Enghouse Systems: Murky Challenges, But Stock Buybacks on the Horizon (OTCMKTS:EGHSF)

Please note all $ figures in $CAD, not $USD unless otherwise noted.

Introduction

Last time we covered Enghouse Systems (OTCPK:EGHSF) (TSX:ENGH:CA) in March 2024. At the time, we issued a “buy” rating on the company, noting that the market had overreacted to a weak quarter but a medium-term trend of steadily improving financials and with an improving balance sheet.

Since the company just reported its Q3’24 results on September 5th, I wanted to revisit my original investment thesis to see where Enghouse Systems stands. In the last quarter, management was increasingly positive, with indications that the weakness in organic growth could be due to the migration of customers to the cloud. Despite this, offering on-prem licenses improves customer retention and wins customers from competitors. Management has also hinted that they may be more aggressive with share buybacks in the short term.

In this article, I will analyze in detail the most recent quarterly results, provide my outlook for the company and what I see as the main risks. I’ll also present my thoughts on the valuation and why I continue to see the company’s stock as attractive today.

Company overview

I won’t spend too much time explaining Enghouse’s business model (as I already discussed this a lot in my previous article from March). To recap, Enghouse is an enterprise software company that targets unique and specific verticals. Founded in 1984, Enghouse today specializes in providing advanced software solutions designed to improve customer interactions and streamline operations for companies in various industries. Enghouse’s business model revolves around two core areas: communications solutions and public safety and government services.

In the communications sector, Enghouse provides software that helps companies manage customer interactions across multiple channels, including phone, chat and social media. Their solutions are especially valuable to contact centers, enabling them to improve customer service, increase efficiency and seamlessly integrate with other business systems. On the other hand, Enghouse’s public safety and government software supports emergency response systems and government operations, including handling 911 calls and other critical communication needs.

The company’s offerings include both cloud-based and on-premise solutions that cater to a wide range of organizations from small businesses to large enterprises. Enghouse’s growth has been supported by strategic acquisitions, enabling it to incorporate new technologies and expand its market presence. With a strong global footprint and a consistent track record of profitability, Enghouse Systems continues to be a key player in the technology sector with a focus on improving communication and operational efficiency.

Results and outlook Q3’24

Looking at the latest quarterly results for Enghouse’s Q3’24 results, the company reported revenue of $130.5 million during the quarter, up 17.6% from last year. In terms of recurring revenue (an important figure to consider for SaaS-based companies), sales rose 22.8% to $88.8 million.

Overall, my takeaway was that this was a strong quarter for Enghouse. First, sales revenue beat analysts’ consensus estimates by $0.8 million. And on EPS, adjusted earnings per share were 3 cents above estimates, coming in at $0.39.

As was consistent with last quarter, adjusted EBITDA did not grow at the same pace as revenue, with adjusted EBITDA growing just 12.9% to $37.7 million. This was a direct result of EBITDA margin contraction, as EBITDA margins contracted 120bps to 28.9% this quarter. As I mentioned in my original article on Enghouse, this has been a concern for investors for some time, and negative organic growth (perhaps due to cloud migration) certainly hasn’t helped.

On the company’s earnings call, management indicated that the decline in software license revenue was largely due to customer migration to the cloud, which in my view could imply that investors’ estimates of IMG’s organic growth may be largely due migration to the cloud. For me, I see an angle to see this as a slight positive, as it may suggest that Enghouse’s SaaS solution is successfully retaining customers. Customer footfall is steady and there has been little pressure on prices so far. Additionally, management also noted that declines in Vidyo are largely behind them.

Another important theme during the quarter was Enghouse’s on-prem licensing. Despite the cloud success, management attributed this quarter’s sequential growth in part to offering perpetual license options to its customers. Enghouse also claims it has helped with customer retention and competitive gains. However, I believe a higher mix of recurring income is favorable given the higher stability, visibility and long-term economic value. Going forward, a higher mix of recurring revenue is positive for adjusted EBITDA margins and therefore the company’s valuation.

