Quality Systems (QSII) has been on my watchlist for the past several years and 2012 is the first time Quality Systems has presented itself as a clear opportunity, falling over 50% this year.
A lot of the problems and the reason for the drop in stock price is associated with the board fight which has been forcing management away from focusing on the business.
But instead of discussing whether an activist is needed to unlock value, and who is right and who is wrong, let's try to see whether the fundamentals indicate the quality of Quality Systems business.
Quality Systems Overview
Here's a dashboard summary taken from the OSV stock valuation spreadsheets.
To help you follow along, you can download this 12 page PDF stock valuation report on Quality Systems.
Quality Systems Fundamentals Discussion
Quality Systems is one of the rare companies to have consistently increased revenue and even managed to increase it during the recession.
Strong Revenue Growth
Working from the top, the company has strong gross margins of 63% compared to its larger competitor, Allscripts (MDRX), whose gross margin is 43%. Such a large gap over its competitors and industry is a good indication that a competitive advantage exists.
Strong Balance Sheet
There is zero debt and plenty of liquid assets for Quality Systems to invest and generate growth.
In the balance sheet, there is a line for deferred revenues, which indicates the amount of future sales and revenues the company will record.
An increasing amount indicates that future revenue will increase, while a decrease indicates that sales is slowing down.
The current quarter deferred revenue is down by 12.5% compared to the previous first quarter which is a potential sign that Quality Systems is slowing down.
Combine the slowdown along with increasing goodwill and intangibles and this is probably the biggest part of Quality Systems to watch out for.
Both goodwill and intangibles now make up 25% of totals assets in the TTM.
My standard is 10%, and seeing how intangibles seems to grow every year, I would deduct points for this unless the intangibles really do add to growth.
Free Cash Flow Cow
FCF has been positive for over 10 years, and by a large margin too. But over the past couple of years, capital expenditures is increasing. I expect the capex to stay at the current high levels rather than enjoying the low capex through all these years.
Quality Systems Management Effectiveness
Whether it is due to increased competition, return on equity has been declining since 2007.
An ROE of 36.4% with zero debt in 2007 was phenomenal but difficult to maintain for long periods.
TTM, ROE has dropped to 23.5%, which is still above average but far below its peak.
Even still, ROIC and CROIC are abnormally high. Or maybe abnormally is not a good word. Maybe management should be described as exceptional to be able to post a ROIC (Return on Invested Capital) of 140% in 2005, but this has come down to more reasonable levels of 38% in the TTM.
Likewise, CROIC (Cash Return on Invested Capital) was 150% in 2005, but now 58% TTM.
Here's another metric that I like to use to determine just how strong a company is.
FCF/Sales shows you how much of sales is converted directly to FCF.
Quality Systems FCF/Sales is 8%. This means that for every $1 of sales, $0.18 is converted to FCF. Quality Systems is a cash generating machine.
Check out the valuation ratios below.
QSII isn't screaming cheap, but it is less than half the valuation from 2009.
Analysts are predicting a forward PE or 12.7 which means they are lowering expectations by a large step.
For a company like Quality Systems, in terms of valuation, I use three methods.
Since I won't be going through the details of how to use each method, I've linked to the tutorials below.
- DCF valuation to value the stock based on FCF
- Graham formula valuation to value the stock based on earnings
- Katsenelson PE adjustment method to value the stock based on PE
These three methods give a very good all round range without overly relying on one method.
DCF valuation: $21
Graham Formula valuation: $31
Katsenelson PE Adjustment: $23
The lower range is $21 and upper range is $31.
At the current price of $17.19, the margin of safety is 20% on the low end and 45% on the high end.
Include the 4% yield Quality Systems offers and this is a very tempting stock.
Full valuation calculations can be seen from the PDF linked to at the top of the article.
What's Holding Me Back
Fundamentally, Quality Systems looks very tempting, but I need to understand in more detail about its software and how durable its moat is before I would be comfortable buying.
Digging deeper into the qualitative research will have to wait for another post.