywhere, ship anywhere' capabilities in the next three years.
High margins, under the radar
Unlike other software providers, Manhattan prefers to develop solutions in-house rather than acquire rivals with competing products. Its historic metrics therefore offer a clear view of how well the company’s management team has executed strategies in the past. The business’s return on invested capital has increased from 10% to more than 60% and its ability to consistently generate cash flow is underpinned by sticky revenues, such as maintenance fees.
Manhattan has a market capitalisation of $3.5bn. This size, combined with its preference to not engage in M&A, results in it being covered by only four sell-side brokers. This suits us, as we like high-quality businesses that other investors don’t know so well. This low profile is at odds with the popularity of its software: many investors wouldn’t know, for example, that 40% of all grocery products consumed in the US are transported using Manhattan’s fleet-management optimisation system.
Point of purchase
Following our initial meeting, we continued to monitor Manhattan in order to gain comfort in the quality of its business model. However, while we found the business attractive, we concluded that the stock was intrinsically worth a minimum of $58 on a 10-year discounted cash flow basis, and it wasn’t until market sentiment towards retailers turned negative in January that we identified an opportunity to invest at a sufficient discount to our estimate of intrinsic value. Although the market retains a cautious outlook for the retail sector, Manhattan has signed four new software licences that could each generate more than $1m in revenue. Ultimately, we believe that the company can resume growing earnings of up to 20%, making this an attractive entry point into a stock with the potential to generate strong long-term returns for our clients.
While the broad market remains preoccupied over whether Trump can make good on the stimulative fiscal policies that he has promised, companies such as Manhattan should continue to display strong fundamentals against a robust economic backdrop. While our investment in the stock is not predicated on any specific policy initiatives – which are uncertain in timing and quantum – any reduction in the 36% rate of tax currently paid by Manhattan would be the icing on the cake.
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