Premiere Global Services (NYSE:PGI) announced preliminary Q2 results on July 13, 2015, showing continued, stable revenue at around the $144 to $145M quarterly mark. Sales are roughly flat Y/Y, despite a handful of recent acquisitions.
PGI's acquisition strategy continued in late 2014, with a purchase of TalkPoint, for ~$50M and Central Desktop for ~$25M. In February 2015, PGI borrowed another $17M to purchase Modality Systems. The implied P/S ratio paid was 1.5x and will reach more than 2x if Modality meets future sales targets, upon which, further earn-out payments are dependent. The acquisition is expected to have a neutral effect on PGI's GAAP income. That means there will be no net profit from Modality, at least this year.
In other words, the company spent $75M (13% of sales or 15% of its market cap) on investments into acquisitions over the past 12 months but its sales are still flat Y/Y. PGI paid a high P/S ratio for these acquisitions, implying a great future sales growth potential. If this potential doesn't materialize, the company will have grossly overpaid for sales alone and not enough sales growth, In such a case, we may be in for a goodwill write-off or intangibles impairment. This is one risk that prevents me from being more convinced about PGI as a buy at the moment.
I have seen it way too many times: companies with stagnant or falling sales try to buy sales almost at any price just to prevent total sales from falling Y/Y. However, they are usually forced to overpay and may not be buying much in terms of future sales growth. PGI's acquisitions are masking a weak, organic performance, and I'm concerned the company will keep acquiring sales at any price to maintain flat overall Y/Y sales. Although one can argue the acquired sales have much higher profit margins (SaaS products). Still, given the high P/S paid in acquisitions for uncertain growth and profits, the company's comparably lower P/S (even despite low growth prospects) offer the more financially prudent strategy to acquire a bit less growth, and focus more on the core profitability, customer retention and more share buybacks. Or at least, perhaps, use a different business model for cross-selling - one more based on revenue-sharing, commission-based fees, etc., and less on acquiring expensive products in a "hot" area of SaaS with unpredictable future sales growth rates and high margins, which are likely to fall in the future.
The core product offers opportunities for cross-selling
The problem is the core product, GlobalMeet Audio conferencing software, which is basically a commoditized product and serves as a door-opener for selling other products. So there is no easy solution and the company will probably have to keep acquiring new products and services to cross-sell, as most of the sales growth comes from cross-selling to existing customers, although PGI manages to win some new customers as well.
The core subscription operations are a solid cash flow generator
On the other hand, the current P/FCF is just 12.90x. The attractiveness of this 7.75% FCF yield will depend on the future revenue and EPS growth. The major revenue source, from conferencing business services, fell 5% Y/Y. However, as "new" customers age, the expenses side of the income statement improves, even though the acquisition costs are high at the beginning of the customer lifecycle. Given that forex has very negatively affected sales recently, to the tune of almost 5%, I believe core sales are more healthy, in volume terms, than the financial figures would lead us to believe. So the annual customer churn that looks like 5% per year in sales terms is probably a lot lower in real volume terms, perhaps, close to zero. So as the annual rate of dollar appreciation (most probably) slows down, the forex should have less of an impact and Y/Y sales figures should improve.
To be honest, I like this approach focused more on core business and internal investments more than the acquisition-driven boost that can easily backfire. However, the company should watch its debt levels as the long-term debt currently stands at 62% of sales, 150% of equity and 45% of capital. This doesn't offer much more safe room for acquisition-driven growth that has been boosting past organic growth or for share buybacks beyond the natural, free cash flow generated in-house.
The company has been relentlessly buying back its own shares even when it had to issue new debt to do so due to continued new investments. The unused debt capacity is still ~$225M, but I would argue it is not safe for the company to increase its debt at this stage of the credit and business cycle, with the additional headwind of falling, organic sales.
Debt and interest
The company currently pays 2.71% annual interest rate, mostly based on various floating-rate arrangements, plus a 0.4% fee for unused credit capacity. So the effective interest rate is already around 3%. This may look low but if interest rates were to rise (especially the short-term rates such as LIBOR or the FED funds rate), the company's interest costs would spike significantly at the worst time (PGI's interest rates paid are designed rise with increasing debt ratios). So the company is very negatively exposed to rising interest rates.
In conclusion, I reiterate my previous $14 per share target price, providing a large but uncertain upside. However, PGI is not a high-conviction, long-term bet for me as it comes with many uncertainties: negative debt exposure to rising interest rates, uncertain growth prospects and unpredictable acquisition impact, both to the upside and downside. Sales are negatively affected by the dollar's rise, and EPS growth is driven by acquisitions and stock buybacks, partially financed through taking on additional debt.
On the other hand, the core operations are FCF positive, very stable and recurring, making them very valuable in a highly competitive world where acquiring new sales and earnings is very expensive. The core business provides PGI with a great door-opener and opportunities to cross-sell higher-margin products. If the company tries to focus on less expensive new acquisitions (you need to be very patient in order to achieve this, and can't try to immediately replace falling sales with acquisitions at all costs), the existing operations could become even more FCF positive, as the average life of the customer increases and moves out from the expensive, acquisition year phase.
Tactically, PGI is a moderate buy going into the earnings release on July 30. The stock price spike following the pre-announcement has receded, so this may be a good tactical time to add to a PGI position, although much of the surprise has been taken out by the preliminary earnings announcement. However, if the company can't keep the sales at least flat through further acquisitions, the stock price might react very negatively to falling Y/Y sales. So patient investors may want to wait for an even better entry point to acquire a very nice recurring core FCF stream.
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.