In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Brian Feroldi do a deep dive on Manhattan Associates (MANH 1.37%), a little-known mid-cap consulting and SaaS company with big long-term potential. Tune in to learn about how this company works and why it's transitioning to a SaaS-ier business model; how the SaaS transition has affected its earnings in the last few years, and when that transition should pay off; what industry tailwinds really boost its long-term potential; the biggest risks and yellow flags to keep an eye on; how the company looks in terms of leadership, customer concentration, stock-based compensation, etc.; and more.

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This video was recorded on Oct. 18, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, October 18th. We're talking about a stock that we've never mentioned on the show before, but it's undergoing the software-as-a-service transition and we love doing that discussion. I'm your host, Dylan Lewis, and I'm joined on Skype by's Brian Feroldi. Brian, what's up, man?

Brian Feroldi: Hey, Dylan! Congratulations to your Jets for securing their first win this past weekend!

Lewis: It's been a really rough fall. It was nice to get that first W in the books. It's crazy, the difference actually having your starting quarterback on the field makes for a team.

Feroldi: That's super tough, to play a season without one. But, hey, they got the job done. You must have been pumped. 

Lewis: Yeah, it was good to see a win. Of course, business as usual for you and your Patriots -- although I did see a stat, Brian, it's the quarterbacks with the highest winning percentage right now. Tom Brady, No. 2. You know who No. 1 is?

Feroldi: Would that be Garoppolo?

Lewis: Jimmy Garoppolo, yeah! 

Feroldi: Former Patriot.

Lewis: Former Patriot. He's part of the Belichick system. 

Feroldi: That's correct.

Lewis: I queued up today that we were going to be talking about a stock that we haven't discussed on the show before. I love that you always bring the stock ideas to the show. We're going to be talking about Manhattan Associates, a name that probably a lot of people don't know.

Feroldi: This is a stock that I have personally owned for several years now, when it was recommended by one of our services. This stock has just been a monster winner for investors. Shares are up 1,590% over the last decade. If you are a fan of the "winners tend to keep on winning" philosophy, which I certainly am, this is definitely a stock to get to know. As you teased at the top of the show, one reason that this is a great stock to talk about now is that they are in the middle of converting to a software-as-service business model. We know that is a formula that works very well. It's a great time for listeners to get to know this stock.

Lewis: Yeah, I think this is a company that not only offers the proven track record of a successful business with a software offering that people seem to really love, but they're about to put that into overdrive. They're going to really kick it into the next gear, because they are making this transition from licensing their software to the SaaS model. We're going to touch on all that later. First, though, let's lay the groundwork. What exactly do they do?

Feroldi: These guys are a software and consulting business that specializes in supply chain management. If you are a company that has to deal with inventory, warehousing, transportation shipping, Manhattan is the premiere name in helping to optimize a supply chain, to increase throughput, reduce errors, speed up order times, those kinds of things. These guys sell primarily to retailers, but they also have wholesaler customers, as well as manufacturing businesses and logistics providers. They've really come in vogue recently because they help retailers provide an omnichannel shopping experience to their customers, which we know is just a mega trend that's happening in retail. For those that aren't familiar with that term, omnichannel is just a fancy way of saying they provide a unified customer shopping experience, no matter whether they interact with the company at a brick and mortar store, on the mobile side, through social media, an e-commerce channel, through their website -- basically anywhere that a customer would interact with a brand, that would be omnichannel.

Lewis: Yeah. The value prop here that Manhattan Associates is offering touches on a lot of different things that are super important in retail right now with the e-commerce landscape really putting a lot of pressure on margins for retailers. You think about omnichannel and being available everywhere, that's huge. But also, all of these things we're talking about in terms of supply chain logistics, these are the types of things that add to costs if they're run inefficiently. We talked a little bit about inventory there, too. Having too much inventory on the books obviously creates a lot of problems for businesses. This is something that is trying to make all of these older retailers run a little bit more efficiently, a little bit smarter, and be a little bit more competitive in the modern e-commerce landscape.

