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Robert Abbott
Robert Abbott
Articles (840)  | Author's Website |

A Potentially Intriguing Blend of Capital Gains and Income

OpenText has history of producing capital gains; now it's adding dividend growth

At the end of February, the Daily Buy Sell Advisor reported that OpenText Corp. (NASDAQ:OTEX) had just reached a milestone: it had increased its dividend for a fifth consecutive year. And that’s just one of many positive signals emanating from this growing IT company.

At the same time, OpenText is currently on the Undervalued Predictable screener list, meaning its price is below the discounted cash flow (DCF) valuation at GuruFocus, and it has a history of consistently growing its earnings.

OpenText operates in the field of Enterprise Information Management, which means it handles what is called unstructured data within an organization and is transferred to and from other organizations. This includes email, office and PDF documents, fax transfer, collaborative communications and so on. Needless to say, there is a lot of this kind of information and data.

The company’s main growth driver is mergers and acquisitions (M&A); with 56 successful acquisitions since 1991, it considers itself a consolidator and integrator. That strategy has certainly driven growth. GuruFocus reports the company’s revenue per share has grown by an average of 14.4% per year over the past 10 years; earnings per share have grown even faster, at an average of 37.6% per year over the past 10 years. Yet this is also a company that has increased its modest dividend for five years in a row.

I looked at this company in a GuruFocus article about 2½ years ago; the title of the article summed up the potential: "OpenText: Above Average Prospects & Predictability" (also, see this article for background on the company).

Should investors remain optimistic about the stock, given that it has gone through a number of changes in the 2½ years since that article?

The gurus

Among the gurus followed by GuruFocus, four have holdings in OpenText. The largest holding is that of Richard Snow (Trades, Portfolio),1,851,010 shares, which is 2.58% of Snow's total assets. The other gurus with holdings are Jim Simons (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio).

GuruFocus also reports that 70.27% of its shares are owned by institutional investors (pension funds, mutual funds, hedge funds, etc.) and about 2.4% are owned by short sellers. No insider holdings are listed because the company is based in Canada (interlisted, on the NASDAQ and Toronto Stock Exchange).

The share price

On the date of my first OpenText article, Oct. 20, 2014, the company was selling at $55.75 per share; the stock closed at $33.25 on March 7, but it also underwent a two-for-one split in January, which means if you bought one share on Oct. 20, 2014, you would now own two shares with a combined value of $66.70.

Along the way, you’d have experienced a significant drawdown, as shown in this five-year chart (all in post-split prices):

OTEX 5 year price chart

Note as well the recent and so far minor pullback that has helped put OpenText on the Undervalued Predictable screener list.

The following chart shows the same five-year share price along with the 200-day Simple Moving Average (SMA):

Open Text price simple moving average

Competitors and partners

In its 10-K for fiscal 2016, OpenText says it competes in a market that is “highly competitive, subject to rapid technological change and shifting customer needs and economic pressures.”

Named competitors are International Business Machines Corp. (NYSE:IBM), EMC Corp. (NYSE:EMC), Hewlett Packard Enterprise (NYSE:HPE), Adobe Inc. (NASDAQ:ADBE), j2 Inc. and Pegasystems Inc. (NASDAQ:PEGA). In some markets, it also competes with Oracle (NYSE:ORCL) and Microsoft (NASDAQ:MSFT), which are also partners in other markets.

Like some other companies in the software sector, it works through partnerships. Named partners in the 10-K include SAP (NYSE:SAP), Accenture (NYSE:ACN) and Deloitte.

Growth

The company says, in its Strategic Update of Feb. 2, that M&A (Mergers & Acquisitions) will continue to be its core driver of growth and market leadership. As reported in this slide, the company has spent more than $6 billion to make 56 major acquisitions since 1991, approximately two per year:

Open Text mergers acquisitions

Note it states on the right side of the slide that it expects to make acquisitions with more predictability in the future. What that tells us is that this company is a consolidator, that one of its primary competencies may be acquisitions and integrations, and it expects to get better at it.

Its most recent acquisition was a big one, $1.62 billion, to buy Documentum and ECD from Dell EMC, a subsidiary of Dell Technologies (NYSE:DELL), and closed on Jan. 23.

OpenText funded the deal with some $650 million of cash on hand, $585 million net proceeds from an underwritten public offering of common shares, $254 million from a reopening of its 5.875% senior notes and the remainder from an existing revolving credit facility.

It has not neglected organic growth. It reports spending $609 million on research and development in the past three years; on an ongoing basis, it aims to invest 10% to 12% of annual revenues on R&D.

