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

This week’s Danger Zone pick has seen its profitability decline as new competition has entered the scene. As the market commoditized, this firm’s negative margins and limited service offering undermined its ability to compete. Despite trading at less than half its 2012 highs, this stock is up 21% over the past year and is now pricing in unlikely improvements in profitability and revenue growth. LivePerson (LPSN: $7/share) is in the Danger Zone this week.

Revenue Growth Without Profits Is Meaningless

LivePerson’s after-tax profit (NOPAT) declined from $13 million in 2011 to -$9 million in 2016. This profit decline comes despite revenue growing 11% compounded annually over the same time, per Figure 1. LivePerson’s NOPAT margin has also fallen from 10% in 2011 to -4% in 2016.

Figure 1: LivePerson’s NOPAT Falls Despite Revenue Growth

newconstructs_lpsn_growinglosses_2017-03-20

Sources: New Constructs, LLC and company filings

The company’s return on invested capital (ROIC) is currently a bottom-quintile -5%, which is down from 12% in 2011. Despite positive free cash flow in 2016, LivePerson has burned through a cumulative $86 million (23% of market cap) in FCF over the past five years. With only $55 million in cash and a three year average cash burn of $23 million, LivePerson has just over two years before it would run out of money. All told, LivePerson’s fundamentals are trending in the wrong direction.

Executive Compensation Plan Incentivizes The Wrong Metrics

LivePerson’s executive compensation incentives are not aligned with shareholders’ interests. Misaligned compensation plans can create situations where executives are rewarded despite destroying shareholder value.

LivePerson’s executives are eligible for base salaries, cash incentives, and long-term equity awards. Cash bonuses are tied to adjusted EBITDA and “non-metric strategic goals” such as product development, talent recruitment, and litigation management. Adjusted EBITDA, a non-GAAP metric, removes stock-based compensation expense and is not correlated with real profits or shareholder value creation.

Long-term equity awards are given in a mix of restricted stock units and stock options. Stock options are granted with a service-based vesting schedule. Restricted stock units are granted based on individual and company performance at the discretion of the compensation committee. In either case, executives are given stock awards more as a supplement to salaries than a performance bonus. Furthermore, investors should be wary of heavy use of stock price as an incentive. Decisions can be made to maximize stock price in the short-term while the long-term best interests of the business go ignored.

We’ve demonstrated through numerous case studies that ROIC, not adjusted EBITDA or “non-metric strategic goals”, is the primary driver of shareholder value creation. Without major changes to this compensation plan (e.g. emphasizing ROIC), investors should expect further value destruction.

Non-GAAP Metrics Can No Longer Hide Losses

LivePerson uses non-GAAP metrics such as adjusted EBITDA and adjusted net income to mask its losses. Prior to 2016, the firm was able to report non-GAAP profits while the true cash flows of the business were negative. Below are some of the items LivePerson has removed when calculating its adjusted net income and adjusted EBITDA:

  1. Stock-based compensation expense
  2. Restructuring costs
  3. Acquisition costs
  4. Amortization of purchased intangibles

These adjustments have a large impact on the disparity between GAAP net income, adjusted net income, and economic earnings. In 2016 and 2015, LivePerson removed nearly $10 million (4% of revenue) and $12 million (5% of revenue), respectively, in expenses related to stock-based compensation to calculate adjusted net income. When added with the other adjustments, LivePerson reported 2016 adjusted net income of -$8 million. Per Figure 2, GAAP net income was -$26 million and economic earnings were -$20 million in 2016.

Figure 2: Disconnect Between Non-GAAP & Economic Earnings

newconstructs_lpsn_nongaapvseconearnings_2017-03-20

Sources: New Constructs, LLC and company filings

Negative Profitability In A Fragmented Market

LivePerson’s service began in 1998 and gave the company a head-start to shape the customer service experience. This first-mover advantage eroded over time and profitability issues arose as competition entered the market. In today’s customer support software market, LivePerson faces competition from Oracle (ORCL), Nice Systems (NICE), Nuance Communications (NUAN), salesforce.com (CRM), Genesys, Avaya, Cisco (CSCO), and eGain (EGAN). In addition, the company faces competition from many more online messaging applications, such as FreshDesk, Olark, LiveChat, and Zendesk Chat. The company also notes the potential for tech firms such as Facebook (FB) or Alphabet (GOOGL) to leverage existing technology to offer a competing service. It is clear to see from this non-exhaustive list that this market is filled with firms competing for the same business. The chat function within customer service grows more commoditized with each new entrant.

Per Figure 3, LivePerson’s ROIC and NOPAT margin fall well below its competition. The firms with the highest profitability, such as Oracle and Cisco, have built customer support solutions into their larger, more profitable enterprise offerings. These firms can provide discounts or even take a loss on these offerings and still profit from their overall cloud, customer relationship, enterprise management, or security platforms.

Meanwhile, LivePerson’s focus on chat support while doing away with “1-800 customer service lines” puts it at a competitive disadvantage. If LivePerson is unable to convince potential clients that call centers are no longer needed, it risks losing business to providers such as inContact, which provide integrated call center and chat support solutions.

Figure 3: LivePerson’s Negative ROIC & Margins

newconstructs_lpsn_peerprofitabilitycomparison_2017-03-20

Sources: New Constructs, LLC and company filings 

Bulls Case Ignores LivePerson’s Inability to Scale Profitably

LivePerson bulls will point to customer dissatisfaction with traditional customer support services (1-800 numbers) as reason to buy into LivePerson’s potential. In fact, an Amdocs consumer survey found that 76% of consumers would rather use a mobile app than call a contact center. However, the bulls’ belief assumes chat is the only option for customer support while ignoring LivePerson’s inability to scale its business in a profitable manner.

If LivePerson were a new tech firm, it would be easier to justify the firm’s growing expenses. One could argue that the firm was rapidly expanding its services to disrupt an industry or change an entire market. However, LivePerson has been operating since 1995, and expense growth continues to outpace revenue growth. Per Figure 4, LivePerson’s sales & marketing, general & administrative, and product development costs have grown 18%, 15%, and 15% compounded annually respectively since 2011. Over the same time, revenue has grown just 11% compounded annually. In 2016, general & administrative and product development costs grew YoY despite revenue falling 7%.

Figure 4: LivePerson’s Expenses Growing Quicker Than Revenue

newconstructs_lpsn_opexpensegrowth_2017-03-20

Sources: New Constructs, LLC and company filings 

LivePerson’s business model is also not creating the traditional benefits of a software based business, namely increased profitability as the business scales up. Sales & marketing, general & administrative, and product development costs were 60% of revenue in 2011 and 78% of revenue in 2016. A successful software business model is expected to become more profitable over time, but LivePerson’s is getting less profitable.

These growing costs are a byproduct of the firm’s dependency on new

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