2023-03-31 00:12:56 ET
Summary
- Q3 results, although beating expectations, revealed margin contractions across the board.
- The company is well-equipped for long-term growth even during uncertainties.
- I will present a DCF model that takes into account a slight recession, which will bring down revenues and further margin contraction.
- A strong balance sheet and the DCF model suggest the company is valued at a fair price, so take caution, as uncertainties may present a better entry point soon.
Investment Thesis
Q3 results beat estimates with quite impressive growth all around, however, slight contractions in margins might mean that ePlus Inc. ( PLUS ) is starting to face some pressures from competition or the general macro-economic environment which led to the lower volume of sales. Looking at the company's balance sheet, the company is very healthy in general. The company can generate good returns on capital. I will argue that the company will continue to operate at this level for the foreseeable future as the demand for their services continues to be strong, especially in the tech sector that saw high increases in revenues.
With a simple DCF model that will take into account a decline in revenues for the next two years that will bring down margins slightly also, and then recover and improve margins by only 100bps in the next 10 years, PLUS stock is currently priced correctly with the main concern for not starting a position would be the global economic environment which has seen a lot of volatility and may present a better entry point in the next couple of months.
Recent Earnings Results
Q3 results were quite impressive, beating estimates on revenues and EPS by a long mile. Most of that outperformance can be attributed to the company's massive gain in revenues in their IT segment, which rose 28.3%. Net sales increased 26% y-o-y, gross billings were up 29.7%, and gross profit was up 18.1%. What worried me a little is the company saw some margin contractions from the previous quarter, down 150bps on gross margins, which translated to other margin contractions also.
Q3 is usually a much stronger quarter than the next quarter or Q1 also because the quarter usually marks the end of the budget year for many customers. So far in the last three quarters, the company managed to reach almost $1.6b in revenue, so if we expect the next quarter to be not as strong as this one, we are talking the revenues reaching $1.95B to $2B. That is my conservative estimate for the full year.
Margin Contraction
As I mentioned it is a little worrying that the company lost some of its profitability in the latest quarter. 150bps decrease is not that small considering how tight the margins are in general. The company, over the last 5 years, managed to increase its margins by around 250bps. So that is a substantial decrease. In May, the company will report full-year fiscal 23 results and I would hope to see improvements there and what kind of outlook the company is modeling going forward.
I will take the more conservative approach for my model to give myself a good margin of safety and will model that the company will see further margin contraction of around 50bps and by '32 the margins will have improved only slightly by around 100bps. I feel this is more than achievable in the long run as I mentioned they did much better in the last 5 years.
If we do see some sort of recessionary period in the next 12-24 months, I do believe the company will see further contraction in margins in the short run.
Revenue Outlook
In the last decade, the company saw a couple of years of revenue declines, FY2019 and FY2021. The management expects to see growth going into ’23. I will take on a more cautious outlook for the next 12 months and will assume a slight decline in revenues. Over the last decade, the company managed to grow at around 7% annually. I will also take on a more conservative approach and the next decade will see slightly lower growth. It is hard to speculate on how the revenue is going to grow and which services will be the main drivers. The tech segment will continue to be the main one, but within that segment, it is hard to say what will drive the growth. The new ePlus storage as a service powered by Pure looks promising, however, might be too small in the big picture.
From reading earnings transcripts and looking at the reports, I do not see any other possible growth catalysts that could lift their revenue growth from their usual low single-digit growth, so my model will stick to that.
Financials
As of the latest quarter the company has around $94m in cash and around $140m in short-term debt, $7.2m in long-term debt, and total receivables of $745m. I like to see a company being able to pay off its short-term obligations with cash on hand, however, this is not the case here. Cash flow from operations has been negative for the last three quarters also, however, EBIT at the end of December 31 st 22 was 123m which more than covers the company's interest expense of around 3m.
Speaking of liquidity, the current ratio is healthy. It has been stable throughout the years, suggesting that the way the company is being operated is not a problem and I don’t see any red flags in that regard.
The company consistently manages to reinvest the money into positive NPV projects over the last 5 years or so, with a decent return on assets and even better returns on equity can be seen.
The same story goes for return on invested capital. Very stable at around 10% for a while now which suggests that the management knows how to invest capital efficiently. Over time, these figures may come down if the company is not able to find ways to keep getting great returns, but hopefully, the management will focus on other ways to reward shareholders, by either paying dividends or buying back shares to increase EPS, which should result in a higher share price over the long run. The company is not paying dividends currently but is repurchasing shares.
Overall, the company seems to have a strong balance sheet, which will help if we are going to experience a downturn in the next year or two. I’m confident that the company will have no issues.
Valuation
As I mentioned earlier in the article, I’d like to see what the company would be worth if we take into consideration a recessionary period that will decrease revenues slightly and further margin contractions for the next year or two. After that, the company will regain revenue growth, although, still conservative growth, and margins improve linearly by around 100bps in the next decade.
For the revenue figures on the base case scenario, I will assume a 5% decline over the next year, then the following year will see a 10% increase in revenues, which will decrease in growth linearly to 4% by '32. With these estimates, revenues will grow from the last full financial year revenues of $1.8B to around $3.2B by '32, which translates to around 6% growth a year. These assumptions for revenue are more conservative than what the analysts are predicting for the full year that is coming in May. I assume revenues will come down to $1.7B instead of increasing to $2B as analysts predict.
For the optimistic case, average growth per year ends up being 8% for the decade, and for the conservative case, it is 4%.
For margins, I assumed that the recessionary period will bring down margins slightly for the next 2 years, once the economy recovers, so do the margins, which end up improving by around 100bps by ‘32. This is still conservative in my opinion because the company managed to improve margins at a much quicker rate than that.
Just to be on the even safer side, I will also add a 25% margin of safety on the intrinsic value calculation. I feel 25% is sufficient because the company boasts a strong balance sheet. With that said, the implied intrinsic value with a 25% margin of safety is $48.18, implying that the company is priced fairly.
Closing Remarks
It seems to me that the company is attractive at these prices. Just last month, the company was trading at $57 a share. The decline in earnings I believe presented a great opportunity to start a small position. However, that does not mean it's all going to go up from now. The big risk that affects all of the equity markets is the looming recession that we will supposedly see in the next 6-24 months. It's a big range as it is very hard to predict when. With banks collapsing left and right these days it is hard to put my money where my mouth is. The volatility may bring down prices even further in the next couple of months. For a long-term investor, this should not be an issue. I'm patient enough to wait out a couple of more months, and with full-year results to be released sometime in May, I'm not rushing to invest in the company until then.
The company itself seems like a decent investment, but will it perform as well as the numbers suggest? That is hard to tell. The company is relatively unknown so there’s more chance that the company will not reach its full potential in terms of share price appreciation. The company managed to outperform the S&P 500 index only if we are looking at the 10-year chart. It can outperform in the future but only if the investor manages not to overpay for the company. That is why we have a healthy margin of safety in the model.
For further details see:
ePlus: Attractive At These Prices But Heed Caution, Hold