OpenText: A Good Company That Is Modestly Overvalued

| About: Open Text (OTEX)
This article is now exclusive for PRO subscribers.

OpenText (NASDAQ:OTEX) provides enterprises with Enterprise Information Management applications. Given the substantial growth rate of information, the company is well positioned to meet enterprise needs. Companies need to be able to organize the storage of information and be able to retrieve that information efficiently.

The share price of OpenText peaked just below $75. Currently, the stock is trading at roughly $65.41. On a total return basis, OpenText has outperformed the S&P 500. But, more recently, the company has underperformed the benchmark index. That means there is potential for OpenText to outperform, near term.

OpenText is a cyclical company that benefits from loose monetary policy conditions. Right now, the company is modestly overvalued. I would consider short selling at roughly the $69 level, which is what investors did when they sold just below $75. I will look to get long shares close to $50. OpenText is an investment grade security; investors should be more concerned with percentage of assets allocated than stop loss levels.

Risks

  • The share price has been volatile in the past and may be volatile in the future; investors could lose a portion or all of their investment.
  • Competition from larger technology companies could erode profitability and shareholders' returns.
  • The integration of numerous acquisitions could weigh on financial performance.

Business Profile

OpenText is an independent company providing a comprehensive suite of software products that assist organizations in finding, utilizing, and sharing business information from any device in ways which are intuitive, efficient and productive. Its technologies and business solutions address one of the biggest problems encountered by enterprises today, which is the explosive growth of information in terms of volume and formats. Its software allows organizations to manage the information that flows into, out of, and throughout the enterprise as part of daily operations. OpenText products incorporate social and mobile technologies and are delivered for on-premises deployment as well as through cloud and managed hosted services models to provide the flexibility and cost efficiencies demanded by the market.

As OpenText continues to expand its product offerings through internal development and acquisitions, it has evolved from its heritage in pure Enterprise Content Management [ECM] into a broader and more comprehensive market category known as Enterprise Information Management [EIM], EIM, which forms its foundation on ECM, also includes a much richer set of capabilities that allow organizations to do more than simply "manage" content by optimizing the value of business information while reducing the costs associated with capturing, storing, and managing it. In addition to ECM, these capabilities are: Business Process Management (BPM), Customer Experience Management [CEM], Information Exchange [IX], and Discovery. In Fiscal 2013, OpenText completed its evolution from being an ECM company to an EIM company.

OpenText tracks its business through four revenue streams: license, cloud services, customer support, and professional services. License revenue refers to the sale of its software product offerings, which provide information security and governance for all content and all business processes across the enterprise. The second component, cloud services revenue, refers to the sale of services arrangements. The third component is customer support revenue, whereby OpenText provides renewable, ongoing support and maintenance to customers who have purchased its products. The fourth component is revenue from professional services, which represents consulting fees it receives for providing implementation, training, and process and system integration services in relation to its product offerings.

The licensing of OpenText products consists of five core solutions: Enterprise Content Management; Business Process Management; Customer Experience Management; Information Exchange and Discovery.

The Enterprise Content Management solutions consist of content management, collaboration, records management, e-mail management, and archiving.

The Business Process Management solutions, which interact with other enterprise applications such as those from SAP and Oracle, consists of business process management, dynamic case management, smart process applications, high volume imaging, strategic business planning and modeling, and reporting and analytic.

The Customer Experience Management solutions consist of web content management, digital asset management, social media, customer communications management, portal, and mobility solutions.

The Information Exchange solutions consists of capture, EDI services, fax management, managed file transfer, cloud-based sharing, and data integration.

The Discovery solutions consists of content analytics, auto classification, search, semantic navigation, eDiscovery, and information access platform.

The licensed products are numerous and offer a fairly comprehensive set of solutions. Also, content management will be critical for the success of enterprises as the volume and breadth of information continues to grow. Further, the integration with Microsoft (NASDAQ:MSFT), Oracle (NYSE:ORCL) and SAP (NYSE:SAP) offerings is positive for the valuations of OpenText.

The company lists International Business Machines (NYSE:IBM), EMC Corporation (EMC), Hewlett-Packard Corporation (NYSE:HP) and Adobe (NASDAQ:ADBE) as its competitors. The extent of their competition in the market for EMI offerings is limited; I categorize OpenText as having a differentiated product.

In differentiation strategies, companies attempt to establish themselves as the supplier or producers of products and services that are unique either in quality, type, or means of distribution. To be successful, their price premiums must be above their cost of distribution and the differentiation must be appealing to customers and sustainable over time. For the time being, OpenText is successfully pursuing a product differentiation strategy. Offerings from technology giants do not (to the best of my knowledge) match the features of OpenText.

OpenText is using an active acquisition strategy: during the last three fiscal years, net cash used in investing activities exceeded cash provided in operating activities. Also, the company has a Director that is well compensated for providing acquisition advise to the company. So, the Director has an interest in acquiring companies that will add to OpenText's revenues, the executives are partially compensated based on revenue, and shareholders would like revenue to increase. Time will tell how the acquisitions play out.

