December 3, 2021

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A Rare Quality Story From Eastern Europe

Quality-focused investors may see Eastern Europe as barren land, as it can be challenging to find businesses generating high cash returns and growing organically at a steady pace. However, Poland-based LiveChat Software (WAR:LVC) appears to be an exemption. We at Urbem have researched the customer service software developer, which operates in the Software-as-a-Service model and enables its clients to better connect with their customers, increase online sales and improve online conversions.

Take a look at LiveChat’s financial performance, which shows an over 100% return on equity capital or invested capital (including cash), an operating margin of more than 60%, a free cash flow margin of more than 40%, no debt, plenty of liquidity on the balance sheet and a three-year revenue growth rate of 27%. According to data from GuruFocus, the business consistently delivered super-normal returns on assets while increasing its annual free cash flow by more than five times since its IPO in 2014.

LiveChat’s main product is a tool for quick contact between customers and businesses using a text-based chat feature embedded on the website or application. Around this core use case, the company has built “widgets,” including ChatBot (an AI-driven platform to automate business communication), HelpDesk (a support ticketing system) and KnowledgeBase (a self-service help center). Across the top one million websites worldwide, LiveChat captures around 10% of the market share, which is second to the market leader Zendesk’s (NYSE:ZEN) 27% and the runner-up’s 15%. By geographies, North America, the UK and Australia account for 47%, 13% and 7% of the total revenue, respectively. The domestic market only generates 2% of the company’s sales. Prominent clients include Adobe, McDonald’s, Mercedes-Benz, Paypal, Samsung, Huawei, Ryanair and Sony, although the management believes that its products are addressed primarily to small- and medium-sized enterprises. LiveChat is a truly global company serving global businesses with scale.

Moving forward, the company plans to concentrate on the organic acquisition of new clients. Per the management, the customer acquisition cost is close to zero, thanks to the robust business model. This means that the company can return most of its earnings to owners, with a dividend payout ratio consistently above 70% since the IPO. Meanwhile, we believe that the continuous increase in online retail sales globally will drive the growth of the live chat software category. This means that live chat software developers would be focusing more on acquiring new clients rather than fighting for clients from competitors, at least for the short run.

Over the longer term, it cannot be ruled out that the competition will get increasingly fierce. We have observed the loss-leading approach that delivers a higher growth at Zendesk as well as the threat from freemium players, including the late entrant In the live chat software space, companies mainly compete in terms of quality, features and security, none of which appears to be able to act as a sustainable competitive edge. LiveChat has been working actively on building its ecosystem around the core product. The strategy may work out well with respect to increasing client stickiness and the associated switching cost. In this regard, we hope to see a clearer sign of economic moat in the future.

LiveChat is still founder-led, with aggregate insider ownership of around 47% among founders and key managers. Although the current moat of the business is not visible enough to us, the industry where it operates benefits significantly from the long-term tailwind of digitalization, and the company’s business model proves solid with a balance of both high returns and high growth. We think that LiveChat Software can be a good candidate as a quality compounder, which makes it worth a slot on the watch list.

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We do not own any security mentioned in the article.

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This article first appeared on GuruFocus.

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