Right off the bat, it would seem that Quest Software (QSFT) has two red marks against it. First, the company looks to provide simpler solutions in a world where vendors boast increasingly complex alternatives. Second, Quest is mostly a value play, and lower-growth value plays don't often work so well in the tech stock world. Nevertheless, with such an undemanding valuation, Quest may be worth a look as an undervalued play in a software sector where valuations have been quite high in many cases.
Trying To Patch Big Vendor Gaps
Quest has the unenviable task of trying to make its bones (and not get squashed) amidst the likes of Oracle (ORCL), IBM (IBM), VMware (VMW), BMC (BMC), and CA (CA). The idea here is that these companies often offer complex solutions that are actually difficult for IT personnel to implement and maintain – particularly at smaller concerns that can't throw an army of employees at every IT problem.
Quest steps in with simple-to-use solutions and products that help run heterogeneous and cobbled-together IT environments. The company's development tools, for instance, allow IT workers to manage heterogeneous database environments and improve the overall quality and performance. Elsewhere, the company's administration tools can make infrastructures more efficient and can create private clouds.
Stable Maintenance, But Can It Grow?
Roughly half of Quest's revenue could be considered recurrent maintenance business – business that the company really does not have to fight so hard to keep and carries pretty solid margins. So valuable is this business, in fact, that it's not hard to find the company near fair value just based on the annuity value of this revenue. After all, companies like IBM, CA, and BMC have done well enough for themselves on the basis of sizable maintenance revenue streams.
The problem, though, is overall revenue growth. Over the past couple of years, the company has frankly not met the bar in terms of growth expectations and once-popular products like Toad have appeared to struggle. While Quest did show some signs of life in the third quarter of 2011, with recoveries in bookings and billings, the organic revenue growth was just in the single-digits and the company had some sizable orders from the government sector.
Just consider the scale of the expected growth. Right now, analysts are looking for about 9% revenue growth from 2011 to 2012. That's quite a bit less than darlings like VMWare or Salesforce.com (CRM), still below the likes of Tibco (TIBX), and on par with those mega-caps it's supposed to be exploiting for growth.
Rampant M&A – Value Creation Or Wheel Spinning?
Quest has been extremely active over the past few years in acquiring other small software companies. Management believes this is a critical part of its strategy, building out functionality and expanding the company's position in areas like virtualization and social media archiving. The question, though, is whether the company can leverage this into sustained and worthwhile growth. So far, the only answer investors can really find is “maybe” - these deals haven't really boosted 2011 performance, but a strong end to the year could get sentiment moving in a more positive direction.
The Bottom Line
Every once in a while investors have to re-learn certain lessons about the stock market and Quest is a good reminder to me about the risks of buying “value stocks” in the tech sector. Simply put, in most years the market would rather ignore ridiculous nose-bleed valuations and keep bidding up the high-growth names than settle for more balanced growth/value trade-offs.
Nevertheless, Quest has a good business that I believe is selling for less than its worth. There's no question, though, that better organic growth is key to unlocking that value and fourth quarter earnings (and management guidance for 2012) are going to be telling – can Quest make good on these serial acquisitions or is it going to suffer from the same lagging IT demand that recently hit Oracle? At the same time, could this company appeal to a larger buyer like Hewlett-Packard (HPQ) that could arguably use more tool offerings?
Even with single-digit revenue growth, Quest should be worth something in the mid-$20's or higher. Value-oriented investors should also realize, though, that this stock could well remain a value trap for some time if it cannot produce enough growth to interest less value-inclined tech investors.