OpenText Is Private Equity, Not A Software Platform

Summary

• At OpenText’s current valuation, investors should consider holding, not buying.
• The company has an impressive track record of acquisitions and integrations.
• OpenText has seen negligible organic growth, but the industry has grown substantially in the past five years.
• Management sells the company as a software platform, but many factors make this hard to believe.

Investment Thesis

OpenText (NASDAQ:OTEX) is perceived as a synergetic software platform, but really it is a private equity firm and should be valued as such. Although this is a well-managed firm whose financial performance is exemplary, its current valuation does not leave much room for growth. Keep an eye on this stock.

Industry Overview

OpenText operates in various enterprise software industries with is Enterprise Information Management (EIM) suite of products. EIM is an umbrella term for software that enables firms to better control and utilize all forms of information. In OpenText's FY2019 annual report:

Our EIM solutions are designed to enable organizations to secure their information so that they can collaborate with confidence, validate endpoints with all machines and the Internet of Things (IoT), stay ahead of the regulatory technology curve, identify threats that cross their networks, leverage discovery with information forensics, and gain insight and action through analytics, artificial intelligence (AI) and automation.

OpenText's EIM software portfolio spans many sub-industries of the enterprise software industry. Below is an overview of the sub-industries in which OpenText operates and its historical and projected growth:

Source: Table by Author using data from IBISWorld

Growth in the enterprise software industries has been strong in the past five years due to increasing complexity of businesses and strong corporate appetite to invest in efficiency-improving products. Large firms have already gained the most sizable benefits of adopting enterprise software, and these high adoption rates will reduce growth moving forward. Industry growth will be driven by new products catering to niche/underserved markets and small- and mid-size business (SMB) adoption as enterprise software becomes more ubiquitous, user friendly and cost effective. Other growth areas include continuing expansion into cloud and mobile platforms, data warehousing, cloud security, automation, predictive analytics and other AI applications.

The industry is characterized by high switching costs as enterprise software is complex and highly integrated into a firm's architecture. This combined with low anticipated industry growth means that many firms will experience stagnant organic growth. Consequently, incumbents have been and will continue to pursue aggressive acquisition growth strategies. Companies are in a stronger competitive position and can achieve organic growth through cross-selling a suite of product offerings that are integrated with other enterprise applications and available on multiple platforms.

Industry concentration is moderate and likely to remain so. Large firms have been carrying out aggressive acquisition strategies while smaller firms emerge in niche areas as the capital investment required to enter is low. However, incumbents benefit from the barriers provided by their reputation and ubiquity, a talent barrier from the limited pool of skilled software developers, and high switching costs.

Although providing a competitive barrier, the limited pool of skilled software developers is expected to put pressure on margins as wages are expected to outpace revenue growth. Additionally, industry consolidation presents a risk for enterprise software platforms like OpenText as mentioned in its latest annual report:

Consolidation in the industry, particularly by large, well-capitalized companies, could place pressure on our operating margins which could, in turn, have a material adverse effect on our business

The enterprise software industry is highly competitive and is characterized by rapid technological change. Firms spend a significant portion of their revenue on research and development to maintain a competitive edge.

The software-as-a-service (SaaS) model dominates the enterprise software space. In SaaS, customers access software by paying a recurring fee to software providers instead of a one-time fee. These stable cash flows, along with high switching costs, means that enterprise software revenues are not cyclical. Firms may reduce their appetite to invest in new software during economic downturns. Some enterprise software has anti-cyclical properties as firms attempt to cut costs and replace human capital with software.

In summary, the industry key success factors (KSFs) are:

• Product reputation and ability to attract and retain talent. This is largely benefited by the biggest firms
• Offering an attractive suite of products that are easily integrated across various enterprise software
• Acquisitions that complement existing offerings and/or enable growth, and quick and effective integration
• Effective research and development expenditure and quick technology adoption

Company Overview

OpenText's various software offerings can be viewed here: products and solutions. OpenText software is offered through traditional on-premise solutions, on the OpenText Cloud or a combination of both. Its revenue is generated through licensing of software products, cloud services and subscriptions, customer support which is generally purchased alongside software products, and professional services such as implementation consulting. Here is its revenue composition in FY2019:

Source: Chart by Author using data from OpenText's 2019 annual report

M&A History

Below is the history of all the company's acquisitions made in the past 10 years. The average price/sales paid for acquisitions is 2.5x during the analysis period, which is accretive on a price/sales basis based on OpenText's historical price/sales valuation. This suggests that the company is not overpaying for acquisitions.

