How to manage a non-growth business
Open Text (NASDAQ:OTEX) reported earnings earlier this week. From a 30,000-foot view, it looked as if the company had a small EPS miss of 5% compared to the prior consensus and a smaller revenue percentage miss of 2%, again compared to prior estimates. Misses are rarely good things unless there is some hidden secret which these days is primarily a business model change. But the shares finished 3% higher on the day and are now up almost 20% since I wrote my last article on this name on 2/11/16. Indeed, one analyst chose to raise his price target from $55 to $65 on the shares. Over that same time, IGV (Software Index) showed comparable appreciation, rising 19% over the period. Still the shares have handily outperformed IGV since the start of the year, rising 19% while the software index is down a couple of percent.
Part of the miracle of getting shares to rise with an earnings miss has to do with the location of the miss. As it happens, the revenue shortfall centered in professional services which is not a leading indicator. Management blamed the miss in PS on shoddy execution, and I probably believe that since it reflects poorly on management execution. Not being able to initiate projects already in backlog is a bit embarrassing. That being said, most analysts, seeing that the miss was a function of professional service deliveries, most likely cut the company a hall pass.
I never can know for sure what is in the minds of investors at the margins in situations like this. But what one needs to know, I think, is whether the company's shares can continue to levitate without real earnings growth - or growth in something. If there's going to be alpha left in this name, that alpha can't come from the sources that allowed shares to appreciate and headline numbers to miss.
One thing to note, before exploring that question in some depth, is that OTEX provides but the sketchiest guidance. So, it is hard to determine if the company actually met or failed to meet its own growth targets. Certainly there has been no movement in estimates on the part of analysts.
I think the one significant answer to the seeming conundrum is that the cash flow for the company grew by 33% to a record of $190 million for the quarter. Free cash flow for the quarter was $171 million. The increase in cash flow for the quarter was driven primarily by the more than 100% increase in GAAP net income for the period coupled with a more than 50% rise in deferred revenues.
The growth in cash flow prior for the year to date was far less substantial. For the nine months ending 3/31, cash flow grew by just $15 million or just 4%. Since the company doesn't forecast earnings, it obviously doesn't forecast cash flow either. That being said, analyst consensus forecasts for EPS show earnings rising sequentially by about $19 million. That is probably a conservative forecast as the consensus numbers track normal seasonal patterns. Typically, in Q4s, OTEX sees a significant rise in receivables since license revenue grows due to seasonal factors. In part, however that has usually been offset by an increase in payables. So I think it is probably reasonable to assume that operating cash flow will climb to about $200 million for the quarter, which would be more than 50% growth for the prior year.
If it all works out that way, OTEX will grow its operating cash flow to more than $600 million for the fiscal year that ends 6/30 and will generate free cash flow of around $540 million. That would produce a free cash flow yield of 7.3%, which is quite a bit higher than the free cash yields generated by most "old line" software vendors these days.
This company pays a small dividend and the current yield is 1.5%. But for this company to achieve significantly greater alpha in the future, it is going to have to grow the top line, and that is what I will examine below.
How to achieve top-line growth without really growing
Buy it. I mean buy the growth. Some readers may not like that answer, but as it says in the GEICO ad, "this is what we do." Buying companies is really what OTEX does and has done for many years now. Investors are obviously not going to pay the highest valuation for growth derived inorganically. Many companies with acquisition strategies can't find the right kinds of assets to buy. But somehow, this company has managed to take what are lumps of coal and transform them, if not into silk purses, something that generates significantly greater levels of earnings and cash flow.
The company announced two accretive acquisitions in its earnings press release. One acquisition was of a small company called ANX and the other was the acquisition of the "Customer Experience" suite from HPQ (NYSE:HP). While neither acquisition is earth shattering, they are both strategic from the point of view of fitting into other current OTEX offerings and they are both accretive instantly and will add as much as $.25 in EPS to company earnings.
Open Text has a lengthy history of growth through acquisition. Whatever growth it has been able to generate the past several years has been inorganic. The company has been able to take the doggy assets of its acquisitions and wring out enough cost savings such that the new revenue stream generates average corporate margins. With average corporate margins pushing 34% these days adding $120 million to the revenue stream is going to add $40 million to the operating profit line and $32 million to net earnings. That is almost as much as the overall growth in EPS that the company achieved over the past two years.
