The dismissive nature of Wall Street often enables great stories to remain under the radar until it’s blatantly obvious that something transformative has already occurred. As such, when I hear that an old, sleepy company may be finding new life, I now respond with excited optimism. The thought of buying a dog just before it becomes a "set to triple" darling is nothing if not exciting!
Pervasive Software (PVSW) seems to fit the bill. Two weeks ago, SeekingAlpha released an initiation piece entitled "Pervasive Software Shares Are Poised to Triple." The article outlined some of the factors that will drive accelerated revenue and earnings growth for Pervasive. This article will dive deep into the company’s financial statements and examine the key factors that have kept PVSW under investors’ radar screens:
Investments in R&D have hidden PVSW’s strong underlying profitability. PVSW’s net income in fiscal 2010 was $4.1 million. Using this number, Pervasive’s PE appears to be 26. Looking at that alone, you would think that its stock is pretty expensive. However, over the past few years, Pervasive has invested over 27% of its gross profits into R&D. This is a huge number. In fact, if it cut off R&D, net income would instantly triple giving it a PE of 8. Taking that into consideration, the stock actually looks quite cheap (assuming that its R&D investments have been worthwhile).
The company has been quietly gearing up for a major product cycle. Pervasive has gone three years without releasing exciting new products. As a result, its revenue growth has been muted. Sales have been stuck at $47 million for the past two years. No growth = no investor excitement. However, the company has now released three exciting products over the past few months. The R&D that has been hiding Pervasive’s strong underlying profitability is now about to drive renewed revenue growth.
As for whether or not its R&D investments have been worthwhile, its new products happen to fit perfectly into the burgeoning Cloud Computing paradigm. In this regard, the company was either very forward-looking or very lucky. Either way, it is now in the right place in the right time…and that’s all that matters. Investors that recognize this and buy the shares before the revenue ramp begins in earnest.
Pervasive’s sales are already growing ... but it's a secret to most. Pervasive reported Q4 revenue of $11.7 million, flat versus the year ago period. However, the company has been in the midst of transitioning its integration revenue to a subscription model. Under its traditional model, most of the revenue from any new contract would get recognized immediately and show up in that quarter’s earnings release. Under its new subscription model, new business gets recognized over the duration of the subscription period.
As a result, reported revenues have been artificially compressed. Despite moving to a subscription model, reported revenue has remained flat. This is one sign that its sales have actually been rising (secretly). Further proof of this can be found in the company's balance sheet. Deferred revenue represents cash the company has collected, but has not yet recognized as revenue. A rising deferred revenue balance is generally a sign that a company is growing faster than the numbers it reports to investors.
In Pervasive’s case, deferred revenue has been showing annualized growth for six straight quarters. In fact, after hovering near 0% growth for full-year, PVSW’s deferred revenue has grown in the double digits for four straight quarters. Incidentally, four quarters is generally the amount of time it takes for accelerated deferred revenue growth to transform into accelerated revenue growth. In other words, investors who buy the shares now get to benefit from all hard work Pervasive has done to become more of a subscription-based company without enduring the past several quarters of flat revenues.
The company’s fastest-growing products haven't reached critical mass yet. In Q4, 55% of revenues came from its database business, which has been its slowest growing business (though an upgrade cycle now promises to accelerate revenue growth for that unit).
Meanwhile, 40% of revenues now come from its Integration business. On paper, the Integration appears to exhibit flat growth. However, it has been transitioning to a recurring revenue model, which masks its true growth rate. Management has stated that apples-to-apples growth for this business is actually in the mid-teens. This growth will start to manifest itself in PVSW’s reported results as the subscription revenues get fully recognized. This has already begun and is set to accelerate over the coming quarters.
Last, but not least, PVSW’s newest products only represent 5% of revenue, but are poised to quickly build momentum off a small base. DataRush version 5 is a quantum leap over its previous incarnations and comes at a time when market demand appears ready to "cross the chasm". Given the excitement around Big Data and Cloud Computing, this business has the potential to become as big, if not larger than, PVSW’s other businesses.
Netting it all out, it’s clear that each cog in the PVSW machine is now moving in a positive direction. This is in stark contrast to the September quarter when every growth metric was moving in the opposite direction. Clearly, customers were holding out for the company’s new releases … which are now out and doing well in the marketplace. The December-quarter results bore this out. Results for the next few quarters should show continued progress, with a commensurate impact on the company’s share price.
Most retail investors don't look at cash flow from operations. Since Pervasive appears to be a small company with no growth, institutional investors haven't been giving it much attention. Meanwhile, retail investors tend to be more focused on PE ratios and cash flow metrics. This is a big mistake. By only looking at PE, an investor might miss factors that are keeping stock price artificially depressed. Several of these factors have already been discussed above.Yet another factor is cash flow from operations.
Pervasive’s net income for calendar 2010 was $8.7 million. However, the company generated $16.1 million in cash flow from operations. This is a strong indication that the company is raking in a lot more cash than its earnings reports would lead you to believe. Indeed, the company is only trading at 6.5 times the cash flow it is generating from operations. This is a much cheaper ratio than the company's PE suggests.
Even more exciting, the difference between Pervasive’s net income and its cash flow from operations has been rising for four straight quarters. This is a sign that the company's profitability is improving much faster than the average retail investor thinks. Larger companies don't have this problem because institutional investors pay more attention to cash flow from operations.
As Pervasive becomes bigger and demonstrates accelerated growth, it will begin to show up on institutional radar screens. When that happens, its share price should rise because these investors will give the company due credit for generating strong levels of cash flow from operations.
Most retail investors don't look at hiring trends. Last quarter, Pervasive grew from 228 employees to 239. This is a 5% increase in just three months. Extended over the course of an entire year, this would represent 21% annualized growth. Looking at the statistic, most investors would agree that the company must be poised for strong growth. However, most investors are not aware of the statistic because most retail investors don't look at hiring trends. Those that do can benefit from this advance clue that growth is about to pick up.
These factors may explain why the company has been engaged in an aggressive buyback program over the past several years. The current program is in the process of taking out over 10% of the share base. Clearly, management believes that buying its own stock is one of the best ways it can allocate its cash.
Taking everything into consideration, one can hardly blame them. Many comparable companies have been acquired for several multiples of revenue [i.e. CastIron by IBM (IBM) for $190M and Aster Data by Teradata (TDC) for $263M). Similarly, market-leading Informatica (INFA) trades at 6-times revenue. In contrast, PVSW’s enterprise value remains just above one times sales.
Meanwhile, the company has reported 40 straight quarters of profitability and is now entering into two major product upgrade cycles, while an exciting new product holds the potential to drive accelerated revenue growth for years to come.
And while this has yet to show up in its headline numbers, there are obvious signs that Pervasive’s resurgence is already underway (i.e. deferred revenue growth and cash flow from operations). This is why a company’s stock often takes off a few months before it actually starts reporting strong results.
All of this makes it easier to understand why Pervasive’s shares are poised to triple.