Description
Enghouse Systems Limited (ESL on TSX - C$8.50)
Investment Opportunity
Enghouse Systems Limited (ESL on TSX) is an underfollowed small-cap Canadian software company that trades at a 13% Free Cash Flow yield with excess cash on its balance sheet that it uses to drive growth through acquisitions. The company has a market cap of approx $200 million and a dividend yield of just under 2% (please note that all figures are in Canadian $, except where noted).
Description
Enghouse Systems operates through two segments: a) Asset Management division and b) Syntellect division. In a nutshell, the asset management division develops software that organizes and maps telecom and utility assets (i.e. essentially GIS software - geographical information systems) whereas the Syntellect division provides IVR (interactive voice response) software. The revenue and EBITDA breakdown by division (as of Q2/2010 - please note that the company has an October year-end) is as follows:
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% of Revenue
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% of EBITDA
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|
Asset Management
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17%
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18%
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|
Syntellect
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83%
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82%
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|
Total
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100%
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100%
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Enghouse is able to grow organically, albeit at modest rates as well as grow through acquisition. Details on its most recent acquisitions are below.
Valuation
Given its current stock price, ESL has a market cap of $215 million ($8.50 per share), with net cash of $73 million ($2.86 per share), resulting in an enterprise value of $143 million. ESL reported $17.6 million in 2009 fiscal year EBITDA, resulting in an EV/2009 EBITDA multiple of 8.1x. Fiscal 2009 can be considered a sub-par year given the credit and economic events of that time period. However, if we annualize Q2/2010 EBITDA (adjusted for corporate expenses and interest income) of $4.6 million resulting in an annualized number of $18.4, the EBITDA multiple falls to 7.8x. Comparable companies in the Canadian software space trade at around 10x forward EBITDA.
Trailing twelve month free cash flow is $0.74 resulting in a free cash flow yield of 13% or 8x FCF (FCF has been adjusted to exclude working capital and interest income). Median FCF multiples in the Canadian software space are in the 12x range.
Though the above multiples of EBITDA and free cash flow for Enghouse may be in the reasonable range, they are conservative given the fact that they don't yet account for 2 recent acquisitions on a full-year basis.
For YTD 2010, ESL has deployed $27 million of its cash into 2 deals - Telrex (a small $4 million USD deal for a company that specializes in call center software and generates approx $3 USD in revenue) and Mettoni - a $23 million deal. Mettoni provides unified communications management solutions and has annual revenue of $27 million. Looking at EV/Sales, Enghouse trades at roughly 1.4x whereas the Mettoni deal was done at 0.9x, thus being accretive on an EV/Sales basis. Mettoni closed with 1 month left in Q2 and thus its main contribution is still to come.
Generally, ESL has been able to generate mid-20% EBITDA margins on sales in both of its divisions. In the table below, historical 2008 and 2009 figures are given. The fiscal year 2011 has been given as a full-year where both acquisitions are fully accounted for (acquisition revenue has been added to 2009 actual revenue and EBITDA margin is kept stable in the low/mid 20% range):
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(C$ millions, except where noted)
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2008A
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2009A
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2011E
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Sales
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$53.0
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$78.4
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$108.0
|
|
EBITDA
|
$12.7
|
$17.6
|
$25
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EBITDA margin
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23.9%
|
22.4%
|
23.1%
|
|
|
|
|
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Given its EV of $143 million, ESL trades at 5.7x 2011 EBITDA versus its peers at around 10x forward EBITDA. Even a modest increase to 7.0x EBITDA (a 20% increase in the EBITDA multiple, which is still a 30% discount to comparables) results in a stock price of $7 plus $3.50 of cash (includes cash build over the next year) resulting in a price of $10.50 without further acquisitions or cost synergies from recent acquisitions.
Further Acquisition Potential
Despite the fact that management has been quite active on the acquisition trail this fiscal year, they are still seeing attractive acquisition opportunities. Though competition for deals is more today than one to two years ago, competition for smaller deals is still substantially less than that for larger software deals. Private equity players have returned, but so far seem to be concentrated on deals that are larger than those that interest Enghouse.
Capital Allocation
In addition to being prudent with respect to prices paid for acquisitions, the Company has also been very skilled at share repurchases. From November 1, 2008 to January 25, 2010, the Company repurchased approx. 950,000 shares at an average price of $4.80 versus today's price of $8.50. These share repurchases represent 3.7% of the fully-diluted shares outstanding.
Management and Director Ownership
Management and directors own approx. 34% of Enghouse, of which Stephen Sadler, the CEO, owns 20.5%.
Investment Risks
Investment risks include the potential for lumpy organic revenue growth as well as currency risk due to the fact that a significant portion of Enghouse's revenues are in Euros, British pounds or US dollars.
Catalysts
Additional acquisitions and continued integration of recent purchases
Catalyst
Additional acquisitions and continued integration of recent purchases