OpenText (OTEX) is a Canadian provider of software which allows companies to handle their non-structured data, called enterprise information management. The company employs a roll-up strategy with regards to acquisitions. While more companies employ such a strategy, OpenText has been very successful at integrating the acquired companies. As a result, OpenText has delivered on great sales growth and margin expansion, delivering on +700% returns for its investors over the past decade.
After looking at the aggregate impact of dealmaking, it seems that OpenText's roll-up really creates value. Shareholder dilution has been limited, debt is very manageable as actual GAAP revenues and margins have shown a big improvement. The company continues this strategy with another round of acquisitions, this time buying some assets from HP (NYSE:HPQ) in a $315 million deal.
Looking At The Growth Record
OpenText has increased its sales by a factor of 5 times over the past decade, as revenues are approaching the $2 billion mark. The company proudly claims that cash flows have increased by a factor of 10 times over the same time frame, now coming in at little over half a billion. Growth has been driven by continued dealmaking as OpenText has bought 53 companies since its existence, creating a true roll-up machine.
This spectacular growth needs to be examined, as such a roll-up strategy in potential can hide poor operational performance. While it is hard to find revenue numbers and purchase price for each individual deal, we can find some clues by looking at the annual reports.
The cash flow statement of the annual report reveals a great deal of information. In 2015, OpenText acquire Actuate for $292 million while the purchase of Informative Graphics came in at $35 million. This followed the $1.08 billion purchase of GXS in 2014, accompanied by the $30 million deal of Cordys that year. Going further back in time, OpenText spent roughly $350 million on deals in 2013, $250 million in 2012, and another $250 million in 2011.
These amounts overshadow the regular capital expenditures made into the business. A quick sum shows that OpenText spent $2.3 billion on deals in the period 2011-2015. This follows cumulative M&A worth $650 million in 2007-2010. This indicates that the company has spent roughly $3 billion to expand the business between 2006 and 2015.
How Does It all Add Up?
OpenText has grown from a revenue base of $410 million in 2006 to $1.85 billion in 2015. Operating margins have improved from roughly 10% of sales in 2006 (after backing out special charges), to more than 20% in 2015. This resulted in an earnings explosion, with earnings having risen towards $235 million last year, up from just a couple of million a decade ago. With dilution being limited to just 20% over this time frame, and OpenText operating with a manageable net debt load, it is fair to say that this has not been a low quality roll-up.
As a matter or fact, shares have risen from just $6 in 2006 to current levels at $60 per share. With 122 million shares outstanding, and a $1.2 billion net debt load, OpenText nowadays has a $8.5 billion enterprise valuation. This compares to a valuation of just $500 million back in 2006. The numbers above reveal that roughly $8 billion in enterprise value has been created over the past decade, while actual M&A activity came in at just $3 billion. It is clear that management has created a lot of value in the process.
OpenText reported another deal as it is the latest business to acquire assets from HP (HPQ). OpenText will acquire customer communication management assets including HP Exstream, HP Output Management, TeleForm and LiquidOffice in order to improve communication and automation processes.
OpenText will pay $315 million for the assets which are expected to add $110 to $125 million in sales, for a sales multiple of 2.5-2.8 times. The $8.5 billion enterprise valuation of OpenText shows that the company itself is trading at over 4 times sales.
OpenText cites growth, leading positions and a strong partner channel as reasons behind the deal, pointing towards a recurring revenue base. Not unimportant, the deal will be immediately accretive to earnings, although the accretion has not yet been quantified.
The HP deal follows the purchase of Recommind at the start of June. OpenText paid $163 million for the data analytics business which is anticipated to add $70-$80 million in sales.
The Pro-Forma Business
While the long term performance of OpenText has been great, the company actually reported a 1.6% fall in its third quarter sales which came in at $440.5 million. Currency fluctuations had a big impact, with organic growth coming in at 1.7% in constant currency terms. Similar trends have been reported for the first nine months.
Based on these trends sales come in at around $1.78 billion this year, as the HP and Recommind deal will expand the revenue base to $2.0 billion going forward. The company is posting earnings of roughly $270 million on a trailing basis, for after-tax margins of roughly 15%. A similar after-tax margin of the HP assets could add $15 million to earnings, although the actual contribution is anticipated to be very limited given the financing costs. As recent as May, OpenText raised $600 million in 2026 notes at a 5.875% rate.
The pro-forma business now operates with roughly $400 million in cash and $1.58 billion in debt. This net debt load of $1.18 billion excludes very modest pension-related obligations of roughly $60 million. With EBITDA coming in at roughly $550 million, leverage ratios come in just above 2 times EBITDA. Remember that the company generates a lot of cash, allowing for a quick pace of deleveraging.
Projected earnings of $270 million come in at roughly $2.25 per share. With shares trading up some 30% on a year to date basis, OpenText is certainly not cheap at 27 times earnings. That being said, GAAP earnings are seriously impacted by amortization charges relating to past dealmaking. Goodwill amortization charges alone come in at $110 million a year, suggesting that earnings could come in at around $3 per share if we exclude these costs. That translates into a much more manageable earnings multiple of 20 times.
OpenText is a great business. The aggressive acquisition strategy has been achieved while the company has avoided massive dilution, and it also hasn't increased leverage to non-sustainable levels.
The issue is that the growth results are very well recognized by the market. Following nearly 30% year to date return, OpenText now trades at 27 times projected earnings, while leverage is moderate at 2 times. While some sort of premium can be justified given the great expertise and track record with regards to dealmaking, some caution is also needed.
I am somewhat worried that organic sales growth is pretty flat at the moment. What is particularly worrying is that the cloud service and subscription segment, which makes up 40% of total sales, is not growing at all. This comes at a time when competitors are showing very rapid growth in this area.
The other concern relates to the relevancy of all the deals, as OpenText hereby acquires multiple platforms and software solutions. The lack of cohesiveness in terms of some of the offerings, make that I question the longevity of some of these solutions. This is especially the case at the IT world continues to change at a rapid pace. On the other hand, OpenText has a truly impressive and diversified customer base.
While the track record with regards to operational achievements and past dealmaking absolutely has to be applauded, I am not willing to pay such a high multiple. The bull case reminds me somewhat of the great future value being created by "platform" companies, leaving shares vulnerable for a setback. I furthermore worry about the long term competitiveness of each of the software solutions, given OpenText's very diversified strategy in a rapidly moving world.
While I could be proven very wrong with my cautious stance, and miss out on a further home-run, I'll take my chances. That said, shares have the tendency to fall at times as well. Exactly a year ago, shares traded at just $40 per share. A 20 times multiple on $2.25 in GAAP earnings, or a 15 times non-GAAP multiple (excluding amortization charges) amounts to $45 per share. At those levels, I would be inclined to pick up some shares.
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.