Management stated during the course of the conference call that it expects a more regular and faster pace of acquisitions going forward. It maintains that there are a number of accretive acquisitions currently being considered. Given this company's history, the strategy of growth by acquisition makes lots of sense and has not proven to be as risky as some, including this writer, might have feared a few years ago.
With the company now increasing its cash generating capability significantly, it will be easier to fund future acquisitions. The company has said that it intends to deploy $3 billion over the next few years in pursuing its acquisition strategy. Based on the kinds of companies OTEX buys and its forecast business model of 34-38% operating margins, $3 billion in acquisitions will add something like $1 billion/year in revenues and $350 million in operating income and $280 million in net income. That works out to over $2/share in earnings accretion.
I well recognize that many readers will be skeptical that OTEX can manufacture earnings through acquisitions or that it can do so on a consistent basis. I would point out two things. This company buys the unloved and unwanted assets of the world. Its largest acquisition recently was that of Actuate. Actuate had shopped itself for literally years without getting any takers. OTEX was the only potential suitor and bought the company for a modest valuation after the shares had dropped by 55% in the few months before the acquisition. Most other IT vendors just do not have the mindset to want to emulate such a strategy.
The preponderance of enterprise IT companies would have radically different criteria in making acquisitions. That is the real reason why OTEX can actually find companies or businesses to acquire. I would not bet that it will not be able to do that. But I would bet that in terms of share price appreciation, the shares will always look undervalued until the company can demonstrate sustained organic growth. Not much growth, just a little I think will satisfy most investors.
I discuss the issue of organic growth below because without organic growth, likely returns going forward will not be enough to achieve much positive alpha.
I really don't like to invest in enterprise IT vendors that can't achieve organic growth. OTEX has been able to grow its top line primarily by acquisition. Any chance that it can achieve organic growth any time in the near future?
The simplest answer is that OTEX will probably show some organic growth, but not by all that much. It would be a tremendous boon to valuation and perception if the company could put together two or three quarters of clean organic growth, but that really hasn't happened in more than a few years. If it's going to happen, the next few quarters are the most likely time for the company to deliver organic growth, and primarily because its Version 16 release that is now in general availability, but also because of the changed competitive landscape.
The large companies that OTEX competes with are IBM (NYSE:IBM) and EMC (EMC). IBM has a business in FileNet that directly competes in the ECM space with OTEX. Since ECM is not a focus area for IBM, it has not received the resources to innovate significantly. And that really makes sense. If IBM is going to grow, it will not be because of any success or lack of success of FileNet. Being a share donor in a low-growth space like ECM is the right strategy for IBM at this point.
EMC is obviously in the midst of turmoil as a result of its pending merger with Dell. At one point, Documentum was competing quite successfully with OTEX. Now, EMC has sold off its cloud assets in ECM and it has stopped innovating or investing in the space because it has other, significantly higher priorities. So, if the company is going to achieve organic growth, this is surely its window of opportunity to do so.
The company has been in the process of putting together a strategy to capture market share in its heartland content management space almost since CEO Mark Barrenechea took his current job. Version 16, the latest manifestation of that vision, is now in GA, and this might be expected to be the initial quarter during which it makes a contribution to top-line growth. It was sold to some large existing customers last quarter, but this quarter ought to provide at least some evidence that the strategy is going to be successful.
I would like to say that Version 16 is going to solve all of this company's problems in achieving organic growth, but I can't make any such assertion. Open Text had almost a decade ago during which content management grew apace as it was adopted as a way of solving the document retention problems that most companies now face in order to be compliant with many new laws and regulations and court cases.
There are other use cases for content management that the new release is supposed to enable, but teaching sales people to sell new use cases is not the easiest of undertakings. I think the best that can be said with any degree of confidence is that the Version 16 release has been so hyped both internally and to the company's user base that there is probably some significant pent-up demand for the product.
