Investing in low-growth value-priced software stocks is a little like digging for gold with a Nerf shovel - you can get there eventually, but it's going to take a lot of patience. Clearly Wall Street did not care for the earnings report of Quest Software (QSFT), nor the new of an unexpected change in CEO, but underlying results were not so bad and patience could yet pay off for investors.
Fourth-Quarter Results Mostly Better Than They Seem
Quest reported that revenue rose about 13%, more or less meeting the average analyst guess. License revenue was a little soft, growing 8% on a reported basis, but growing not at all on an organic basis and missing the average estimate. Service revenue was a little better with 18% reported growth and 6% organic growth, but the beat versus expectations was modest.
Quest did fairly well when it came to profitability. Gross margin did fall almost two points from last year, but operating income was up 45% on a GAAP basis and 36% on an adjusted basis and Quest handily surpassed expectations here. A much higher-than-expected tax rate stole the momentum, though, and drove a one-cent EPS miss. Had the tax rate been as expected, Quest would have beaten the average estimate by about seven or eight cents.
Relatively Solid Performance In A Tough Environment
Quest also did relatively better than analysts predicted when it came to both bookings and deferred revenue. Relative to what other systems management companies like IBM, CA, Oracle (ORCL) and BMC Software (BMC) have been reporting, Quest actually had a pretty solid quarter and reasonably solid guidance.
Clearly the health of enterprise IT is emerging as an issue for 2012. Companies are finding the money for cloud/virtualization upgrades, but large orders are increasingly harder to come by. Quest still has a leg up on the likes of Oracle and CA when it comes to easy-to-use tools and software that can cope with a heterogeneous environment, but lower overall spending is sapping a lot of the momentum.
Meet The New Boss, Same As The Old Boss
With the fourth-quarter earnings, Quest announced that CEO Garn was stepping down for medical reasons and would be replaced by former CEO Vinny Smith. As Mr. Smith had not left the company (he was executive chairman), he should be up to speed with the company's current strategy and the transition should be relatively smooth.
It's unfair to cast aspirations on the stated reason for Garn stepping down and I don't mean to imply that the resignation was anything other than health-related. That said, Quest has been struggling to deliver consistent results and show real leverage from a new go-to-market strategy. With the Toad platform not performing as well as hoped and larger software companies like BMC, Oracle, and Microsoft (MSFT) refocusing on cloud offerings, perhaps a change in management can reinvigorate the business.
The Bottom Line
Quest's offerings stand out for their simplicity at a time when many rival products from IBM, Oracle, and others are getting increasingly complex and difficult to manage. Unfortunately, the nature of the products and the underlying growth arguably preclude the sorts of deals that the market has seen lately in software with Oracle and SAP (SAP) paying premiums for cloud players RightNow, SuccessFactors, and Taleo (TLEO). If Quest ever sees a bid, odds are that it comes from private equity.
On its own merits, Quest is arguably fairly valued just on the basis of its service/maintenance revenue stream. Unfortunately, the same has been true for a long time with companies like CA, but Wall Street wasn't interested in the absence of revenue growth and/or capital returns to shareholders. Said differently, the Street rewards lucrative but slow-growing software businesses only slowly and grudgingly.
It takes little to drive an interesting target price on Quest; just 5%-6% forward free cash flow growth is enough for a target well into the $20s. As the past few quarters have shown, though, it is going to take time for that value to materialize in the stock. The change in leadership and sluggish license revenue growth isn't going to help that process, but patient investors may yet have reason to hope for better days here.
Disclosure: I am long QSFT.