The majority of revenues are generated from on-premise enterprise software while its fast growing cloud ERP software is expected to account for nearly 10 percent of QAD's estimated $291 million revenue in the year to January 31, 2015.
Technology research group Gartner forecast the global market for manufacturing and operations ERP software to grow by 7 percent annually between 2014-2018, while cloud ERP is expected to grow at a quicker clip of 18 percent annually. This superior growth is expected to result in cloud ERP accounting for 22 percent of the ~$9.5 billion software market in 2018.
There are many qualities to like about this company. I really like to read that recurring revenues were 58 percent of revenues in the September 2014 quarter. I also like the fact, that this business employs 1595 employees, so its quite a substantial business in comparison with its market capitalization ($326 million with $56 million net cash).
QAD also has a decent heritage being established in 1979, and going through the company website you really feel like this company understand its own DNA, which is not always the case for listed companies.
I like the fact that QAD sells and services the majority of its software directly while only 10 percent of sales and servicing occur through reselling partners. The company sells directly in 19 countries and employs 270 sales staff, which is around 17 percent of total staff employed. The direct sales and software implementation teams are higher cost business models but result is a more more informed software sale and installation. Investors can expect leverage to kick in and margins to scale once the business has sufficient revenue scale.
The company is 61 percent controlled by husband and wife team Karl and Pam Lopker who have openly and consistently invested in the customer experience which should make customers sticky. The company has two different types of traded shares. There are 3.188 million QADB shares which entitle shareholders to 1 vote per share and 100% of any dividend declared. This compares with the more liquid 12.859 million QADA shares which enjoy 120 percent of any dividend declared but have one twentieth of the say in any shareholder vote.
The heavy investment in customer service has translated into mediocre historical gross profit margins (~57 percent of sales) and high sales, marketing and administrative costs (~37 percent of sales) relative to software peers. The company has consistently invested around 15 percent of sales into research and development, with this innovation spend broadly inline with 'maturing' software peers.
Operating margins historically have been pretty miserable at around 5 percent and this is one reason QAD trades on an enterprise value to revenue ratio of less that 1 times, which is a traditional BUY signal for a software companies. The very low stock liquidity with the Founders dominating the share registry is another reason investors don't get excited about QAD.
The stock trades on a 2015 price to earnings ratio of over 28.8 times which is reflection of a pristine balance sheet and the potential for QAD to increase operating margins in the future. The inflection point for rising operating margins is difficult to pin down.
There however has been a positive developments with the company formally outlining its targeted investment metrics in a recent presentation. The company is guiding its gross profit margins can rise 3 percent to 60 percent of sales, while sales, marketing and administrative costs can fall 5 percent to 32 percent of sales. QAD also believe their research and development spend can fall a couple of percent to 13 percent of sales. The net effect of this recent guidance is the current 5 percent operating margins can rise to 15 percent if the company executes well. I have conservatively assumed in the below forecasts these guided metrics are achieved in 4 years, against a backdrop of revenues climbing 5 percent per year.
The risks appear to be more around the global economy. QAD revenues collapse 18 percent in 2010 in response to the GFC, with compound annual sales growth in the 5 years from 2007-2012 being an anemic 1 percent per year. The direct exposure to the manufacturing sector makes QAD's revenue more cyclical than many of its software peers. Revenue growth has subsequently picked up but at slightly under 6 percent for the 3 years ending 31 January 2015, its hardly setting the world on fire. The sluggish long term revenue growth is the monkey on the back of the QAD story.
I'm however happy investing in QAD as I believe many of the building blocks enabling the company to achieve 15 percent operating margins are already in place. We already are doing $291 million of revenues, the majority of which are recurring. Getting to the 15 percent target is now about scale benefits requiring QAD to spend less (in proportion to sales) on cost of goods, sales, marketing, admin and research and development. Businesses are typically pretty good at managing these type of costs. There is also a risk these initiatives to reshape the business, slow down the already anemic top line revenue growth.
This is a classical under valued sleeper which I have a space for in my portfolio. The investment rationale being a manufacturing ERP software specialist like QAD that lives and breaths in a few key industry verticals can deliver more relevant and timely software when compared to IT conglomerates like Microsoft, Oracle or SAP. It is also of a size with nearly $300 million in revenues, that investors can expect scale benefits to start to flow. The recently announced 15 percent operating profit target feels like an achievable goal in the medium term.
I have blindly used the company's guidance and forecast its profitability through to 2019 with my key assumptions as follows.
- Sales Revenue growth of 5 percent pa 2015-2019
- Gross Profit margins rise from 57 to 60 percent 2015-2019
- Selling General and Admin costs fall from 36 to 32 percent 2015-2019
- Research and Developments costs falling from 15 to 13 percent 2015-2019
- Shares on issue rise 2 percent per annum to account for scrip based remuneration
- Tax rate 35 percent
- Dividend payout ratio is 50 percent
The company valuation looks very sensible today especially on an enterprise value to sales revenue metric. You don't see credible software companies trading on enterprise values to revenue metrics of 0.93 times too often.
The Enterprise Value to EBITDA and EBIT metrics look a tad ritzy for 2015, but acceptable for 2016 on-wards while the price to earnings ratio at 28.8 times for 2015 falling to 19.9 times in 2016 feels rich. The company valuations look pretty strong across the board by 2017 on-wards.
See Disclosures in About Me
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