CA - Open Text Is The Ideal Play For The AI And Tech Supercycle

2023-12-21 16:51:46 ET

Summary

• Open Text recorded a Q1'24 revenue of $1.41bn, a 75% YoY increase.
• Open Text leverages its existing client base for integration as it expands its range of offerings in AI.
• Open Text's financials show superior growth capabilities and justify greater long-run growth.

Open Text ( OTEX ) is a Waterloo, Canada-based multinational enterprise information management software developer and wholesaler. The company works across all cloud topographies, working at the intersection of AI and analytics, content management, business networking, application automation, IT operations management, and cybersecurity.

Through these activities, Open Text recorded a Q1'24 (with Open Text's fiscal year being 2 quarters ahead) revenue of $1.41bn - a 75% YoY increase - alongside a net income of $79.87mn and a free cash flow of $9.46mn, a 89.52% decrease driven by a steep decline in financing cash flows.

Introduction

Through its broad-focused approach to information management, Open Text is effectively able to guide clients through its suite of products and upsell services for recurrent revenues and utmost retention. Beyond that, as Open Text aggressively expands its range of offerings in AI, it leverages its existing client base for integration.

The combined stability and strength derived from Open Text's operational focus, in addition to its overarching operational strategy, judicious capital deployment, and general undervaluation, lead me to rate the company a 'buy'.

Valuation & Financials

Trailing Year Performance

In the TTM period, Open Text's stock, which is up 42.54%, has experienced substantial growth, with performance between the tech industry, as represented by the Technology Select Sector SPDR Fund ( XLK ) - up 51.00% - and the broader market, as represented by the S&P 500 ( SPY ) - up 23.05%.

While Open Text's superior price action relative to the wider market can be attributed to the more macro rally of the tech industry and more tame inflation and rates, the company's underperformance is likely a product of a higher cost of servicing the debt used to acquire Micro Focus, thus poorer relative earnings.

Comparable Companies

Although Open Text operates in a well-populated information management industry, most direct competitors either operate with proprietary, specialized management platforms or are much larger aspects of vertically integrated information technology companies such as Oracle ( ORCL ) or Dell ( DELL ). As such, I sought to compare OpenText to similarly sized companies in a similar operational vicinity. This group, as seen on Seeking Alpha's 'Peers' tab for the company, includes the Mountain View, California-based SaaS company, Elastic N.V. ( ESTC ), the San Jose, California-based database-aaS company, Nutanix ( NTNX ), the San Francisco, California-based file hosting leader, Dropbox ( DBX ), and the Carpinteria, California-based enterprise SaaS company, Procore ( PCOR ).

As demonstrated above, Open Text, in the trailing quarter, has experienced price action in line, at the median, with its peers. This can be attributed to the opposing forces of Open Text's overall operational strength but also the higher costs associated with this strength. Despite this growth, I believe Open Text's multiples-based value, superior growth capabilities, and payouts justify greater long-run growth.

For example, Open Text maintains the second-lowest trailing P/E ratio of the group, alongside the lowest forward P/E. Additionally, Open Text maintains the lowest P/CF, and P/B, exemplifying financial strength across all three financial statements.

Moreover, Open Text has seen the third-highest 5Y return of the group, with the highest earnings growth, illustrating the company's commitment to sustained margin expansion. This commitment is amplified by Open Text's best-in-group ROE and second-best ROA.

Furthermore, Open Text is the only firm in the group to pay a dividend, with a 2.39% yield at a modest 31.42% payout ratio.

And though the company does maintain the highest debt/equity of the peer group, Open Text maintains the highest book value per share of the group, offsetting this effect; beyond that, this debt, driven by the Micro Focus acquisition, will only accelerate scale and margin growth.

Valuation

According to my discounted cash flow model, at its base case, the net present value of Open Text is $46.73, meaning, that at its current price of $41.01, the company is undervalued by 12%.

My model, calculated over 5 years without perpetual growth built-in, assumes a discount rate of 10%, accounting for the debt-heavy capital structure of the company as well as higher implied volatility. Additionally, to remain conservative, I estimated an arithmetic averaged forward 5Y revenue growth rate of 7%, lower than the trailing average of 11.34%, owing to the firm's rising cost of revenue.

Alpha Spread's multiples-based relative valuation tool more than corroborates my thesis on Open Text's undervaluation, estimating a base case undervaluation of 60%, or a relative value of $102.90.

However, while Alpha Spread's analysis provides important context regarding Open Text's multiples-based value, it is sometimes prone to overvaluation due to outlier multiples and thus does not adequately reflect Open Text's value in my opinion.

Enterprise Position, Micro Focus Acquisition Accelerate Operational Opportunities

At its foundation, Open Text continues to provide information management and ancillary services across the data pipeline, specializing in the automation and streamlining of information for connector tools, transformation into content management engines, and so on and so forth. With the advent of enterprise-specific AI tools, driven by the rise of ChatGPT and its peers, Open Text is leading the space in feeding client data into its AI and analytics engine, supporting superior insight provision capabilities, enabling clients to develop proprietary LLMs based on provided APIs, and ultimately feed back into Open Text's Aviator suite.

Since enterprise technology promotes greater retention than consumer technology, OpenText is able to vertically expand its suite of offerings- even more so with the acquisition of Micro Focus and the wider focus on AI - and upsell its products, at superior marginal utility to clients. This allows greater cost optimization for OpenText while also reducing the need for customer acquisition since each consumer can extract greater revenue.

While the latter operational strategy will inevitably lead to improved operational outcomes and consequent growth, investors can expect consistent income in the form of dividends, which have grown at a 31% CAGR over the past decade. Moreover, the firm continues to engage in opportunistic share buybacks when optimal.

Wall Street Consensus

Analysts generally echo my positive view on Open Text, estimating an average 1Y price target of $50.08, an increase of 22.13%.

Even at the minimum projected price target of $42.05, analysts project 2.53% growth, enhanced to an even greater number by Open Text's dividend.

I believe this positive outlook reflects Wall Street sentiment around Open Text's operational capabilities.

Risks & Challenges

Debt-Heavy Cap Structure is More Sensitive to Rates

Although I remain bullish on Open Text's acquisition of Micro Focus and the growth opportunities associated with it, this aggressive M&A may lead to unhealthy (in tech) levels of leverage. And although rates may see reductions over the next year, stagnant rates or resurgent inflation leading to higher rates loom over the company's income statement, since they may reduce Open Text's future investment or payout abilities.

Increased Competitive Intensity May Reduce Margins

Open Text's enterprise focus and integration across the information management vertical generally insulate the company from explicit reductions in revenues. However, competitive intensity in the area from larger competitors, especially in AI, may reduce Open Text's ability to expand or sustainably grow its margins, since the company would either be forced to spend more on differentiation or on price competition.

Conclusion

Going forward, Open Text's enterprise focus and positioning in the information management sector support sustainable scale and margin expansion, and, thus, price appreciation.

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