Blackbaud Finds a Complementary Edge

 Blackbaud (BLKB) announced Tuesday that it is set to acquire MicroEdge, a complementary software player focused on the philanthropic market, for an aggregate purchase price of $160 million in cash. The deal is projected to close in approximately two months, subject to customary conditions, and we expect the bulk to be funded by debt. Although Blackbaud has been focused on product investment and simplification of the portfolio suite this year, and a deal of this size comes as a surprise, we think it makes sense. There is no change to our $37 per share fair value estimate, and we would seek a wider margin of safety before committing capital to this narrow-moat firm.

Blackbaud is the global leader in supplying nonprofit organizations with software that streamlines marketing, organizes donor information, and improves financial and accounting functionality. We think Blackbaud is well-established as the market leader and will continue to increase revenue as NPOs lean on software and digital products to reduce costs and allocate funds more effectively. The company generates revenue through sales of perpetual software licenses, hosting service subscriptions, and providing maintenance contracts that update software and offer product support.

MicroEdge is well-positioned with the largest independent and corporate foundations; it has approximately 80% of foundations with more than $500 million in assets among its client roster. With an estimated 2,000 customers, an end-to-end (grant-making lifecycle) solution, subscription-based model and (likely) a higher average revenue per customer than that of Blackbaud, there should be plenty of cross-selling and market-expanding opportunities for the combined entity.

Blackbaud's Products Are Well-Received by the Marketplace
Blackbaud is the only remaining pure play (of scale) focused on NPOs, and during its 30-year history it has developed a reputation of providing high-quality integrated applications and tools as well as extensive customer support. Blackbaud's software is one of the few programs designed specifically for the unique needs of NPOs and is designed to improve fundraising capabilities by reaching more potential donors, improving message efficacy, streamlining business operations, and keeping track of donors' needs and preferences. The firm's products, with their various critical business functions, have been well-received by the marketplace; they span large and small organizations and reach multiple industry segments such as hospitals, universities, and charities. In most cases, customers perceive the cost and risk of replacing software that supports core daily functions to be greater than the price of paying recurring support and maintenance fees. Where there is undoubtedly some level of churn in the NPO universe (driven largely by closures or consolidation), historically, Blackbaud's customers have rarely replaced the company's software, as demonstrated by an estimated 90% customer retention rate.

Through its acquisition of Convio in May 2012, Blackbaud was able to not only remove a key competitor but also strengthen its position in cloud-based solutions and expand its presence in larger enterprises and advocacy-based organizations, which positions Blackbaud well in faster-growth areas. Additional tuck-in acquisitions followed, but we still believe Blackbaud serves less than half of the 4,000 largest enterprise NPOs today (an $8 billion addressable global market opportunity) and is similarly underpenetrated in the equally large midmarket space. The accelerated shift to a software-as-a-service provider has the potential to be a game changer and offers multiple cross-selling opportunities. There is still some cyclicality baked into the model, but we view Blackbaud as having plenty of runway to reach management's long-term revenue target of $1 billion.

We See Continued Solid ROICs Supporting Our Narrow Moat Rating
Our fair value estimate of $37 per share implies 2014 adjusted price/earnings of 24 times, an enterprise value/EBITDA multiple of 16.5 times, and a free cash-flow yield of 4%. We anticipate that the firm is well-positioned for high-single-digit top-line growth in 2014, but we expect margins to come down by roughly 200 basis points as the firm invests ahead of demand. Longer-term, we estimate annual organic sales growth of approximately 9% in our discounted cash-flow model, driven by a combination of new subscribers, cross-selling opportunities, and incremental pricing gains. This is slightly below management's long-term goal of low- to midteens organic growth (plus selective acquisitions), but we still have the company reaching its $1 billion revenue target within our explicit forecast period.

We expect Blackbaud to improve GAAP gross margins to around 56% in 2023 from 54% in 2013, a recent trough. Put in perspective, historical gross margins averaged more than 60% before 2012. Our 10-year financial model includes modest selling, general, marketing, and administrative expense leverage, leading to upper-teens GAAP operating margin at the end of our forecast period, up from 10% in 2013 and a historical average of nearly 16%. Through 2023, we believe the firm will post solid returns on invested capital, providing support for our narrow economic moat position.

In March, Blackbaud entered into a new and extended credit agreement, including a $175 million senior secured Term A loan and a $150 million senior secured revolving credit facility. The accordion provision, which allows an additional $200 million under the revolver, added the necessary financial flexibility. The company ended the second quarter with $147 million in net debt, and assuming $100 million were added to the year-end 2014 number, this would place leverage north of 2.0 times EBITDA, not terribly high by many standards, but toward the upper end of our comfort zone.

Management's Tactics Are Prudent and Transparent
Overall, we view Blackbaud's stewardship of shareholder capital as standard, though we like the firm's general trajectory and recent focus on pay for performance. In January 2013, the company announced the planned retirement of CEO Marc Chardon and named CFO Anthony Boor as interim president and CEO in August of the same year. CEO Mike Gianoni joined the firm officially in January 2014. We like that he is embracing the firm's underlying strategy while also putting in place plans to reaccelerate top-line growth and margins. Management has demonstrated prudence in acquiring value-added companies, including Convio and now MicroEdge, over the past few years.

From a compensation perspective, management is measured against various metrics including revenue growth, EBIT, bookings, and customer retention targets, and while restricted stock units vest over a multiyear period (usually three or four), the firm's long-term incentive program appears to skew more toward recent history than the medium term. Average compensation for active directors in 2012 was $185, 000, perhaps slightly aggressive for a company of Blackbaud's size, but we don't hold any major reservations here. Chardon earned a total of $2.1 million in 2012, and we view compensation at the executive level as reasonable. We think it's worth noting that CFO Boor joined the company in November 2011, and one of his first acts was to issue a restatement of Blackbaud's financials since 2006. While the restatements were inconsequential, we like Boor's up-front demeanor and transparency with investors.

As the management team continues to methodically tick down the list of steps necessary to both accelerate top-line growth and drive absolute (and incremental) margin gains, we continue to like the firm's path. We view Blackbaud as a high-quality name and think it benefits from high switching costs that provide extensive competitive advantages, support impressive levels of profitability, and lead to excess returns on capital. However, we believe the shares are fairly valued.