Software Consolidator Prepared for a comeback
Enghouse Systems (TSX:ENGH)
(I) What Got Me Interested:
When I first became introduced to the magical world of finance Twitter one thing came as a surprise to me. When searching for some great investments and for some of my favourite investor’s portfolios there was always a consistent pattern, Constellation Software. After some digging around I began to understand why these brilliant investors were gladly paying up to a 20x FCF multiple for this business. Although it would take me a long time to capture all the fantastic aspects of Constellation’s business model I believe it can be simply attributed to their industry-leading management team and company culture. A key factor of why I have become so enamoured with Constellation’s management team was due to their ability to consistently allocate its free cash flow into accretive acquisitions, consistently increasing Constellation’s in-organic growth, and compounding its intrinsic value in the process. Now since Constellation Software is a large-cap stock that has garnered the attention of several intelligent investors I believe it is in my best interest to look elsewhere, finding similar companies which can be deemed as “consolidators” or “compounders” which are smaller in size. Two companies similar to CSU in the technology sector are Topicus and Enghouse Systems. Topicus is actually a spin-off from Constellation Software which deals with their European operations. Although I’m a huge fan of Topicus as a company I believe it is trading for an expensive, albeit justifiable premium which has allowed me to begin exploring other options in Enghouse Systems. Something unique about Enghouse System which is not seen with any other of its technology consolidator peers has peen its share price performance during the past year. Open text, Topicus and Enghouse Systems all experienced rapid declines from their COVID-19 highs falling more than 50% each. Now during these bottoms, investors began accumulating shares of Open Text, Enghouse Systems and Topicus seeing them have sharp recoveries, rising more than 50% in less than a year. Since this quick recovery, Enghouse has experienced a sharp decline of roughly 25%, seeing Enghouse's most recent close fall around $31. This decline has not been unwarranted as Enghouse has failed to meet analyst’s estimates over the past 2 quarters, struggling to follow up a very strong 2022 (I will talk more on this issue later on in the post). Now I believe this decline has resulted in Enghouse Systems shares being fundamentally mis-priced as investors are being overly hawkish on shares and fail to reward Enghouse for their history of strong capital allocation and long runway for growth.
(II) Business Overview:
Enghouse Systems is a small-cap stock ($1.7B market cap) publicly listed on the Toronto Stock Exchange (TSX:ENGH). Enghouse provides enterprise software solutions focused on contact centers, video communication, virtual healthcare, telecommunications networks, public safety and the transit market. The company’s business model is focused on in-organic growth through acquisitions by recycling operating cash flows (I talk about the company’s acquisition strategy more in-depth later on). The company is organized around two main business segments: the Interactive Management Group (IMG) and the Asset Management Group (AMG).
Interactive Management Group: (~55% of 2022 revenue, 74% GM 2022)
IMG specializes in contact centers and interaction software services designed to facilitate remote work, enhance customer service and increase efficiency by managing customer communication on all platforms.
IMG’s customers are diverse including financial service companies, media businesses, telecoms, healthcare providers, etc.
Asset Management Group: (~45% 0f 2022 revenue, 65% GM 2022)
AMG provides a portfolio of software and service solutions to a number of verticals including cable operators, network telecommunication providers, media, transit, defence, utilities and public safety companies.
Its products include network infrastructure, Operations Support Systems (“OSS”), Business Support Systems (“BSS”) and revenue generation solutions such as video and Cloud TV solutions.
AMG also provides transit e-ticketing, automated fare collections, fleet routing, dispatch, scheduling, communications and emergency control center solutions for the transportation, government, first responders, distribution and security sectors.
It is very important to note that a large portion of Enghouse’s revenue is generated from their SaaS and maintenance services segment which is recurring and high margin (accounts for 60% of 2022 revenue).
Acquisition Strategy:
Enghouse has had an extensive track record of allocating capital into acquisitions, which has been primarily financed through recycling internally generated FCF (has deployed $600MM of capital into acquisitions).
Enghouse has constructed a very attractive M&A pipeline through the years as they are able to cast a wide net, facing no geographic or financial constraints due to their large cash balance and relatively small size. I believe it is important to factor in Enghouse’s size as that allows them to compound capital at a much quicker rate (much like Constellation in the past or even their subsidiaries like Topicus or Lumine are currently doing).
Enghouse’s vast history of creating meaningful shareholder value through acquisitions can be attributed to their high-teens investment hurdle rate (2nd highest among Canadian software consolidators). This can periodically serve as a double-edged sword since Enghouse’s M&A activity can meaningfully slow down during a time of rich valuations, however, in the long run contributes to conservative investments and high IRR’s.
Target companies in the $5 -$50m revenue range with strong recurring revenue. Also looks for high barriers to entry and the ability to scale products.
Enghouse targets a cash-on-cash payback within 5-6 years.
Recurring Cashflows:
As previously mentioned roughly 60% of Enghouse’s revenue is generated through the recurring SaaS & Maintenance segment. This is very attractive as it provides more visibility into Enghouse’s future cash flows while also serving as a defensive revenue stream or hedge during times of stalling in-organic growth.
High Cash Flow Conversion Rate:
Enghouse has historically converted roughly 20% of its revenues into FCF. This is very attractive considering Enghouse’s ability to recycle its cash flows to fund value-accretive acquisitions.
