The technology sector has been the hottest sector in world markets in 2020. But for UK-focused investors, the choice of technology stocks is quite limited, with only three technology stocks in the FTSE 100 and just 15 across the entire FTSE All-Share market. Wanting to increase my choice I decided to broaden my horizon to London’s junior market: the Alternative Investment Market, or AIM for short, where we find that the FTSE AIM All-Share index has 90 technology company constituents.
Screening for fast-growing sales and a business that seems to be focused on “next generation” areas I found Blue Prism Group plc (OTCPK:BPRMF), a company which is described by the London Stock Exchange as “a leader in Robotics Process Automation, supplying a Virtual Workforce powered by Software Robots that are trained to automate routine back-office clerical tasks.”
With sales growing from £25m in 2017 to £101m in 2019, the growth rate initially looks very good. Robotics Process Automation and Virtual Workforce sounded ultra-modern and wonderful enough for me to do a dive deeper into this stock. Could this be the next “to the moon” AIM quoted technology stock?
Based in Lancashire, England, Blue Prism like many AIM-quoted companies is loss-making. Early investors in this software company would need to be patient to suffer the painful part of the hockey-stick J-curve period with the hope that early stage losses would lay the foundation for rapid growth and a later boom in equity value. This is normal enough, but with a market capitalization of around £1.2bn, Blue Prism isn’t really a penny share that I can buy a few shares and treat as a low-cost call option on the future, not caring too much if the stock goes to zero.
I find technology to be an interesting sector, and my vision of the distant future is somewhat like how it appears on Matt Groening’s Futurama, so the robotics theme appeals to me, and with “work from home” the new normal in many parts of the world “Virtual Workforce” is also a theme that I expect to do well in the coming years. But software is an extremely competitive industry where bubble valuations supported by enthusiastic venture capital funds are frequently found. Thus, Blue Prism’s long-term success is going to depend on its product quality. Unfortunately, my research led me to the conclusion to avoid this stock, despite two other enthusiastic Seeking Alpha articles published in 2020 on the stock (see here and here).
The bear case
Early stage technology is risky, but one way to reduce the risk is to try to understand the level of innovative activity a firm is carrying out. Probably the best indicator of innovation and potential for innovation is a firm’s research and development – R&D from now on – budget. Unfortunately, Blue Prism’s low levels of R&D spending turned me off investing in this company. But to check I wasn’t being overly pessimistic based on just one factor, I wanted to see the short interest in the stock, and who exactly was reporting large short interest in Blue Prism. As at 18th November 2020, according to the UK regulator’s data, investors with positions of over 0.5% of share capital in the issuer had shorted 2.24% of Blue Prism’s equity. The largest short, Sylebra Capital had a short position of 1.72%. This is significant for me because Sylebra is a specialist long-short technology fund focused on mid-sized market capitalization companies.
Losses have increased at Blue Prism, with a £26m pre-tax loss in 2018 blowing out to an £81m loss in 2019. However, on the surface Blue Prism’s business model has some attractions for a software firm. Last year the company reported a high proportion of repeat revenues at 96% and gross margins of 92%. By April, the company had nearly 2,000 customers and upselling represented almost 75% of new monthly recurring revenue in 2019.
Trading in 2020 has been relatively good, with no obvious big problems from Covid-19, except for some contracts slipping which is to be expected in this environment. The relatively smooth year so far is probably because Blue Prism usually sells to larger more established companies that generate enough back-office documentation work that spending on software to automate much of it makes commercial sense. Blue Prism claims clients such as eBay, EY and Deloitte. Robotics Process Automation has been a growth market and Blue Prism’s revenues have increased over the past four years by a respectable compound average growth rate of over 100%.
Questioning cost priorities
That sales growth looks good until you look at the costs associated with sales and marketing which for 2019 came in at £105m, a figure that represents 104% of revenues. Obviously, that’s not sustainable and when compared with the expenditure on R&D of just £6.1m, one wonders what is the real long-term future of this company?
The next red flag is that another £4.6m of development spending was capitalized, and this pales in comparison to the £23.6m of sales commissions that were capitalized. The Global Investor much prefers to see expenses expensed rather than capitalized even though accountants allow this choice. In my opinion, capitalization of these costs flatters earnings and boosts book value. Commissions on multi-year sales are sometimes paid upfront at Blue Prism, meaning a salesperson will get a commission on, for example, a multi-year contract well before the full value has been realized on the firm’s income statement. This is a very attractive incentive for software salespeople but in my opinion this promotes short-term thinking and potentially puts getting the act of sales closing above the provision of long-term customer service on current customer contracts.
The sales spending has been driven by staff costs, as a doubling of the firm’s recruitment costs to £6.8m last year shows. The latest year of hiring doubled the company’s headcount to over 1,000 which compares with a headcount of less than 100 four years ago. This has driven revenue per employee down, a key metric for fast-growing companies and means questions about the scalability of the business have to be asked.
In 2019, Blue Prism spent on travel and entertainment 3x on the amount spent on R&D. CEO Jason Kingdon acknowledged on a recent analyst conference call that Blue Prism needed to do more on R&D, and the company plans to triple R&D spending by 2021 but actions speak louder than words. Indeed even if this target was met Blue Prism’s R&D ratio would still be smaller than peer Pegasystems (PEGA) which currently spends about 25% of revenue on R&D.
Cash flow breakeven by 2021, really?
Blue Prism claims it is progressing “to cash flow breakeven in 2021” but the firm may feel under pressure to spend because it is competing with much larger players. US rival UiPath is set for an IPO valuing the company at potentially $20bn, and Microsoft (NASDAQ:MSFT) is also active in this space.
To date Blue Prism has taken advantage of the sentiment around this sector to raise equity on a regular basis, but who is to say this won’t continue and as an investor getting diluted or being asked to stump up extra cash is never fun.
The Global Investor thinks the market might have underestimated the growing risks and overestimated the profit potential for Blue Prism in this competitive space. Fighting against Microsoft seems like a fool’s errand and the ratio of R&D spend to marketing spend is just too worrying an indicator.
Valuation and summary
A price-to-sales multiple of 12.4x shows that a lot of optimism on growth continuing is being priced in. A price to book value of 12.2x compared to the UK software average of 11.2x shows the company isn’t especially cheap, and The Global Investor has already discussed the issues around capitalization of expenses boosting book value. If the company becomes profitable it might be worth another look in the future, but for now The Global Investor recommends avoiding this stock.
Vain investors focus on sales, sane investors focus on profits. Never mind, there are 89 other UK junior market technology fish in the investing sea.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.