Warren Buffett has said that ‘leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return’ and ‘a truly great business must have an enduring “moat” that protects excellent returns on invested capital’.
We think we’ve found one. Hansen Technologies (ASX: HSN) is an off-the-radar small-cap stock that makes billing software for telcos and utilities. If you’re an Optus or Energy Australia customer, Hansen prepares your monthly bill.
Here’s the great thing about Hansen. The company doesn’t have customers, it has voluntary hostages. A utility chooses its billing software provider but, once the software is installed, it isn’t going anywhere without significant risk. It can take a year or two for a utility to install new billing software and often costs millions. Any stuff-ups and the company faces cash flow problems and a customer relations nightmare.
With this in mind, it’s no surprise that of Hansen’s 200-plus customers, only a handful have ever left the company in its 20-year history. They may not be happy with Hansen every minute of every day, but it’s a big deal for a utility to change billing software providers due to the risk and cost of switching.
Thanks to this ‘customer captivity’, Hansen has significant pricing power and a profit margin of 18%. Sticky customers also ensure highly recurring revenues. At least 70% of Hansen’s income is recurring, including things like yearly contracted payments, licence fees and support services. Annual price escalations built into its contracts also ensure steady – albeit slow – organic revenue growth.
High returns on capital
What’s more, the company needs almost no capital to operate – it’s just a collection of geeky software engineers, laptops and the odd roof over their heads. Employee salaries make up two-thirds of total expenses.
This has a couple of benefits. The first is that Hansen doesn’t need to keep reinvesting profits in upgrading expensive equipment, so free cash flow over the past five years has matched net profit almost one-for-one.
Compare this to, say, Qantas (ASX: QAN), which must constantly upgrade its aircraft using last year’s profits (if it should be so lucky), leaving little cash to distribute to shareholders. Hansen, on the other hand, can direct its cash flow to dividends, share buybacks or use it to make acquisitions.
Few capital requirements also mean Hansen’s balance sheet is squeaky clean. As of June, the company had net cash of $30m.
So, high switching costs and captive customers give Hansen a competitive advantage – or ‘moat’ as Buffett likes to say – as well as good margins. And, without much need for capital equipment, the company earns an excellent return on equity, which is consistently above 20%. But what about the growth part of Buffett’s magic equation?
We already mentioned that Hansen’s contracts usually have built-in price escalations, which should ensure revenue growth in the low-single digits. However, Hansen is also adding new customers and is likely to benefit from a worldwide trend towards privatising and deregulating utilities.
A survey of worldwide utilities in 2013 found that 28% of respondents had billing software installed more than 10 years ago and a further 12% had software installed more than 20 years ago.
Many utilities will need to upgrade their outdated, internally developed systems because privatisation and deregulation tend to encourage product variety and more price points, both of which require nimble billing software. The roll-out of smart meters and the explosion of data volumes also works in Hansen’s favour.
What’s more, as complexity requirements increase, so too do economies of scale. This makes outsourcing more likely as substantial upfront research and development costs can be spread around. We expect increasing billing complexity to leave smaller billing providers in the dark and to favour large, global players like Hansen. Better yet, customer stickiness is likely to increase as software requirements become more complex, making the software more difficult and complicated to remove.
Hansen increased revenue 40% in 2016 and net profit was up 50% to $29m. That’s a high hurdle helped along by acquisitions – but with steady organic growth, sticky customers, and plenty of opportunities to reinvest capital at high rates of return, Hansen is one of our favourite small caps.