With margins in the 28% range, I think it might be possible to get back to the low 30% range. Why? When we factor in the integration of the assets from the SeaChange acquisition ($30.8 million transaction) and other operating leverage that the company can use through this transaction, margins may not be where they could be. Additionally, from an overall company perspective, Q3 is not typically Enghouse’s strongest quarter (Q4 generally sees more normal margins) and so some seasonal factors are at play. As we move into Q4, I believe we may see improved performance and efficiency gains, particularly as management comments that they are focused on several key areas, including cost management, operations and demand generation, factors that I believe should boost margins in the quarters. before.

Historically, acquisitions (such as SeaChange) have positioned Enghouse as a serial acquirer with a track record of creating shareholder value. Some of the acquisition criteria and strategy were typically to look for businesses with positive cash flow generation, a history of recurring revenue (or a repeat sales component) and mission-critical solutions with high barriers to entry. From a financing perspective, the company is targeting a cash-on-cash payback in 5-7 years (implied IRRs above 15%) and Enghouse typically avoids shareholder dilution through new share issues.

To fund its acquisition strategy going forward, I believe Enghouse currently has the balance sheet to continue to accelerate its M&A pace. First, the company had a cash balance of $259 million after spending $30.8 million on the SeaChange acquisition, $14.4 million on dividends and $1.8 million on share repurchases .

With no debt on the company’s books, I think more share buybacks are possible. Right now, even though the company has cash to make deals (and a very flexible balance sheet), valuations in the M&A market remain above management’s preference after accounting for high levels of leverage. With the stock trading at historically low valuations, management has suggested it may favor share buybacks. With $118 million in free cash flow next year, I suspect about half ($57.6 million) will be used for dividends, with the rest available for buybacks. Against the company’s $1.7 billion market cap, the company could buy up to 3% of the market cap per year, assuming management is willing and able to execute share buybacks at the current share price. With the stock where it is right now, I suspect it’s something the company is thinking very strongly about.

Evaluation and conclusion

I continue to believe that Enghouse is one of the cheapest names in midcap/small cap software in Canada today. At 20.2x P/E and 12.0x EV/EBITDA, the company trades well below its ten-year historical multiple of 17.6x EV/EBITDA. While some of that makes sense (a slowdown in growth, a more uncertain outlook on AI disruption, and a potential slowdown in M&A), there’s a lot to like about Enghouse. Widening the spread and more share buybacks at a cheap multiple means the stock could be due for a revaluation once fears are over.

Analysts seem to agree. Based on the three sell-side analysts covering the stock, all have price targets substantially higher than the current price. The average price target of $38.00 implies an upside potential of about 23.3%, in addition to the company’s 3.4% dividend yield. With a total return potential of 26.7%, analysts seem to be quite bullish on the company. Plus, with only three analysts covering the stock, there’s certainly room for Enghouse to gain a larger following, as it’s currently fairly undercovered with a market cap of just $1.7 billion.

Compared to other Canadian software peers, Enghouse looks relatively attractive when comparing the trailing twelve months and multiples ahead. As shown below, compared to peers like Descartes (DSG:CA), Constellation Software (CSU:CA), and Open Text (OTEX:CA), Enghouse’s valuation is just a fraction of what a larger software company is trading for. great. While the Enghouse may not be of the same quality as some of these larger multiple stocks (shorter register and smaller margins), the discount has certainly widened since my original piece and I think the gap has become way too big. As such, Enghouse shares look compelling when stacked against them.

All in all, I think Enghouse’s latest third quarter results were pretty good. Despite challenges such as margin contraction and some potential shifts in customer preferences towards cloud solutions, Enghouse has demonstrated its adaptability by using on-premise licenses to increase customer retention and fend off competition. The potential increase in share buybacks as indicated by management should be viewed positively, especially with a growing cash position and non-existent debt. With the stock currently trading at historically low valuations relative to its peers, as well as a historic multiple, I believe Enghouse presents an attractive investment opportunity. For investors looking for a combination of growth and income, I think Enghouse is a compelling candidate.

Editor’s Note: This article discusses one or more securities that are not traded on a major US exchange. Please be aware of the risks associated with these stocks.