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There’s no denying that the future of technology rests in “the cloud.” However, red flags appear when a firm sacrifices profitability to join the cloud and transitions to a business model with negative margins. Add in significant competition and an overvalued stock price and investors should be running for the hills. Nevertheless, this stock is up 20% over the past two years. Bottomline Technologies (EPAY: $25/share) is in the Danger Zone this week.

Profitless Revenue Growth Doesn’t Create Shareholder Value

Since 2011, Bottomline Technologies’ after-tax profit (NOPAT) has declined by 21% compounded annually to $3 million in 2016 and -$2 million over the last twelve months (TTM). This deterioration in profits occurred despite revenue has growing 13% compounded annually during the same period, per Figure 1. Revenue growth means very little if the business cannot convert it to meaningful profits.

Figure 1: Profits Decline Amidst Impressive Revenue Growth

newconstructs_epay_nopatdecline_2017-01-16

Sources: New Constructs, LLC and company filings

The issues do not end with declining NOPAT. Bottomline’s NOPAT margin has fallen from 5% in 2011 to -1% TTM while the company has burned through a cumulative $240 million in free cash flow (FCF) over the past five years. Across multiple key metrics, Bottomline’s business is showing significant signs of deterioration.

Destructive Acquisitions Cannot Be Overlooked

Over the past five years, Bottomline Technologies has acquired 19 separate companies at a cost of over $361 million. Management touted the importance of the acquisitions to revenue growth and growing the business as a whole. While these acquisitions appear to be accretive (to EPS), due to the high low fallacy, more rigorous research reveals these acquisitions did little to earn a quality return on invested capital. Bottomline’s ROIC has fallen from 5% in 2011 to a bottom-quintile 0% TTM. Management must be held accountable for its capital allocation decisions. Per Figure 2 below, it’s clear Bottomline’s acquisitions have been a poor use of capital and led to the decline in the firm’s overall ROIC.

Figure 2: Acquisitions Fail To Earn A Quality Return

newconstructs_epay_deterioratingroic_2017-01-16

Sources: New Constructs, LLC and company filings

Compensation Plan Incentivizes Destructive Acquisitions

Misaligned executive compensation plans help line the pockets of executives at the expense of shareholders. Bottomline Technologies’ executive compensation plan, apart from base salary, rewards executives for meeting revenue and non-GAAP operating income targets. Each of these metrics do not align executive interests with those of shareholders.

As shown in Figure 1, Bottomline Technologies has been able to grow revenue, largely through acquisition, and meet the bonus goal. At the same time, non-GAAP operating income conveniently excludes expenses such as acquisition and integration related costs and restructuring expenses, which are quite meaningful for a firm that’s done 19 acquisitions in five years. Ultimately, Bottomline is able to meet revenue goals through acquisition, and by excluding key costs related to acquisitions, also meet non-GAAP operating income goals.

As we’ve demonstrated through multiple case studies, ROIC, not revenue or non-GAAP income, is the primary driver of shareholder value creation. Without major changes to this compensation plan, preferably to emphasize shareholder-creation-friendly metrics (e.g. ROIC), investors should expect further value destruction while management continues to get big payouts.

Non-GAAP Metrics Mask Economic Reality

Non-GAAP metrics should be a red flag for investors because they often mask the true economics of the business. Bottomline Technologies uses non-GAAP metrics such as “core net income” and adjusted EBITDA to “better represent the business.” We can agree that these metrics “better” represent the business, in that they make the firm look profitable when it is in fact losing money, but these metrics are certainly not more accurate. Below are some of the expenses EPAY removes to calculate its non-GAAP metrics:

  1. Stock-based compensation expenses
  2. Acquisition and integration related expenses
  3. Restructuring related costs
  4. Global ERP system implementation costs
  5. Minimum pension liability adjustments

These adjustments have a significant impact on the disparity between GAAP net income, “core net income”, and economic earnings. In 2016, EPAY removed over $30 million in stock-based compensation expense (9% of 2016 revenue) to calculate “core net income.” This adjustment allowed Bottomline Technologies to report “core net income” of $58 million,” compared to -$20 million GAAP net income and -$28 million economic earnings, per Figure 3.

Figure 3: Disconnect Between Non-GAAP & Economic Earnings

newconstructs_epay_misleadingnongaap_2017-01-16

Sources: New Constructs, LLC and company filings

Lagging Profitability In A Fragmented Industry

Bottomline Technologies provides cloud-based business payment, digital banking, fraud prevention, and financial document services. Ultimately, Bottomline facilitates the transfer of money between businesses and vendors. EPAY faces competition from many different angles, including firms that offer
“one-stop solutions” and those that provide more customizable services that facilitating only one subset of payment transactions. Competitors include Wells Fargo & Company (WFC), Fiserv Inc. (FISV), American Express (AXP), NCR Corporation (NCR), Infosys (INFY), and even ACH capabilities offered by banks, such as direct deposit and money transfers. Per Figure 4 below, Bottomline Technologies lags the profitability of its peers within this fragmented industry.

Most notably, the firms with the highest profitability in the industry are those that have business lines apart from payment facilitation. Firms such as Oracle (ORCL), Wells Fargo, and American Express each have NOPAT margins above 18% and can support payment processing through resources derived from main business lines. Bottomline Technologies on the other hand, with its -1% margin, faces significant competitive disadvantages without a profitable segment to bolster its payment services.

Figure 4: Bottomline Technologies’ Bottom Barrel Profitability

newconstructs_epay_competitorcomparison_2017-01-16

Sources: New Constructs, LLC and company filings 

Bull Hopes Rest On Profitable Cloud Transition

As noted above, the transition to the cloud and subscription-based revenues has not been a profitable venture for Bottomline Technologies. We’ve covered many unprofitable cloud companies in previous Danger Zone reports. Bottomline is unique in that prior to its transition to subscription based products, the firm was able to generate positive NOPAT, albeit a small one.

In transitioning to the cloud, EPAY prioritized revenue growth, in hopes that investors would put faith in the firm’s ability to regain profitability sometime in the future. However, as shown in Figure 5 below, this profitability seems far off, if not impossible.

Per Figure 5, Bottomline Technologies’ operating expenses are growing faster than revenues. Product development & engineering, sales & marketing, and general & administrative costs have grown 17%, 16%, and 13% compounded annually respectively since 2011. Meanwhile, revenue has grown only 13% compounded annually over the same time period.

Figure 5: Costs Outpace Revenue Growth

newconstructs_epay_costvsrevenues_2017-01-16

Sources: New Constructs, LLC and company filings. 

These rising costs undermine any revenue growth EPAY has achieved through acquisition or organically. Soaring costs, industry lagging margins, and the poor executive compensation structure outlined above make it rather hard to keep the faith that EPAY will return to profitability anytime soon.

Making matters worse, any bull case rests on the hope that EPAY will not only return to profitability, but earn significant market share and grow profits at unrealistic growth rates, as we’ll show below.

EPAY Is Already Priced To Perfection

Despite deterioration in

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