Feroldi: Yeah. Retailers these days have tremendous pressure on them to really make investments into their e-commerce capabilities. One way that they are differentiating themselves from companies like is to order things like buying online and picking up in stores, or shipping directly from their retail stores to consumer homes from either a retail store or their warehouses. Those are all things that Manhattan Associates excels at and really is the leader in. So, they have a big trend that's behind them. 

Lewis: If you look over at their customers, some pretty big stamps of approval. They have Home Depot, Under Armour, Safeway, which is a huge supermarket over here in the D.C. area, Target, just to name a few, but the list goes on. It's clear they're offering something that people find valuable. 

Feroldi: Yeah, and these guys are the identified leader by consulting firms such as Gartner. If you are a brand that wants to get into the space and you need help, Manhattan Associates is the premiere name to go to.

Lewis: Let's talk a little bit about the transition with SaaS here. This is something that often creates a lot of problems, creates some messy financials and some difficult comps for companies.

Feroldi: Yeah. Manhattan Associates has basically five sources of revenue. No. 1 would be their software-as-a-service offering, which is only about 4% of revenue right now. But as we know from SaaS offerings, they are very high margin, and this is a major focus of the business right now. This is the fastest growing segment for Manhattan Associates. 140% revenue growth last year. 

No. 2 would be their legacy licensing software business. This is when companies purchased a license upfront from the company and just ran their supply chain from it. This has fallen to 8% of revenue. This number is declining as the SaaS conversion takes place, and we should expect that to continue to happen. 

Third would be customer support services. This would be maintenance revenue for that software. This is a decent chunk of the business, 26% right now. It's actually still growing at a moderate pace. But as SaaS becomes more and more, the SaaS number should also overwhelm this target, too. Those three sectors are just going to be overwhelmed by SaaS revenue growth in the next couple of years. 

And this company's biggest source of revenue, surprisingly, is actually professional services. Those are where companies pay Manhattan Associates consulting fees to help with implementation of the software, planning, training of the customers, converting and transferring their old data, education, system upgrades. This comprises 60% of total revenue, so it's not out of line to call this a hybrid software and consulting business. 

And then finally, the last little bit is just hardware sales, where they sell third-party hardware that works with their software natively, so like RFID readers, scanners, barcode readers. They are really just a middleman for getting this stuff to customers in a convenient way. 

But combine all that together, and that's how this company makes its money. 

Lewis: You really get a sense of that hybrid model you were talking about when you look over at the gross margins for this business -- right now, somewhere in the mid-50% range. You typically expect a software company to be 70% and higher, maybe even into the 80% range. The consulting business does bring margins down a little bit lower than you'd expect them to be for a software business. 

Feroldi: Yeah. And as you mentioned, that's the consolidated number. This company doesn't break out specifically margin by those revenue opportunities, but I think it's fair to say that the professional services revenue -- which again, is the bulk -- probably has a 40%, 50% margin, something along those lines. But it's really the SaaS and the licensing software and the support software that has the very high margins.

Lewis: You look over at the business. I mentioned that when companies make these transitions, it tends to have a weird effect on financials. We saw that looking at their year-by-year revenue. They showed declines over the last couple of years. That's because they had to eat some revenue due to some accounting changes and this business model shift they're going through.

Feroldi: If you look at their revenue, in 2016, $580 million in revenue. Last year, 2018, that dropped to $560 million, for two primary reasons. No. 1, the shift to focus on software-as-a-service, which we have said time and time again is lower revenue upfront in exchange for a more dependable, recurring revenue model over time. And then, there was another accounting rule change that changed the way they booked their hardware revenue. Those two things have combined to basically make the revenue go nowhere but down for the last couple of years. 

However, 2019 should start to reverse that trend. The current estimate is about $600 million in revenue for this year, and $630 million for 2020. So, the pain points of the SaaS conversion are starting to be behind this company.

Lewis: And this company was really in a strong position to go through this transition. You look over at the balance sheet, over $100 million in cash. Zero long-term debt. You can afford to take those short-term pinches when your balance sheet is that strong.