In the Strategic Update, it argues its current portfolio should also deliver organic growth with:

  • Leadership positions in key markets.
  • A global sales force and strengthening distribution deals with partners.
  • A new product cycle, with the recently unveiled Release 16, and The OpenText Cloud (cloud-based services are one of its emphases).

The company is able to invest in both M&A and organic growth as well as paying an increasing dividend because of its low capital intensity. This chart from Vuru.com shows the relationship between net income (blue line) and capital expenditures (yellow line):

Open Text capital expenditures

Financial strength

The GuruFocus system gives OpenText a middling score for financial strength and a strong score for profitability and growth:

OTEX financial strength

As the cash-to-debt and interest coverage icons indicate, long-term debt is dragging down the company’s financial strength rating. However, this excerpt from the Strategic Update puts the debt load in context (a net leverage ratio of 0.98:1:)

Open Text long term debt

Over the past decade, revenue has grown, as shown in this GuruFocus chart:

OTEX revenue

EBITDA (earnings before interest, taxation, depreciation and amortization) has also grown:

Open Text Corporation EBITDA

And free cash flow is up as well:

Open Text free cash flow

GuruFocus reports that OpenText’s operating margin is growing:

otex operating margin

The company has an impressive WACC-ROIC ratio. Its weighted average cost of capital is 4.27% while its return on invested capital is 45.7%.

Returns to investors have been strong. ROE is 45.48%, and ROA is 20.52%.

The company reports, in its Strategic Update, that it has delivered 544% in total returns to shareholders over the past 10 years while the NASDAQ index has returned 150%.

Valuations

No price-earnings (P/E): In assessing valuations of OpenText, bear in mind the usual metrics, including P/E, PEG and DCF Earnings, will not apply. In the first-quarter fiscal 2017 financial report the company said, “Recorded a significant tax benefit in first-quarter fiscal 2017 of $876.1 million that is specifically tied to the company's internal reorganization and applied to this quarter only and, as a result, will not continue in future periods,” and “We also completed our internal reorganization of our intellectual property into Canada, which resulted in a significant tax benefit applied to this quarter.”

Looking at other valuations, the analysts followed by Nasdaq.com have a 12-month consensus price target of $36.50, which represents about a 10% gain over the next year. Overall, most have a strong buy recommendation:

Open Text analysts

An analyst at Zacks, who may or may not be among the analysts followed by Nasdaq.com, said on Feb. 6, “analysts are becoming more optimistic on OpenText's earnings for the coming quarter and year. In fact, consensus estimates have moved sharply higher for both of these time frames over the past four weeks, suggesting that OpenText could be a solid choice for investors.” Zacks also has a strong buy recommendation.

OpenText enjoys a GuruFocus 5-Star Predictability rating, putting it among the elite companies that have delivered consistent earnings growth over the previous five years. According to the All-In-One screener, just 126 of the many thousands of companies covered by GuruFocus are in this class.

Other considerations

OpenText isn’t yet ready to get out of growth mode, but it does appear to have an eye on that possibility with its history of dividend increases. It has increased dividends for five consecutive years, a significant marker for any company. Having a reliably growing dividend should put some upward pressure on the share price as income investors start buying.

Market cap may figure into pricing in the not-too-distant future. It is currently a mid-cap, with a total valuation of $8.75 billion, which is just $1.25 billion shy of $10 billion and large cap status by all standards (some market observers define large cap as $5 billion or greater, but most, it appears, prefer a $10 billion benchmark). Divide that $1.25 billion by the 245.65 million outstanding shares and the result is $5.00. In other words, when the price rises another $5, the company will hit large-cap status. That means inclusion in more ETFs, mutual funds, market indices and so on. In turn, that means greater demand, which should also pull up share prices a bit.

The Documentum/ECD acquisition should have an immediate effect on the top and bottom lines. The company outlined the accretive results in its Strategic Update:

Open Text acquisition of Documentum and ECD

Conclusion

At its current price, OpenText is not notably undervalued; indeed, it might even be fairly valued.

But it may be worth examination by value investors looking for a medium- or long-term holding. While growth stocks, including OpenText, do wax and wane in the market, companies with solid dividends suffer less volatility. That makes this company an interesting candidate for the short lists of patient investors.

It’s likely too soon for income investors to do much more than dabble here; five consecutive years of increased dividends are important, but investors would be starting from a low base (1.38% current yield).

Of course for growth investors it should be considered a growth position plus potential future stability through dividends.

Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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