Does Manhattan Associates Have a Moat?

Manhattan Associates (MANH -1.16%) is a leading provider of software and consulting services that help companies optimize their supply chain. The company has grown considerably since it was founded, and long-term investors have earned multibagger returns for hanging on. In this episode of Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Brian Feroldi break down Manhattan Associates' financial statements and competitive advantages and talk about the growth opportunity ahead. 

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This video was recorded on Oct. 18, 2019.

Dylan Lewis: First, though, let's lay the groundwork. What exactly do they do?

Brian 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 Amazon.com 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.