Feroldi: Yeah. These guys have operated with zero debt for as long as I've been following them, years. It's just the ethos of the company. Another thing that I like about this business is, even throughout this SaaS transition process, they've been producing more than $100 million in net income and free cash flow. They haven't had to go into a huge free cash flow sinkhole and net income sinkhole that we've seen with other SaaS conversions. That's something that investors should like about this business.

Lewis: You mentioned that it is a fairly sticky business. That's borne out when you look at the renewal rates for customers. While they're going through this transition from licensed to SaaS, I have to imagine that people are going to stick around, and once that transition is made, that's going to be nice, easy money for them. They also have a fairly strong brand in the space.

Feroldi: Yeah. Those two things are what give this company a moat. When you think about what it takes to get the software going for the logistics side of your business, the warehouse, the inventory, that is a very complicated process to get up and running. Once you're in Manhattan Associates' ecosystem, it's very hard to leave and go elsewhere for any reason. The switching costs of this business are very high, and the brand name is very high. They actually say that when they are competing head-to-head against other companies in the industry, their win rate with customers is about 70%. That's very high. I think the brand here helps them attract new customers, and the high switching costs help keep them around. Those make for a very dependable business.

Lewis: This is a company that's been around for a little while. It's not in the start-up, 80% year over year growth mode that we talk about with some of the companies on the show. What does growth look like for them? What are you seeing with this business over the next couple of years?

Feroldi: One thing, when we're looking at a software-as-a-service company, or a potential one, is that management touts this huge total addressable market opportunity number. Manhattan Associates doesn't really do that. They more point to the mega trends that are the long-term drivers of their business. We already touched upon one. Really changing consumer preferences with how they shop. The general move is toward e-commerce, omnichannel, and smaller, more frequent shipments to customers. That applies to individual consumers as well as businesses. That trend is generally pushing retailers to make investments in their supply chain and to become leaner. That's an opportunity that Manhattan Associates really supplies.

The other thing that we've seen is that the "retail apocalypse", where we've seen so many weak retailers go out of business, that's putting huge pressure on those that are remaining to really become much more competitive and fend off the competition from Amazon -- again, leading them right into Manhattan Associates' hands. It's astounding, the number of retailers that still haven't made this a priority. A recent survey showed that about 80% of retailers admit that they are not offering their customers a unified brand experience. Only 22% of them are making an omnichannel sales experience a top priority. That's a mismatch that is only going to become a stronger incentive over time to work with Manhattan Associates. 

Lewis: All right, Brian, we can't talk SaaS without talking customers. You're big on customer concentration and making sure that that's not the case for anything that you're buying. What's the picture with Manhattan Associates?

Feroldi: Yeah, concentration is definitely not an issue here. They have hundreds of individual customers, and their largest customers do not make up an outsized portion of revenue, so we can check that box. When you think about what it takes to bring a customer into their business, that is a very expensive, very long process. They call out nine-plus-month sales cycle just to get a yes. And then, once they are chosen and implemented, that is a multi-month, if not multi-year process. So, acquiring customers is very expensive for this business. 

On the flip side, once a customer is in their ecosystem, they are very dependable sources of revenue, and going to become even more so as the company converts to the SaaS model. That's a major reason why we love when businesses go from licensing to SaaS. I think that there's reasons to believe that Manhattan Associates does have good relations with its customers, and it could even in time boast pricing power, because once they get in, it's so hard to switch over. That is something that I like to see as an investor.

Lewis: Something else I like to see is, management's been with the company for quite some time. You look at the people calling the shots. CEO Eddie Capel has been with the business for a good amount of time, and seems to be pretty well liked there, too.

Feroldi: He started at this company in 2000 in the management team. Worked his way up to take over the role as CEO in 2013. He has been at this company for a long time. If you check out his Glassdoor ratings, they're pretty good. 88% of employees approve of him as CEO. The business itself gets about 3.7 stars out of five. Those are good -- not stellar, but pretty good -- numbers. 

