Open text (NASDAQ: OTEX) has underperformed for some time, and we expect it to continue due to a lack of value creation opportunities for investors. However, based on our valuation assessment, we believe the stock has the potential to return 75% from current levels if there is significant M&A interest from a financial buyer. If the direction continues on the right path, we see value emerging in the stock closer to the $20 levels.
Open Text is a provider of information management software and related services.
The “Cloud Services and Subscriptions” and “Customer Support” divisions are the SAAS offerings, the other two being the legacy software and services offerings.
The company is relatively well known; however, its overall growth has stagnated since 2019.
While the pandemic was a major reason for slowing growth, the company’s M&A-focused product portfolio kept subscription rates high to be dragged down through support and on-site activities.
We find the level of granularity of Open Text management’s financial performance expectations to be very transparent.
Additionally, there appears to be a reasonable level of resilience in the company’s margin profile.
- Non-GAAP gross margin increased, indicating pricing power
- The adjusted EBITDA margin evolved between 36% and 40%
- FCF margin has been much more volatile but remains above the 20% mark
FCFs have moved primarily due to mark-to-market adjustments to investments, income tax changes and some minor working capital adjustments – all of which are explainable in business, especially with the changes that the world has experienced over the past three years.
To management’s credit, despite Open Text’s acquisition spree, the company’s gross margins and EBITDA have been quite resilient.
Despite growth in cloud revenue, profitability and FCF generation, the stock underperformed. We think the market viewed the following issues negatively:
- Low overall growth (2-4% organic growth)
- The time it takes for the cloud installed base of 33% to reach the target number of 92%
- Heavy M&A strategy
Given the relative commodity nature of the information management business, growth of 100 basis points above the GDP growth rate is a reasonable expectation.
We note that over 80% of the company’s revenue comes from a recurring (subscription) basis, and given that most of the investment is on the cloud side, Open Text should see a steady shift towards the targeted installed base.
Open Text’s Mergers and Acquisitions Handbook is also pretty clear on the acquirable business areas, TAMs, and revenues the company is considering.
The operational and financial aspects of the incumbent raise the question of why the stock underperformed.
While market sentiment is difficult to decode, we look at Open Text from a valuation perspective. The company’s growth, margin and profitability characteristics make it more suitable for a cash flow-based valuation than a multiples-based approach. Even within the cash flow method, we believe that understanding Open Text’s shareholder return potential will require more than one valuation method.
The company must be valued by a DCF and a DDM. The DCF will estimate the value of Open Text based on FCF or the financial core of operational performance. The DDM or Dividend Discount Model will give an idea of how much of the cash flow generated can be paid out to investors – i.e. how much of that equity value can be expected in your bank account versus being consumed in mergers and acquisitions, etc.
Additionally, we will first derive our FCFs based on the management guidelines and then develop scenarios on how much of these can potentially be distributed as dividends. The range of values can potentially give a clearer picture of what an investor can expect from the company.
Based on management’s target model, past performance and market consensus, we arrive at the financial statement estimate as follows:
We expect revenue growth to be driven by cloud revenue, with on-premises revenue declining. Rising cloud revenues should bode well for gross margins. Additionally, benefits of scale should start to help EBITDA margins, which should ultimately contribute to free cash flow growth.
We take a WACC of 7% and a terminal growth of 2% to arrive at an equity value of $19 billion, which is 75% higher than the current share price.
Please note that this value is based on the assumption that all of the FCF or free cash flow to the business is available for distribution. Such a scenario will only occur when acquiring Open Text. Given the company’s growth profile and profitability, in our view a financial takeover (such as Thoma Bravo) is far more likely than any strategic player. Thus, we examine the potential dividends that Open Text could distribute.
The Dividend Discount Model or DDM attempts to estimate the value of a dividend paying asset, in this case Open Text.
We estimate the cost of equity using the Capital Asset Pricing Model or CAPM. We assume the risk-free rate is the 3-month T-bill rate of 1.13%, expected returns of 10.5% or about S&P returns since inception, and a beta of 0.93 (from Yahoo ! Finance). We arrive at a cost of equity of 9.8%, which is well above the WACC of 7% (from Gurufocus) for taking no debt into account in this calculation.
Over the past three years, dividends as a % of FCF have evolved from 21% to 26%. We consider three scenarios:
- As a % of FCF, dividends continue to grow to more than a third of FCF: in this case, the present value of expected dividends is $4.9 billion.
- Dividends as a % of FCF are set at a quarter of FCF: in this case, the discounted value of the expected dividends is $3.6 billion.
- Dividends as a % of FCF decrease to one-fifth of FCF: in this case, the present value of expected dividends is $3.1 billion.
Our MDD estimates imply a 50-70% decline from current levels. It should be noted that the company will always have cash that it would use for other purposes (most likely mergers and acquisitions).
Open Text is a healthy business, generating significant cash flow. Accordingly, we believe that the stock may see a revaluation in the following cases:
- Major Player Acquires Open Text: In such a scenario, the intrinsic value of $19 billion could become realizable, generating significant value for the existing shareholder. Of course, as noted, we expect this to be a financial buyout rather than a strategic buyout, given the characteristics of the business. While this may be the more bullish case, in the current environment of tighter monetary conditions, we believe the possibility of this option is low.
- Increased dividend payouts: We believe this is an easy option for management. However, this will delay the focus on mergers and acquisitions and therefore expected growth, limiting any further distribution of dividends.
- Accelerating cloud growth: Management’s focus on cloud revenue growth is the right way to go. However, it must be around our estimates to ensure value creation. By management’s own admission, organic growth is expected to be 2-4%, which may not be what growth investors expect.
Unless the Open Text can generate conviction on how investors may view value creation, we believe the stock is likely to struggle. However, at levels around $20 (compared to the current $40), we see the stock reaching its fair value based on our DDM.