I am a value investor and only like to buy undervalued stocks with enough margin of safety. However, I also like healthy growth companies with sustainable competitive advantages. So, when I see a stock that is undervalued and has strong sustainable growth potential, I do not hesitate - I pull the trigger as soon as I can.
This one is Pansoft Company (Nasdaq: PSOF)
Pansoft is an enterprise resource planning (ERP) software and professional services provider for the oil and gas industry in China. (For those of you who have never heard of “ERP”, please see here.) In short, ERP is a computer system to integrate all segments of a company to efficiently allocate financial, material and human resources.
China ERP market
The ERP concept entered China 10-15 years ago. The market experienced slow adoption and expansion. Since 2005, it developed rapidly and most mid to large size enterprises have adopted ERP systems.
Current major problems for leading global ERP vendors (i.e. SAP and ORCL) are that the Western-style value proposition, operating model, business process design, and supply chain integration model are hard to quickly fit an emerging market like China. Chinese users prefer to use the system to automate current processes rather than change processes to fit in an ERP system. As a result, foreign vendors have limitations to define and understand the real functional and business needs.
Although domestic ERP system developers have started challenging global vendors, foreign ERP developers can still win contracts from the largest state owned enterprises such as PetroChina (PTR) not only for the capability and scale of the systems, but also for the future global expansion ambitions of these companies. An international platform will be necessary to integrate their cross-border operations.
However, for companies like PetroChina, they have big overseas market, but even larger domestic market. As a huge company, PetroChina has thousands of subsidiaries and oil fields in China. So with a mature SAP or Oracle system installed, some localization or customization are definitely necessary to seamlessly integrate domestic operations into a global platform.
PSOF’s niche market
PSOF is not an ERP system developer that directly competes with SAP/Oracle. It actually is good at localizing and customizing the financial module of the SAP system.
Pansoft has been working with oil companies since its inception. Its expertise is to interpret oil companies’ business requirements to IT system, which needs years of accumulated hands-on experiences. In addition, PSOF also understands SAP’s data model, work flow and development tools. Based on all of this expertise and experience, the company’s software offers solutions in accounting, order processing, delivery, invoicing, inventory control, and customer relationship management.
PSOF’s barrier to entry
ERP systems are very expensive. PetroChina spent millions (if not billions) of dollars on the SAP system. The switching cost is huge. PSOF helps PetroChina to further develop the financial module and integrate all of the subsidiaries and oil fields. The switching cost is also tremendous. As long as the software itself doesn’t have a fatal flaw, the user usually has no motivation to switch to other software.
Also, the oil industry in China is dominated by three state owned enterprises: CNOOC (CEO), PetroChina, and Sinopec (SHI). According to the company, PSOF has signed contracts with two of these three. This is a huge barrier to entry.
PSOF’s future growth
PSOF is leveraging its experiences in the oil industry to expand to the coal sector. In the meantime, it has packaged some of its programs that are suitable for general ERP systems. This general application software will be sold customers in other industries.
With PetroChina and Sinopec as customers and fixed long term contracts, this company has stable revenue and strong potential growth.
As of March 19, 2010, PSOF has a market cap of 31.2 million, $14.7 million in cash, no debt, and a net asset value of 18.6 million. With 5.78/share, this is actually around $2.7 cash/share. After cash, the PE ratio is only 3.85/0.53 (2009 fully diluted EPS) = 5.8x
We can also use earning power value to value PSOF. This is a process to adjust 2009 operating income. I don’t want to put too much technical stuff here, but the concept is simple: The earning power is not reflected by the operating income only. I believe some part of SG&A and interest income should be added back to operating income because the money spent on SG&A can secure a sustainable barrier to entry. So after taxes, sustainable earning power is around $4 million.
I then use 10%-20% discount rate to calculate perpetuity. The range is $20 million – 40 million. Don’t forget cash. Adding back $14.7 million cash and I get $34.7 million - $54.7 million valuation.
Compared to current valuation of $31.4 million, I think this stock is seriously undervalued. If we can buy this stock under $6, we have a huge margin of safety.
Disclosure: Author holds a long position in PSOF