Source: Table by Author using data from OpenText annual reports and OpenText press releases

Corporate Strategy

OpenText pursues a Total Growth strategy, "Retain. Grow. Acquire," through both organic and inorganic growth. Inorganic growth is largely funded internally; in the past five fiscal years, operating cash flows have covered 89% of acquisition costs (3.0b vs. 3.4b). Its inorganic growth has been executed very effectively, with no goodwill write-downs in the past 10 years and tight controls on costs and its operating margin. It is exceptionally rare and difficult for a company pursuing an inorganic growth strategy to show strong cost control. In fact, over a 10-year period, OpenText's margin has improved significantly. If this tells me one thing and one thing only, it is that management shows talent in cost cutting and restructuring after making acquisitions.

Source: Chart by Author using data from OpenText annual reports

Organic growth is a key part of the company's strategy, as it wishes to penetrate more of the Global 10,000 firms. Organic growth includes cross-selling products to newly acquired OpenText customers. Customer retention appears to be strong; management claims that 75.6% of TTM revenues are recurring, and customer support and cloud services renewal rates are in the mid-to-low 90s (01/2020 Investor Presentation).

OpenText has achieved a 13.6% CAGR in revenue since 2010, but the company does not report any organic vs. inorganic growth figures. However, management generally discloses the trailing twelve-month (TTM) revenues of its acquisition targets. Using these figures and the date of the acquisition, you can prorate one year's worth of the acquisition targets' revenue to get an estimate of year-over-year organic vs. inorganic growth.

Source: Table by Author using data from OpenText annual reports and press releases

GAAP revenue is compared against the following year's M&A adjusted revenue. The average year-over-year organic growth over the analysis period is 0%. This is surprising in the context of the considerable industry growth over the last five years. This may speak to issues regarding customer churn, the obsolescence of certain products, inability to cross-sell newly acquired customers, or the fact that OpenText may not be acquiring targets that are complementary to its existing product portfolio. Management also mentions that a 10% drop in revenue is common upon the first year of acquisition because of the disrupting effects of integration. It is difficult to attribute this issue to any one thing, but I assume that the 0% average year-over-year organic growth is due to a combination of the above factors.

An important pillar in the company's growth strategy is its strategic partnerships. OpenText has strategic partnerships with Amazon AWS (AMZN), Microsoft Azure (MSFT), Oracle (ORCL), Salesforce (CRM), and as of FY 2019, SAP (SAP), Google Cloud (GOOG) (GOOGL), and Mastercard (MA). By making its software available on these ubiquitous platforms, OpenText is effectively marketing its products, delivering them to market, and triumphing on the industry KSF of making its software easily integrated with other enterprise software.

Company Risks

The company is currently in the appeals phase of an IRS matter that may lead to a $770m tax charge that arose from the consolidation of intellectual property and internal restructuring between 2010 and 2012. A $770m charge represents a $2.84 destruction of value per OpenText share and may halt dividend payments and hamper acquisition activity. However, the risk of this damaging the long-term financial and strategic strength of the company is low.

Peer Valuation Comparison

OpenText shares its direct competitors in the latest annual report:

Our primary competitor is International Business Machines Corporation, with numerous other software vendors competing with us in the EIM sector, such as Veeva Systems Inc., j2 Global Inc., Pegasystems Inc., Hyland Software Inc., SPS Commerce Inc., Box Inc. and Adobe Systems Inc. In certain markets, OpenText competes with Oracle and Microsoft, who are also our partners.

For the peer analysis, OpenText's competitors were selected along with other software companies in similar markets. Adobe (ADBE), Oracle and Microsoft are not comparable as only a small portion of these consolidated firms are comparable to OpenText.

Source: Table by Author using data from finbox.com

OpenText is conservatively valued among its peers. For some tech and software firms, EV/Sales may be a more powerful metric to pay attention to than earnings-based multiples. Many of these firms are not maximizing their profitability in the pursuit of growth. The company's valuation based on this metric is hovering around its five-year average and many five-year averages of peers. OpenText has lower growth prospect than the majority of its peers, hence why it is trading at a lower multiple.

OpenText's 15.7x EV/EBITDA valuation is among the more conservative among these peers also due to relatively low growth expectations. This amounts to a 6.4% EBITDA yield per share, which is much more reasonable than the lofty valuation of many peers. Given OpenText's historical growth trajectory and cost management, this valuation alone may be attractive to many investors. For reference, the S&P 500 has historically averaged 11-14x EV/EBITDA and a value below 10x can be very attractive.

