A Slow-and-Steady Tech Growth Story

03/22/2011 10:33 am EST


Ryan Irvine

President, KeyStocks.com

Canadian software developer Enghouse is using well-timed acquisitions to deliver long-term growth at an attractive price, writes Ryan Irvine, editor of KeyStone’s Small-Cap Stock Report.

Enterprise software provider Enghouse Systems (Toronto: ESL) is a little-known small cap that will require patience.

We expect no big miracles in the near-term, but with the company recently crossing the $100 million threshold in annual revenue—and on pace to double that in three years—the financial industry will eventually take notice. Whether that happens today or two years from now we can't say.

Until then, we like the management team and the balance sheet strength, and will sit on the approximate 1.7% dividend and wait until the cash flow is eventually discovered.

We believe we will be rewarded long-term in this sleepy tech story.

The company is organized around two business segments: the Interaction Management Group (IMG), formerly the Syntellect Division, and the Asset Management Group (AMG).

IMG serves the customer service market segment through the provision of Interactive Voice Response (IVR) systems and speech/voice recognition solutions, as well as an advanced contact center platform that manages customer interactions.

AMG provides visual software solutions for the design and management of complex network infrastructures to telecommunications, utilities, public and private transportation, and oil and gas companies.

On December 16, Enghouse announced that revenue for the year ended October 31 increased 20.1%. Net income of $10.2 million ($0.40 per share) in fiscal 2010 compared to $6.7 million ($0.27 per share) in fiscal 2009. (All figures are in Canadian dollars.)

A Discriminating Shopper
Acquisitions form a large part of Enghouse's overall growth and diversification strategy.

Management's goal is to complete acquisitions that are a good fit for the overall direction of the company, are accretive to both the top and bottom lines, and that may complement or extend current product offerings both within and outside its current operating groups.

Enghouse continues to operate profitably and replenish its cash reserves. It will only deploy its capital when acquisition targets can be acquired at reasonable valuations, recouping the acquisition outlay within five years.

The company spent approximately $30 million on cash acquisitions in 2010, up from $7 million in the prior year. Given the economic meltdown experienced in late 2008 and through 2009, last year was an opportune time to pick up solid assets that were on sale.

Enghouse closed the fiscal year with $78.3 million ($3.11 per share) in cash and short-term investments, accumulated principally by retained earnings. The company has no debt.

Enghouse also generated operating cash flows of $18.6 million in fiscal 2010, an increase from $15.8 million in fiscal 2009, primarily as a result of the impact of increased revenue from acquired operations.

The company is well positioned with a strong war chest for additional acquisitions. Having said this, the general economic climate continues to present challenges. As a result, management is not scaling up investments for internal or organic growth in 2011 so we do not expect material organic growth in the near term.

Top- and bottom-line growth in the next two quarters will continue from acquisitions made in the first half of calendar 2010, as well as slight margin improvements from further integration progress.

Moreover—given Enghouse's strong cash position—the current challenging economic conditions generally provide a better backdrop for acquisitions, and management continues to be optimistic that deals will develop on attractive terms in 2011.

Next: Dividends on the Rise


Dividends on the Rise
While the current dividend yield is under 2%, Enghouse generated strong cash flow in the fourth quarter of fiscal 2010, and is positioned to boost its dividend once again. Continued cash generation should result in dividend increases over time.

At first glance, with a trailing price/earnings ratio above 20, Enghouse may not appear cheap. However, when we dig a little deeper, we find that the company's consensus earnings per share estimate of 2011 is in the range of $0.54 and its forward-looking price/earnings ratio is a more reasonable 15.5, given its growth.

Strip out the $3.11 in cash per share that the company holds, and we are paying closer to ten times forward earnings for the operating business. The company's trailing enterprise value to earnings before items ratio is 6.8 and 5 on a forward-looking basis, which are below industry averages.

Investors should be prepared to give management time to execute on its stated strategy to produce meaningful earnings per share growth over the next one to three years.

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