PRGS - Progress Software: Unimpressive Pro Forma Growth Tells The Story

2023-09-27 12:34:00 ET

Summary

• Progress Software Q2 earnings beat expectations.
• Growth has been driven by accretive M&A deals while the underlying trends are less robust.
• We expect shares to remain volatile, lacking a clear catalyst to rally higher.

Progress Software Corp ( PRGS ) reported its latest quarterly earnings, beating expectations with management revising full-year guidance higher. The company continues to capture demand across its extensive portfolio of infrastructure software and development applications. Indeed, accretive acquisitions are a big part of its strategy with recent deals propelling growth and adding to profitability.

There's a lot to like about the stock with overall solid fundamentals and a positive outlook. That being said, shares have faced increasing levels of volatility in recent months following a big rally at the start of the year.

Our take is that while the trends are good, the setup here might not quite be good enough for a big breakout higher. We can point to otherwise tepid organic growth and a large debt position which raises some valuation questions. Overall we view PRGS as at most fairly valued and see limited upside in the near term.

PRGS Earnings Recap

PRGS Q3 non-GAAP EPS of $1.08, came in $0.08 ahead of estimates. Total revenue of $175 million, climbed by 15% year-over-year, although the caveat is that the bulk of that increase captured the impact of the company's "MarkLogic" acquisition which closed earlier this year also adding to the bottom line. The adjusted operating margin at 39% was flat from Q2 2022.

Through the software-as-a-service (SaaS) mode, the annualized recurring revenue ((ARR)) is a key performance metric. Favorably, the headline number is up 18% y/y, although we note that on a pro forma basis, assuming MarkLogic had already been included, ARR increased by a modest 2%.

We believe this measure is a better indication of the current business conditions and operating environment the company is facing. Growth is positive, but it's been mostly driven by these types of M&A activity.

That 2% pro forma ARR also includes a net retention rate of 101%. This implies the average customer is increasing their spending across all products by 1%. Connecting the dots, what we have here is essentially a business that has nearly flat underlying growth.

That theme is extended when we look at the updated full-year guidance. The good news is that targets across revenue and EPS ticked marginally higher. The company now expects fiscal 2023 adjusted revenue of around $696 million as a midpoint estimate, compared to $694 million from the Q2 results.

Again, that revenue level represents an increase of 14% from 2022, or just 2.2% higher on a comparable pro forma basis. The non-GAAP EPS forecast is between $4.20 and $4.26 compared to the $4.13 reported in 2022 .

The trend in adjusted free cash flow tells what we view as the real story, with the 2023 target around $180 million, representing a decline of -5% from last year.

What's Next For PRGS?

PRGS is "fine" but we're just not too impressed with the numbers. This is the type of name that falls into a gray area where the numbers don't make it a good "growth stock", while valuation is far from "value" territory.

Trading with a forward P/E multiple of 13x, we'd need to see a re-acceleration of the top line or some effort to push the operating margin significantly higher to start turning aggressively bullish. Keep in mind there is also a quarterly dividend that yields approximately 1.3%

During the earnings conference call , management mentioned many of the products are integrating artificial intelligence "generative AI" features, but those efforts have not yet been shown to drive growth. The net retention rate above 100% is good, but expanding the pie with new customers across the existing ecosystem is a different challenge.

The capital allocation strategy to keep growing through acquisitions also raises some concerns, particularly in the current environment where interest rates are at a multi-decade high. Simply put, the balance sheet position with currently $625 million in net debt raises the question of the capacity to make a major new deal that will move the needle.

On one hand, the ecosystem of more than 50 applications and experiences offers a good level of diversification, but there is also a risk that some of those products lose market momentum against competitive pressures from emerging startups. One concern is that the company is going in too many directions in search of growth while losing track of core strengths.

PRGS Stock Price Forecast

We rate PRGS as a hold, balancing the real fundamental value of the currently positive free cash flow and recurring earnings, against what we view as weak underlying growth trends.

With shares already down about 15% from their recent highs, we believe the downside will be limited from the current level but prospects for a new high in the near term are also unlikely. From the stock price chart, a breakdown under ~$52.50 would signal a more serious deterioration, opening the door for a deeper level low towards $45.00.

On the upside, we mentioned the need to re-accelerate growth. By this measure, the pro forma ARR is a key monitoring point as well as the net retention rate and adjusted operating margin.

There is also the risk to consider that Progress Software remains exposed to volatile macro conditions. Weaker global growth would undermine the demand for business management tools and force a reassessment of the earnings outlook.

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