A large portion of the executive team leading OpenText are new to their positions. The company reports that they have been in their current roles for roughly one year. That is a red flag. I would prefer a more seasoned managed team; they have sufficient professional experience, but not in their current roles.

The named executive officers increase their compensation by increasing shareholder value, worldwide revenues, and worldwide adjusted operating income. I consider their goals to be relatively well aligned with shareholders' interests. On the other hand, there are incentives to use inappropriate methods to boost these metrics for personal financial gain, at the expense of long-term investors.

Further, under the long-term incentive compensation plan, total return outperformance relative to a peer company index is incentivized. That, to boost executive compensation through increased total returns, could have been the reason the company deciding to start paying a dividend. Or, returning capital to shareholders could be the best use of excess liquidity.

What Employees Say

Employees of the company say that they would like higher wages. That breaks down into a few parts. One part is that OpenText wants to operate at the lowest possible cost while being able to attract and retain talented employees. On the other side of the coin, employees may not be putting forth the effort to earn higher wages. Or, they may not have the talents required to earn premium compensation. That said, almost everyone wants to be compensated at the wage that they perceive to be fair; said differently, who doesn't want more money?

Next, some people are dissatisfied with management. A portion of that stems from their decision making; some people think management is making too many non-strategic decisions which is adversely impacting the quality of their strategic planning. Management is relatively new; so, they may be focusing on details that will allow them to execute their strategic vision. Another portion of the dissatisfaction stems from a belief that management doesn't understand what is happening in the "trenches."

This may sound a bit harsh, but it is an honest opinion. There is some chatter about unsatisfied customers. In terms of the "unhappy or ignored customers across all solution silos," I'm not sure how able this person is to accurately perceive the facts. I'll leave it at that (so it isn't too harsh). But, more than one person said the same thing. So, the company may need to pay more attention to its customers' needs.

There is dissatisfaction with the integration of the products.

One thing that really jumps out is when a current employee says there aren't any pros to working for the company. Further, it seems the sales reps are having trouble meeting the company's sales goals and are looking for new jobs.

Overall, this sounds like the typically company. Employees want higher wages; employees are second guessing management's decisions. Some customers are dissatisfied. And, the sales force is not meeting its goals and is in the market for new jobs.

Financial Performance Forecast

As previously stated, OpenText derives revenue from four categories: licensing; cloud services; customer support and professional services. The cloud services began generating revenue from OpenText in fiscal 2013. Overall, I am expecting the consolidated revenues to increase in fiscal 2014, relative to 2013; the software industry is growing.

Revenues from licensing could be between $250 million and $322 million. Customer support revenues could be between $630 million and $790 million. Professional service and other revenues could be between $239 million and $302 million. Cloud services revenues could be between $170 million and $244 million; cloud services should have substantial amounts of upside with limited downside potential in fiscal 2014. Thus, on a consolidated basis, total revenues could be between $1.29 billion and $1.66 billion. Fiscal 2013 revenues were $1.36 billion.

Further, on a consolidated basis, I'm expecting operating income between $155 million and $250 million with net income between $123 million and $199 million and EPS between $2.08 and $3.37.

I think it is probably that the fiscal 2014 financial performance acts as a tailwind to the valuations.

OpenText is both liquid and solvent. The firm does use leverage, which boosts returns to equity holders. I'm forecasting profitability to remain roughly flat.

Valuations

I will use a few models to value the common equity shares of OpenText. I'll use a discount cash flow model and multiplier models. The company recently began paying a dividend; so, the dividend model may not be as accurate, longer term. That said, the estimate of value using the available inputs for the discounted cash flows is pretty accurate.

Using a discounted cash flow model, I estimate the intrinsic value of the common equity shares of OpenText as $60. The current share price is $65.41. OpenText is overvalued by 9%. Discounted cash flow models are sensitive to changes in its inputs.

Using the same inputs into a justified value model, I estimate that the justified price/earnings ratio is 30.66. The current price/earnings ratio is 33.6. Based on this model, OpenText is 9.6% overvalued and its intrinsic value is $58.87.

Relative to its 5-year average price/earnings ratio, OpenText is 24% overvalued; that means the intrinsic value is $49.71. Using the price/book ratio, OpenText is 15% overvalued; the fair value is $55.60. Using the price/sales ratio, OpenText is 16% overvalued; the fair value is $54.94. The fair value based on the price/cash flow ratio is $67.12. The average of those fair values is $56.84. Thus, OpenText is 15% overvalued.

The intrinsic value of OpenText is $58.57; OpenText is 11.7% overvalued. The lowest level that I would consider short selling shares is $68.68.

The return on equity is higher than the cost of equity; consequently, OpenText is creating wealth for equity investors.

Disclosure: I 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.