It feels like 1999 on steroids. Companies with little or no earnings and minimal growth are commanding enormous valuations.
One of the poster children of the era is WiseTech: a truly bubblicious business, led by AC/DC’s former guitar repairman Richard White. White’s wealth has ballooned to almost $4 billion, making him currently one of the richest people in Australia.
WiseTech sells software to help freight forwarders and third-party logistics providers manage their business (like a mini SAP or Oracle). It was listed on the ASX in 2016 for $3.35 per share. By September last year, its share price hit a remarkable $38.80, although a critical report by Hong Kong-based hedge fund J Capital saw its share price drop materially.
When COVID-19 struck in March, WiseTech’s share price fell to $10.48 but, like John Howard and Lazurus’ love child, White and WiseTech have risen once more. The company almost hit $28 per share last week after it announced financial results.
There are two reasons to be very skeptical about WiseTech’s remarkable ascent. First: it remains extraordinarily expensive. Second: its financial statements give rise to the first point even more.
How expensive are we talking?
Let’s look at the results announced last week.
At first glance, the business had a stellar year, with profit before tax rising from $76 million to $181 million. However, this year’s result included an $111 million one-off gain which resulted from WiseTech saying it no longer needed to pay earn-outs from acquisitions. (An earn-out is a contingent payment to someone who is selling a business based upon hitting certain targets).
WiseTech claimed in its financial statements that “contingent consideration [is based] on a number of milestones, including performance-related targets, and the integration of the acquired businesses with the Group.”
If WiseTech is no longer needing to make these earn-out payments, one conclusion to draw is that the acquisitions haven’t performed as expected. Remove that windfall, and profit before tax fell this year.
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That means WiseTech is trading on a comical underlying price-earnings multiple of 177. (The long-term average for the market is around 15 times).
A company might be able to justify that sort of multiple if they had a one-off hit to earnings, or they are expecting massive growth through scale or a fantastic new product. But WiseTech is a mature business and allegedly grew revenue by 23% while its operating profit was flat.
WiseTech can’t exactly blame COVID-19 either for its ho-hum profit result. It claims customer churn of only a few percent, and its customers pay subscriptions fees for a product which is essential to running their business — it’s not like a marketing expense which can just be turned off.
Interestingly, the WiseTech board noted that senior management missed their recurring revenue, EBITDA and growth targets.
Usually when a company is growing revenue but not profit (and also spent $147 million buying other businesses and assets), generous speculators may attribute a multiple of say 20 times net profit in a buoyant market. In a bear market, a multiple of single digits would be more likely — that would value WiseTech optimistically at around $500 million. But WiseTech is currently pegged at $8.9 billion.
I’d suggest WiseTech’s share price could fall 95% and it still be expensive.
The ‘growth by acquisition’ model
Then there’s WiseTech’s accounting policies. A significant chunk of WiseTech’s growth has been via acquisition — it ostensibly buys small competitors and transfers clients to its CargoWise platform. In effect, it buys businesses to avoid having to sign up clients directly via an expensive enterprise sales team.
The beauty of this “growth by acquisition” model is that WiseTech doesn’t need to pay for expensive salespeople (which reduces annual profit). Instead, WiseTech buys assets which seem to sit forever on its balance sheet.
In 2019, it paid $389.4 million to acquire businesses which had net identifiable assets of $33 million. The difference is recorded as “goodwill”, which WiseTech claimed “is attributable predominantly to key management, specialised know-how of the workforce, employee relationships…”.
Remember: WiseTech was able to increase this year’s profits because its acquisitions weren’t performing or integrating well enough to justify earn-out payments to the sellers, but then didn’t see fit to write off any of the associated goodwill (all $652.9 million of it) attaching to those acquisitions.
There’s also WiseTech’s treatment of IT development expense. It’s not uncommon for digital businesses to capitalise spend on developers. The argument is that it’s a bit like building a factory: a business which invests in a factory can depreciate that cost over say 25 years. The same argument is made with software.
Last year, WiseTech capitalised $74.2 million of spend, claiming this related to “increased commercialisable technology assets from product developments”.
WiseTech amortises the product design and development expenses “over the estimated life of the asset”. The business recorded only $17.4 million in amortisation of software this year. WiseTech booked $85 million in expenses relating to development last year, so WiseTech booked only 47% of its IT spend as an expense (or 58% if you include amortisation). By contrast, Xero capitalised 45% of its IT spend but when you include amortisation, it effectively ran 79% of IT spend through its P+L.
WiseTech is audited by Big Four firm KPMG, who are paid more than $1.7 million annually for audit and other services. KPMG identified capitalisation of expenses, revenue recognition and impairment of goodwill as “key audit matters”.