Epiq Systems (EPIQ) is a provider of integrated technology solutions for the legal profession. As the company's total revenue growth re-accelerated, so has the share price. (The chart pattern could be a cup-and-handle pattern.) I attribute the slower growth to the recessionary conditions that prevailed through 2010. Following 2011, EPIQ has posted top-line growth north of 20%.
The company's revenue recognition disclosure seems normal. EPIQ earns revenue from fees; specifically, it earns fees related to the delivery of a variety of services, hosting fees, deposit-based fees, legal notice fees, monitoring and reimbursed expense fees.
I think the company will continue to generate more revenue from its eDiscovery platform. My baseline revenue forecast for this year is $473 million and for 2014 it is $568 million. The adverse scenario for 2014 is $497 million. In other words, I think we see 5% to 20% revenue growth in 2014. The 2014 optimistic forecast is for $615 million.
Based on a free cash flow to equity and multiplier model, I think EPIQ still has substantial upside. The baseline models suggest an intrinsic value between $26.50 and $39 per share or 62% to 138% upside.
Not including the general risks of investing, the momentum may be able to absorb a temporary decline in the top-line growth rate but a sustained decline in the growth rate could result in a decline in the valuation.
For a company growing at 20+% with significant off-balance sheet intangible assets, paying 1.7 times book value is reasonable.
Analysis of Third-party Research
With all due respect, I think Mr. Trainer is analyzing EPIQ from an accounting perspective. Specifically, I think his intense focus on profitability is inappropriate; this is a common mistake when evaluating a growth stock and one that I have made. In this case, I think EPIQ investors are looking for continued 20+% revenue growth and a favorable macro-economic backdrop. EPIQ is more of a momentum play than a traditional value play, and right now the momentum suggests being bullish.
Additionally, as EPIQ gains scale, management can reduce operating expenses as a percentage of revenues to increase profitability; my baseline scenario suggests a 10% to 15% net profit margin, if EPIQ continues to increase consolidated revenue. Further, Mr. Trainer's chart suggest GAAP and non-GAAP earnings on an absolute basis are increasing. Lastly, EPIQ has been free cash flow positive in all of the last 10 years.
In conclusion, I think EPIQ is a growth stock, about to cross $500M in annual revenues, which has the potential to increase profitability with scale.
Please note that Mr. Trainer probably intended to do the research from the specific angle in which he wrote, and I truly appreciate his effort, due dilligence and demonstrated analytic skill.
Free Cash Flow to Equity
To obtain a free cash flow to equity-based valuation, I'm going to have to make estimates of the company's sustainable growth rate, and required rate of return. I estimate the near-term free cash flow to equity growth rate as 9%, which based on the growth metrics for the company is reasonable. Longer term, using adjusted observable data, I estimate the sustainable nominal growth rate as 4.5%.
My model assumes 9% FCFE growth for the next six years, when EPIQ could reach $1 billion in annual revenue, and then 4.5% growth. This is a simplification of a complex and uncertain reality.
The weighted-average interest rate of 6.2% on the 2017 capital leases is my base for forming a required rate of return. Adding a 200 basis point equity spread, I get a required rate of return of 8.2%. Given the financial leverage ratio of about 2, this rate seems fair.
|FCFE Valautions||Intrinsic value||Undervaluation|
|3.5% growth rate||$30||83%|
|4.5% growth rate||$39||138%|
|5.5% growth rate||$53||224%|
My FCFE model suggests the intrinsic value of EPIQ is $39 per share in the baseline scenario. Under the adverse scenario of a 3.5% sustainable growth rate, the intrinsic value is $30; the optimistic scenario of 5.5% growth gives a value of $53 per share. The baseline scenario suggests EPIQ is 138% undervalued.
Given the growth rate of EPIQ and the multiplier model valuations, I think that the FCFE model could be right about EPIQ being undervalued.
To determine the relative valuation of EPIQ using the price/book ratio, I will use the method of forecasted fundamentals and the method of comparables.
Using the method of comparables, EPIQ is trading at fair value relative to its 5-year average price/book value ratio; the historic value is 1.5 and EPIQ is trading at 1.7. The price/book value ratio is adversely impacted by the recent increase of share repurchases. But on an absolute basis, 1.7 times book value is not expensive given the substantial amount of intangible assets that services companies possess.
The method of forecasted fundamentals required that I make assumptions. Under the adverse scenario with a ROE of 10%, EPIQ is slightly overvalued. Under the baseline scenario of a 15% return on equity, the justified P/B is 2.84. The optimistic scenario of 20% return on equity suggest a justified P/B of 4.19. The baseline scenario suggest an upside of 62% or $26.50 per share.
My assumption is that EPIQ increases its return on equity as it gains scale. This is consistent with my use of the long term sustainable growth rate as a model input.
The valuations suggest that at worst EPIQ is fairly valued, but more likely it is undervalued and could have between 62% and 138% upside.
Lastly, the chart above says the valuations are still below 2009 levels.