Other Peer Comparisons

A company that is paying its executives exorbitant amounts raises a red flag. With OpenText's strong historical growth, cost management, and track record of successful acquisitions, one would expect that the CEO is being paid handsomely. OpenText's CEO's compensation lands modestly in the middle of the peers, which I am comfortable with as a potential investor.

Source: Chart by Author using data from Morningstar and company documents

Through the analysis period, the company has maintained strong operating margins in the context of its total growth, which sits above the peer group. From OpenText's annual report, research and development expenditure is "an appropriate balance between managing our organic growth and result of operations." The R&D expenditure is notably less than its peers, yet its operating margin remains strong. The lack of expenditure or effective R&D may explain the stagnant organic growth, but this is a difficult connection to make. Overall, it seems to be striking a good balance.

Source: Table by Author using data from finbox.com

Return on total assets, measured as operating income divided by total assets, has seen a decline over the analysis period and sits noticeably below its peers. Goodwill and acquired intangibles represent the majority of OpenText's assets, which indicates to me that it is not realizing the full value of its acquisitions. This may be due to difficulties in cross-selling and revenue synergies, difficulties in achieving cost synergies (which I do not believe is the case), or the fact that OpenText is simply overpaying for acquisitions. Investors should pay close attention to this metric (and other similar metrics such as ROE, ROIC, EVA, ROCE) as this may be an obstacle to generating shareholder value moving forward.

Source: Table by Author using data from finbox.com

Valuation

Valuation performed at $41.54/share

OpenText was valued using a modified Earnings Power Valuation (EPV), which is a zero-growth model, reflecting the company's negligible organic growth. As the company grows only through acquisitions, the value of this growth will be incorporated qualitatively. Many of the cash flows and expenses are normalized over the analysis period, and 2014 was chosen as the first year due to the significant change in capital structure occurring this year. Share compensation liability and long-term debt were revalued to market values using the most current available data.

Source: Chart by Author using data from OpenText annual reports

S&P gives OpenText a BB+ issuer-level credit rating. Using FRED economic data, reproducible BB+ credit rating is equal to 4.16%, which is in line with industry benchmarks and OpenText's average forward-looking interest rate on long-term debt of 4.01%. This is a conservative credit score given its 6.41 OCF interest coverage in FY2019.

Source: Table by Author using data from OpenText annual reports, Standard and Poor's, FRED Economic Data

I performed two cash flow analysis, an unlevered cash flow analysis (left) and a levered cash flow analysis (right). The levered free cash flow analysis is more relevant to potential common shareholders like you and I, but both valuations should theoretically produce similar valuations.

Source: Table by Author

Assuming zero-growth, the intrinsic value or reproduction value of OpenText's shares is between $29 and $33 per share. This valuation lies below its current share price of $41.54, suggesting that the investor should stay away if no growth assumed. However, there lies some true value in OpenText's proven ability to use internally generated cash flows to acquire and integrate other firms. Here is a sensitivity of this model to understand what the value of growth can be:

Source: Table by Author

At OpenText's current valuation, investors are pricing in moderate growth expectations. We will summarize the main findings in the company overview to see if we can qualitatively justify the current valuation (hold OTEX), and a margin of safety (buy OTEX). This is done in context of the industry key success factors.

OpenText Strengths

• Strong liquidity position, only moderate growth expectations are priced in; risk of significant shareholder loss is low
• Undeniable talent in acquisitions and integration; no drop in operating margins or goodwill write-downs
• Prudent fiscal track record; modest CEO compensation, strong dividends, effective R&D expenditure, above-average operating margins, not overpaying for acquisitions
• Strong strategic partnerships that reduce costs in switching to OpenText's product
• Strong customer retention
• Cyclically stable revenues

OpenText Concerns

• $770m IRS charge, equal to $2.84 per OTEX share
• Low/no organic growth and declining return on total assets. Reasons for this:
  • Not concerning - temporary shocks to revenue due to integration stress
  • Concerning - non-complementary acquisitions, inability to realize revenue synergies
• Declining industry growth expectations and aggressive industry competition

Recommendation

Overall, I do not believe there is a significant margin of safety to purchase shares at OpenText's current valuation, and I advise that existing shareholders hold their positions. My main concern is that OpenText is more of a private-equity firm that is acquiring a non-complementary suite of software products. There is value in this, and it seems to be a fantastic acquirer and cost-cutter, but not enough for me to justify its valuation and initiate a position. I feel that OpenText's growth prospects justify a significant margin of safety to enter at $29-33/share. I will keep a look on ROTA, ROIC, and the company's ability to achieve revenue synergies in its latest acquisition of Carbonite before reconsidering the purchase of shares.