One knock I do have against this management team is that inside ownership is pretty low. CEO Capel owns about $10 million worth of stock, which is peanuts compared to the grand scheme of things. But that is enough of an incentive for him to continue to see the share price move higher. 

So, I would say, pretty good management in culture. Not the best we've seen, but by far not the worst.

Lewis: Yeah. To put that $10 million in context, I think they're currently trading at like $5.5 billion. That's roughly their valuation. This is definitely one of those companies that's in that mid-cap sweet spot when it comes to SaaS. They are big enough to have a sizable business, not so big that it becomes really interesting for one of the tech giants to hop in there and say, "You know what? I think we're going to get a piece of this, too."

Feroldi: Yeah, totally.

Lewis: All right, we're going to run through the red flags quickly. I know listeners like your checklist, Brian. I want to make sure that we don't miss anything over there on the risks side as well.

Feroldi: Sure. There are, of course, numerous risks for investors to keep in mind. But this isn't a penny stock of any kind. As we touched upon before, there's no customer concentration to worry about. One of the things I like to ask is, does this industry face long-term headwinds or tailwinds? I believe the answer is tailwinds, because retailers have huge pressure on them to invest in their omnichannel experience. 

One thing I will note is, one question I like to ask is, does this business rely on any outside force for success? And I think the answer there is sort of. They do sell a lot to retailers. That is their No. 1 customer segment. So, a healthy retail environment is important. If the retail sector in general took a big decline because a recession, you could see the case for retailers to make less investments into their business. That is something for investors to keep an eye on here. 

And then finally, I like to look at stock-based compensation. Stock-based compensation is actually very low for this company, about $19 million all of last year -- again, compared to a $5.5 billion market cap. So very, very small in the grand scheme of things. This company actually produces so much free cash flow and so much net income that they've actually been a net buyer of their stock over the last couple of years. The share count has actually declined by 13% in the last five years. That's something that investors should applaud.

Lewis: Yeah, if you look at the share price appreciation, too, it looks like a lot of those buybacks have been coming at pretty good valuations because the stock has just generally been up and to the right, particularly over the last year, but definitely over the last couple of years as well. 

I think, to mitigate one of those risks, talking about the dependency on retail, I do see that as a possibility. If you're running into several retail customers that are facing cash crunches, they may decide to lower their investment in the space. But, it's one of those things where, long-term, if retail wants to thrive, they need to be making these investments. I think that's where the industry is going, and they're in a good spot to take advantage of that.

Feroldi: Yeah, I totally agree. Even some struggling retailers that we've seen, sometimes they do have pressure on them from investors to return to growth. One way that they can do that is by really investing in their e-commerce capabilities and building out their omnichannel experience. That, again, pushes them into Manhattan Associates' hands. So there is a counter-argument to be made that weakness in the retail environment would increase the pressure on them to make investments in themselves. That could be a counter-balancing factor. 

As for the stock itself, you mentioned that the share price has been fabulous performing this year. It's about doubled since the start of the year. I think this is a very good, very dependable business that should just steadily crank out double-digit growth for the foreseeable future. But it is quite expensive right now. 55X forward earnings, and almost 10X sales. I wouldn't be in a rush to buy the stock today. But I do think it is a stock that tech investors should put on their radar.

Lewis: Yeah, I am definitely a fan of having a little post-it note with a couple of stocks that I'm interested in, particularly if we see a bad day in the market and I can start out a position, a small one, at a price that I really like. Having that watch list is huge. I think this is a company that absolutely deserves to be on people's watch lists.

Feroldi: Yeah, I totally agree with you. We've seen a lot of our favorite high-flying tech stocks really get crushed over the last six weeks. This stock has actually held up very well, which I think is because the company is already profitable and trades at a moderate valuation in comparison. If you want to get in on the SaaS conversion space, but you don't want to take on a huge amount of risk, this could be one to check out. 

Lewis: Thanks for putting another great stock on our radar and joining us today, Brian!

Feroldi: Anytime, Dylan!

Lewis: Listeners, that's going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, you can shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or catch videos from the podcast on YouTube, along with a ton of other video content we're putting over there. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!