SPS Commerce (NASDAQ:SPSC)

SPS Commerce SPSC

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

Often times, revenue growth, coupled with non-GAAP income, can mask losses to those not willing to look under the surface. This week’s Danger Zone pick is a company that touts 61 consecutive quarters of revenue growth despite five years of shareholder value destruction. Increased competition, misleading non-GAAP metrics, and an overly optimistic valuation land SPS Commerce (SPSC: $66/share) in the Danger Zone.

Top Line Growth Hides Losses

SPS Commerce’s economic earnings, the true cash flows of the business, have declined from $2 million in 2010 to -$4 million in 2015 and -$5 million over the last twelve months (TTM). This decline comes despite revenue growing from $45 million in 2010 to $159 million in 2015, or 29% compounded annually. Figure 1 highlights the contrast between economic earnings and revenue. See a reconciliation of SPS Commerce’s GAAP net income to economic earnings here.

Figure 1: SPSC’s Profitless Revenue Growth

NewConstructs_SPSC_RevVsEconEarnings_2016-08-29

Sources: New Constructs, LLC and company filings

SPS Commerce’s return on invested capital (ROIC) has fallen from 24% in 2010 to a bottom quintile 4% TTM. The company’s after-tax profit (NOPAT) margins more than halved from 7% in 2010 to 3% TTM. Further compounding the poor fundamentals, the company has burned through cumulative $81 million in free cash flow (FCF) since 2011 and FCF sits at -$19 million TTM.

Misaligned Incentives Fuel Shareholder Value Destruction

Executive’s annual bonuses are paid out based upon the achievement of revenue and adjusted EBITDA goals. The compensation committee believes that SPSC’s “financial results are driven most significantly by the revenues we generate.” Unsurprisingly, SPSC has done an impressive job growing revenue and adjusted EBITDA, but not real profits. Adjusted EBITDA, a non-GAAP metric, excludes stock based compensation expense, which represents a significant portion of GAAP results, as we’ll show below. Through the use of either revenue or adjusted EBITDA, executives are incentivized by metrics that do little to create shareholder value, and can actually improve while shareholder value is destroyed. The best way to create shareholder value, and align executives with the best interest of shareholders, is to tie performance bonuses to ROIC.

Non-GAAP Metrics Improve While Economic Earnings Decline

Because businesses have discretion over which items they choose to remove or leave in non-GAAP, these metrics often obfuscate true profits and lack comparability across firms. See dangers of non-GAAP metrics. Here are the expenses SPSC has removed to calculate its adjusted EBITDA and non-GAAP net income:

  1. Stock based compensation expense
  2. Amortization of intangible assets

While SPSC may not remove a large number of expenses, the dollar value has a meaningful impact on reported results. In 2015, SPSC removed just over $6 million (138% of GAAP net income) in stock-based compensation to calculate its adjusted EBITDA and non-GAAP net income. In 2014, the company removed just over $5 million in stock-based compensation, which was nearly double GAAP net income. By removing this large expense, SPS Commerce reports non-GAAP metrics that are much better than economic earnings. Adjusted EBITDA grew from $5 million in 2010 to $23 million in 2015, or 34% compounded annually. Non-GAAP net income grew from $4 million in 2010 to $14 million in 2015, or 32% compounded annually. Meanwhile economic earnings declined from $2 million in 2010 to -$4 million in 2015, per Figure 2.

Figure 2: SPS Commerce’s Misleading Non-GAAP Income

NewConstructs_SPSC_NonGAAPvsEconEarnings_2016-08-29

Sources: New Constructs, LLC and company filings

Low Profitability In A Competitive Market

The electronic data interchange (EDI) or integration brokerage industry is highly fragmented with many competing services. Two of the most prominent competitors include Sterling Commerce (owned by IBM (IBM)) and GXS (owned by OpenText (OTEX)). At the same time, Hewlett Packard Enterprises (HPE) offers supply chain management software in addition to other providers such as Covalent Works, Edicom, Covisint, DiCentral, and Liaison Technologies.

Per Figure 3, SPS Commerce has a lower NOPAT margin and ROIC than both IBM and OTEX. Such low profitability leaves SPSC with a competitive disadvantage in regards to pricing power. Also, IBM and OTEX’s other profitable business lines not only allow for greater cross-selling, but allow them to pursue only the highest value customers, leaving the less profitable firms for other competitors. Sacrificing margins to boost revenue growth may work in the short-term, but over the long haul, depressed margins leave SPSC vulnerable to competitors who control the “playing-field.”

Figure 3: SPSC’s Profitability Lags Largest Competitors

NewConstructs_SPSC_CompetitorROICcomparison_2016-08-29

Sources: New Constructs, LLC and company filings 

Bull Hopes Imply Competition Still Lags

Bulls will make the case that SPSC is sacrificing profits to grow its user base and gain market share. Despite strong revenue growth, the first mover advantage SPSC hoped to obtain, by simplifying the traditional on-site EDI services and moving to the cloud, has quickly eroded. Larger competitors have moved into cloud EDI by creating their own products that allow on-premise offerings, cloud offerings, or a mix of both. As these other competing services have come to market, SPSC has seen its margins cut in half. Now, SPSC is facing competition that not only offers a similar, if not more robust, product suite, but does so with more scale, per Figure 4.

Figure 4: Competitor Business Connections/Trade Partners

NewConstructs_SPSC_Competitor_BusinessConnectionComparison_2016-08-29

*Reported prior to being acquired by Open Text in 2014. 

Sources: New Constructs, LLC and company filings/press releases

Post acquisition of GXS, Open Text’s CEO noted that the combined platform would connect over 600,000 businesses. Additionally, Di Central notes it processes transactions for over 30,000 organizations worldwide and Edicom is the EDI provider for over 14,000 businesses, including Carrefour and Toys R Us.

The many firms, with robust partner networks and similar offerings, only increase the likelihood of the service becoming commoditized and price being the primary differentiator.

Expense Growth Exceeds Revenue Growth & Puts Valuation In the Cloud

Further casting doubt on SPSC’s ability to meet the expectations baked into its stock price is the firm’s aggressive spending, which continues to prevent revenue growth from translating into profits. Since 2010, while revenue has grown 29% compounded annually, cost of revenue and R&D have grown 32% and 33% compounded annually respectively. Over the same time, sales & marketing and general & administrative costs have grown 27% and 25% compounded annually respectively.

Making matters worse, each year since 2012, the year-over-year (”YoY”) growth in cost of revenues has been faster than YoY revenue growth. At the same time, in three of the past four years, YoY growth in R&D expense has outpaced revenue growth. In order to grow the top line at rates that meet market expectations, SPSC is sacrificing the bottom line and masking that sacrifice behind misleading non-GAAP metrics.

Apart from fundamentals, the valuation of the stock also presents an issue. The current share price implies that SPSC is and will be highly profitable for many years into the future. Given the litany of competition, SPSC’s low profitability, and the spending required to maintain top-line growth, it’s hard to make a

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