Analyst’s 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.

Comments

[BlueChipRick]

I know this is an old article but I just read it a few weeks ago. Excellent analysis on organic growth. The article could be better if you break it down further into License/Cloud/Support/Professional but I realize that would be very difficult. It's clear from their reports that they are bleeding License revenue, but growing Cloud at a high rate and Support at a lower rate. You are probably correct that legacy software is struggling. It seems to me that they are basically acquiring new customers via acquisitions to put the on their own cloud and support. That doesn't mean they are private equity, it's a business strategy to simply get larger. Can a cloud/software support company achieve economies of scale? That leads me to my next point - I don't like how you value the company. Just because they have been a serial acquirer does not mean that they are private equity or should be valued as private equity.

[A.C.T. Investing]

Tech companies achieve organic growth. I am arguing that OTEX does not deserve tech-level valuations. Because it experiences zero organic growth, we should value it as such.

Margins have not been declining over the analysis period, suggesting that they are not driving any significant value through economies of scale.

[BlueChipRick]

@A.C.T. Investing I get what you're saying but growth is growth and the market doesn't care. It probably doesn't make sense to value them as a high growth company, simply because they haven't been one for a few years. That may change though. Right now the stock is at 13x earnings imo which is an ok price for even a company that can do 5 to 10% earnings growth. The thing is, this company can do more. Look at valuations on Constellation and Enghouse.

[johngonole]

@BlueChipRick I agree with your point about growth being growth. I also agree with the author that the serial acquisition without synergies or purpose is also concerning. My guess is that they have some products performing better than others. MIght be time for the company to sell off the nonperforming assets and keep the ones that make sense. There is no way all segments are performing exactly the way they were upon acquisition.

I would also say that acquiring so many companies has hopefully allowed them to acquire some talented employees. That might be the most important part. Have they been able to keep their employees. I'm really only familiar with the Carbonite product. The rest I don't know.

But I think I will pass. From my point of view a company unable to grow organically has poor management and is in trouble. It shows a lack of imagination and creativity. My guess is that for a lot of their products they are simply milking the products until they hit end of life in practical terms. All I know is that they should be able to achieve organic growth with a product like Carbonite.

[Heuristic Alpha]

Comprehensive fundamental analysis; excellent historical drill-down to analyze M&A contribution, derivation of organic vs inorganic growth; rigorous valuation analysis and comparative valuation. The qualitative view is equally fully covered. I for one do not believe that future acquisitions will come as easily (and cheaply) as past precedents, in which case the implied growth rate in the current forward multiple is not sustainable. A+ effort.

[A.C.T. Investing]

Thank you, and agreed- I think it is trivial to assume that the past will be the same as the future due to the intensifying competition and growing appetite for M&A in the software industry.

[Jack R. censored]

didnt say it was fair, i said it was a bargain. 12x is fair for a flat revenue dairy company, a car dealer, a train maker. for one of the few companies that didnt report a profit warning during covid, this is dirt cheap

[Jack R. censored]

M&A is an optionality that comes on top for free. returns are declining of course like all M&A returns due to increased competition from private equity in a low interest environment

[Jack R. censored]

I really dont understand what you are talking about. You elaborate on complex calculations to value OTEX and at the end you arrive to weird conclusions.

Put it simple:
OTEX is trading at around 12-15x times cash flow or normalized earnings less amortizations.
Add to that their savings plan to reduce I think around 70M per year going forward

For a company that has extremely sticky and revenue recurring products, this is a bargain.

Whatever external growth they can deliver through M&A comes on top, and they have an impressive track record doing this.

[A.C.T. Investing]

@Jack R. I used rigorous calculations to find the base-case-valuation that myself and others can feel confident about. I can then incorporate the qualitative discussion more convincingly once I have done this. This is better than just a simple discussion or valuation, in my opinion.

Management has a clear financial incentive to market their company as a software platform- what I have tried to highlight in this article is that they are not. Their return on M&A is declining. The industry is fiercely competitive. Their product mix is not synergetic. Because of these factors, they should not receive the lofty valuations that software companies do.

I agree that OTEX's 12-15x cash flow valuation, as you have said, is fair. But I do not want to initiate a position in a company at a fair price. I want to initiate at a great price.

Great company, and I do acknowledge that my conclusion is quite conservative. I hope you learned something from my perspective!

[KR1527]

I like OpenText but it does seem expensive here ...

[Ludo5312]

An interesting perspective! That PE has been very kind to my pension fund...