Insider Ownership: Enghouse System’s CEO and Chairmen Stephen Sadler retains around 11% of the company shares outstanding showing that management’s interests are aligned with shareholders, prioritizing long-term shareholder value.
Recent Quarterly Performance:
As mentioned in the introduction Enghouse has struggled in the past 2 quarters, missing analyst estimates which has punished shares in the process.
Q1: There’s no doubt that Enghouse’s first quarter in 2023 was very underwhelming seeing revenue decline 4% YoY and adjusted EBITDA declining 16% YOY. EPS also failed to meet analyst’s consensus estimates of $0.37 with Enghouse only able to deliver $0.30. This miss can be attributed to negative organic growth and a failure to stabilize its Vidyo revenue segment which experienced a massive jump in COVID (a big factor as to why Enghouse shares railed over 100% in 2020).
Q2: Enghouse’s 2nd quarter was more of a mixed bag, seeing revenue beat analyst’s consensus estimates while also increasing 7% YoY. This was followed by an 11% decline in adjusted EBITDA as margins took a 370 BPS hit QoQ. At first glance this seems quite alarming, however, this can be attributed to 1) recent acquisitions which are initially lower margin then Enghouse’s core business and 2) large public contracts which are initially low-margin before shifting to the high-margin maintenance phase.
Overall, I believe that these 2 quarters posed short-term problems in nature which don’t materially impact the business’s intrinsic value or long-term ability to compound its capital at high rates.
(III) Return On Invested Capital:
As frequently mentioned throughout the post Enghouse System has a history of effective capital allocation throughout the years, achieving a 23% (EBIT) 5-year ROIC average and a 19% (NOPAT) 5-year ROIC average. This ROIC only continues to show Enghouse Systems company quality as their history of consolidation, effective capital allocation and attractive targeted IRRs have continued to drive shareholder value and long-term returns.
Formulas:
ROIC (EBIT) = EBIT/ Average invested capital
ROIC (NOPAT) = EBIT * (1-tax rate) / Average invested capital
(IV) Thesis : Fantastic M&A landscape & Valuation approaching trough levels
The weakening macroeconomic backdrop that has been building up in the past 12 months has resulted in valuations in the technology space taking a drastic hit. This provides a fantastic opportunity for Enghouse to tap into its M&A pipeline and deploy capital at high rates while still satisfying its high hurdles rates. The increasingly attractive M&A landscape is positively paired with Enghouse’s near-all-time high net cash position. This is a fantastic combination as Enghouse is able to reinvest its free cash flow while also having access to its treasure trove of cash to accelerate its M&A speed in the next 12-18 months. I believe the first sign of M&A beginning to ramp up will reinstall faith in investors, serving as a huge catalyst for shares to experience a significant re-rating. Another reason why I believe shares are trading at attractive levels is due to the average multiples of Canadian software consolidators. Although I typically tend to ignore relative valuation methods, it is important to acknowledge the significant disconnect in valuation between Enghouse and its peers. Companies like Constellation (18x), Topicus (24x), Descartes (23x) and Lumine (19x) all trade well above Enghouse’s 8.5x 2024 EV/EBITDA multiple (5-year average of 16x). I believe this highlights how Enghouse is currently fundamentally mis-priced as investors have dismissed Enghouse’s excellent track record of compounding (15% FCF/Share growth rate over the past 10 years) due to short-term headwinds. This re-rating will simply serve as the cherry on top as the true value is to be unlocked as a long-term investor, watching Enghouse continue to compound its capital at high rates through its disciplined and highly-accretive growth by acquisition business model.
(V) Valuation:
Discounted Cash Flow: To derive the intrinsic value of ENGH I decided to use a discounted cash flow analysis which projects out the company’s future cash flows across a 10-year projection period and then discount them back to present value. Due to investors’ concern regarding Enghouse’s ability to tap into its history of strong capital allocation and in-organic growth, I thought it would be effective if I were to use a 3 scenario analysis showcasing bull, base and bear projections for Enghouse’s valuation. I also opted for the use of an exit multiple method at the 5-year mark since I believe it more accurately rewards high-quality compounders which many investors gladly pay a premium for. I believe the EV/EBITDA multiples I used during my valuation are very conservative considering Enghouse has been trading around a mid-high teens EBITDA multiple for the past decade.
DCF Assumptions:
Overall, the results of the DCF are quite appealing and support my thesis as it outlines how even with the bear case there is a limited downside in terms of the company’s intrinsic value delta. This remains consistent with the multiple method as it also suggests that ENGH is trading around a 40% discount to its intrinsic valuation. With this in mind, I believe the intrinsic value of ENGH is around the $38 mark, implying a 35% upside.
FCF Data Table:
The data table below shows that ENGH shares could potentially offer investors a 5% FCF yield in 2024E. This is already an attractive entry point to investors as management has an extensive track record of driving strong FCF/Share growth in the past.
VI) Conclusion
Overall, I believe that Enghouse System appears to be an attractive investment to hold for the long-term and currently appears to be mis-priced both relatively and intrinsically. At the end of the day, I believe that a company that has historically compounded capital at an elite level should not be trading at a 10x 2023 EV/EBITDA multiple or a 35% discount to its intrinsic valuation. Enghouse remains one of my highest conviction investments due to its excellent track record of compounding (high reinvestment rate paired with high returns on invested capital), all-time high net cash position, excellent dividend (2.8% yield), attractive M&A environment and disciplined yet highly-accretive growth by acquisition business model.
