Game Changer, Macquarie Reckons

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– Reckon Will Terminate It's Agreement with Intuit in 2014
– Royalties saved but R&D required
– Most analysts circumspect but Macquarie calls a Sell

By Greg Peel

Reckon ((RKN)) is an accounting software developer who Australians would recognise through brands such as Quicken and Quickbooks for business and personal bookkeeping and accounting. Reckon's biggest competitor in the market has always been MYOB which controls a greater slice of this particular market.

MYOB used to be listed but was last year bought out by private equity, leaving Reckon as the only locally listed company in the field. Reckon's share price has had its ups and downs of late but at around $2.20 currently, it has provided investors with 145% capital appreciation from its depths of 90c in late 2008.

Reckon nevertheless does not own the Quicken brands, rather they are owned by US contract partner Intuit. In 1998 Reckon signed a licensing agreement to become Intuit's Australasian distributor of desktop applications. However, with the subsequent development of cloud computing, online applications have since become popular and this prompted a new agreement to be signed in 2010.

The problem was that the two companies found that they had what you might call, were they a rock band, “musical differences”. Intuit retained multinational aspirations but Reckon was keen to concentrate only on the Australasian market. So while the desktop agreement stood, the new agreement allowed for each company to go down their own online product strategy paths. To maintain the analogy, two years later Reckon has found it is a lot more rock and Intuit a lot more pop and so inevitably the band has decided to break up. The 2010 agreement will terminate in 2014 and not be renewed.

Everything will remain the same up until 2014, and thereafter Reckon will retain Intuit's Quickbooks intellectual property and be allowed to develop that as it sees fit. This is good news, as is the fact Reckon will no longer have to pay royalties to Intuit after that time. The bad news, on the other hand, is that Reckon will no longer be able to use the Quicken brand names and will have to fund all its own research and development. Previously it rode on the back of Intuit's R&D. Moreover, in late 2015 Intuit will be permitted to return and compete with Reckon on its own turf.

BA-Merrill Lynch sees the end of the agreement as “a set-back, but not terminal” for Reckon. Deutsche Bank suggests “it's not all bad news”. RBS Australia believes there may be upside potential for Reckon after 2014, but not without risk. The announcement of the agreement termination came as a bit of a shock to analysts, and while there's plenty of time to mull the implications over there are a lot of “what ifs” to consider.

Looking at forecast 2014 numbers, the royalties Reckon will no longer have to pay represent $6m or 15% of 2014 earnings, by all calculations. But the question is as to just how much of that saving the company can hang on to given it now has to spend up big on its own R&D and on marketing its own new brands once the Quicken name is lost. There is a clear transitional risk, given customers may prefer to stick with the Quicken they know rather than trusting a shift to Reckon's home brands. On the positive side, Deutsche sees Reckon as gaining more flexibility in product development.

There are nevertheless further pros and cons to weigh up. Competition from Intuit itself after 2015 is an issue, but Reckon has the advantage of owning the local distribution channel. What will MYOB do to take advantage of the situation? And that's not to mention any upcoming players in the cloud. Reckon shares trade at quite a premium to the Small Ords, mostly because there has always been a perceived chance Intuit would make a full takeover bid, springboarding off its 11% stake, or that MYOB's buy-out would spark similar interest in the number two player.

Merrills is looking on the bright side of potential corporate action, using the MYOB private equity takeover and the removal of the Intuit connection as reason to see Reckon as a potentially attractive acquisition. Merrills retains its Buy rating. Both Deutsche and RBS are a little less bold, and given the risks noted above would rather play the waiting game on Hold, particularly given Reckon's premium.

Macquarie, on the other hand, sees risk with a capital R and wasted no time last week in downgrading Reckon to Underperform. The analysts then went away and thought about it for a while, and came back even more convinced. In contrast to the other three brokers in the FNArena database who cover the stock, Macquarie believes the pending termination of the Intuit agreement is a “game changer”, and not in a good way.

“Although RKN will save on the royalty fees and may be able to survive on existing product code,” suggest the Macquarie analysts, “if the company is going to remain competitive then substantial R&D investment longer term is unavoidable, in our view”.

Merrills notes Reckon spent 11% of sales on R&D in FY11 which it believes is “relatively high for a software vendor”. Yet Macquarie notes that another software vendor, Technology One ((TNE)), spends around 20% of sales on R&D every year. That equates to about $30m per annum, while Reckon's earnings are only $35m. Closer to home, MYOB's earnings are $85m and it spends $25-30m on R&D every year.

Macquarie does not believe Reckon could make an adequate return on matching this kind of money, and thinks it unlikely the company would try. Yet if it doesn't, its customer base might hang in there for a while (accountants are known to be “sticky”) but over time Reckon's offerings are at risk of becoming obsolete. There is a near opportunity to lift prices, which is what MYOB has been doing, but every way the analysts run the numbers they just can't arrive at a valuation that isn't well below the current share price.

As for a takeover of Reckon, Macquarie can't see it. The analysts can see Intuit divesting of its 11% stake, however and thus that holding may well become an overhang. Reckon could increase debt and buy back the stake for an accretive outcome, they note, at least in the short term.

Macquarie was quick to downgrade reckon to Underperform last week, but left its target unchanged at that point before it had a chance to run some numbers. With numbers now run, Macquarie has slashed its target to $1.65 from $2.39, or some 25% below the current trading price. The analysts see Reckon's price/earnings multiple being de-rated by the market over the short to medium term.

The other three brokers' target range from $2.50 to $2.65, which, with Macquarie, leaves an average of $2.35 but quite a gap.

Will 2014 see a day of reckoning?
 

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