Open Text recently appointed a new President, Steve Murphy, to oversee field ops. While Murphy reports to Barrenechea his responsibility is primarily revenue attainment; in other words, sales. He claims that in his introductory tour, the feedback regarding Release 16 is clear - "We have the best products positioned in the right market with deep customer loyalty, reflected both in the amount of follow-on sales and the growth of cloud revenues."
I'm not going to try to spend time doing a deep dive here for readers. Version 16 has brought the company an intriguing partnership with salesforce.com (NYSE:CRM) in which salesforce will sell the ECM suite to its own users. That is a significant new channel for OTEX and matches what it already does for Oracle (NYSE:ORCL) and (NYSE:SAP). No panacea, but another source of revenue. OTEX will be using the CRM cloud to host its V.16 cloud offering. And the enhanced release of Version 16 will support Apache Hadoop immediately, which is a way for this company to compete with IBM's Watson. I think it was well said by the CEO that "a sledgehammer (Watson) is not needed for the majority of predictive workloads that we can see." Over the next 15 months, this company will start competing with Watson head to head.
I imagine that there is some hype regarding the capabilities of V.16. It wouldn't be the software space if that weren't the case. But it seems likely to me that V16 will engender some level of renewed growth in the ECM space although how much is hard to calibrate with the level of information that is accessible.
The other growth area that has been in arrears almost since it was announced is the Open Text cloud. Without a tiresome repetition of the numbers, the OTEX cloud hasn't been achieving much growth. Part of the reason for that is that the OTEX cloud, for the most part, consists more of a managed service offering than SaaS applications. SaaS exists at OTEX, to be sure, but the focus is on managed services. The CEO said that Release 16 was going to be the solution pillar for future sales of managed services. Again, without quantification it becomes really difficult to draw specific conclusions. I think cautiously optimistic best encapsulates what I think of the probability that V.16 reignites sustainable organic growth for this company.
Is the valuation at a level that upsides will be appreciated to the extent of producing significant alpha?
Let's start by taking a look at valuation on an absolute basis. Certainly, as I mentioned above, the company's cash-generating capabilities have led to a free cash flow yield well above the expected range for older software vendors. The other valuation metrics aren't quite so straightforward. The company has a current enterprise value of $7.59 billion. Revenues this current fiscal year are forecast to be about $1.82 billion using the analyst consensus from 15 analysts who publish estimates. So, that is an EV/S of a bit over 4X, and that is no particular bargain for a company without organic growth. The P/E of 15.5 is reasonable, but not particularly cheap.
I think the good thing here is that expectations are quite modest at the moment. Next year's growth is expected to be 6.6% although that number is likely to rise given the two recent acquisitions. EPS growth from this year's $3.60 to $3.90 also is not particularly a stretch since the acquisition alone is going to account for two-thirds of the expected increase.
Analysts have a mean price target of $57.47, and the shares are now $56. There are a couple of buys and the same number of holds in terms of analyst recommendations. So, really, no one is looking for any great performance for this company, I think. Indeed, the highest price target currently listed is $65. It will be a considerable surprise to the analyst community if this company can achieve real organic growth.
That is a good set-up for appreciation. Low expectations, lots of skepticism and a potential new product cycle. Like I said above, cautiously optimistic.
OTEX delivered another humdrum quarter when it reported a couple of days ago. It missed, but the miss was relatively small, and it was focused in the area of professional services, not a leading indicator of future performance. The company has announced two acquisitions that will add materially to both revenue growth and to EPS during FY 2017. The company generated record cash flow of $190 million during the quarter. Management believes that it will be able to make $3 billion of accretive acquisitions over the coming years which would have the impact of growing earnings by more than 50% from current levels. It is hard at this juncture to handicap the probability of that happening. The company does have a long and quite successful track record in terms of making smaller highly accretive acquisitions.
I think the key to the performance of the shares in terms of substantial differentiated upside is going to be the potential resumption of organic growth. If it is going to happen, it is going to happen now. Competition is in disarray. The company has what it self-describes as its foremost software release ever in V.16. The product was only available the last few weeks of last quarter. This should be the quarter in which some indication of its success becomes visible.
Given this company's historic track record in terms of organic growth, I'm cautiously optimistic. On the other hand, the positive alpha potential will be substantial in the wake of a successful V.16 launch.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.