2023-11-09 16:27:35 ET
Summary
- PROS Holdings sells profit and revenue optimization software that helps companies in pricing products.
- The company has experienced strong revenue growth and is transitioning to a subscription-based billing model fueling sustainable future growth.
- Despite the growth, PROS seems overpriced as too much growth and operating leverage seem to be priced in.
PROS Holdings ( PRO ) sells profit and revenue optimization software. The company has grown its revenues through a subscription-based model, with airlines representing a good portion of PROS’ revenues. Still, the company has negative earnings as a result of extensive R&D and marketing investments. PROS has taken cost control measures in 2023 improving the margin, but even with the subscription model’s good operating leverage, I believe that profitability will take a good amount of time to achieve.
The Company & Stock
PROS sells a software that helps businesses with optimizing revenues and profit margins through pricing. The company uses an AI-powered software that accounts for a large number of factors in determining an optimal pricing.
PROS’ offering has customers in a wide range of industries, ranging from industries such as Automotive & Industrial, Chemicals & Energy, Food, Healthcare, and Technology. Most notably, PROS’ offering is competitive and useful in the Travel industry – airlines are well-known for using complicated pricing algorithms for flight pricing. In the Travel industry, PROS has prominent customers such as Lufthansa, United Airlines (UAL), Emirates, and American Airlines (AAL). In other industries, PROS’ customers include companies such as Adobe (ADBE), Exxon Mobil (XOM), Nestle (NSRGY), Securitas, HP (HPQ), and Lenovo.
Even with prominent customers and growing revenues, PROS’ long-term stock price hasn’t performed very well. The stock has yielded a negative result in the past ten years, despite a significant rally of 46% in the past year:
Financials
PROS has a fantastic history in terms of revenue growth. From 2004 to trailing figures as of Q3/2023, the company has achieved a compounded annual growth rate of 12.5%. The revenues stayed relatively flat in 2020 and 2021 due to the pandemic – as airlines represent a good part of PROS’ customer base, the pandemic affected PROS’ revenues negatively. Since, the company’s revenues have started to grow again:
The company has started a transition into more revenues coming from a subscription-based billing model. The subscription revenues have had an even better growth than the whole company in recent years, although the growth has partly come from transferring revenues. The subscription revenues have gone up from $29 million in 2015, into a 2022 figure of $204 million, now representing the majority of PROS’ revenues. PROS also seems to be fueled for future growth through subscription growth. In Q3, the company achieved topline growth of 9.8%, with subscription revenues growing by 16%. PROS has a focus on leveraging partnerships to accelerate the company’s growth, and targets a total revenue growth of 16% to 21% in 2026.
On the other hand, PROS’ margins are very weak. The company has invested heavily into R&D and marketing to fuel growth, resulting in very negative EBIT margins:
The company has had a good cost control so far in 2023, as R&D expenses have gone down and SG&A has stayed stable despite the growing revenues. As a result PROS’ EBIT margin has gone up from -27.7% into a current trailing figure of -18.5%. Still, the margin is well on the negative side – I believe that it’ll take a long amount of time and a significant focus on cost control to bring PROS’ margins positive. As a software company, the growth should induce a very low amount of incremental expenses, resulting in significant operating leverage, though – I believe that positive margins are likely in a few years, if the growth continues.
Valuation
To analyze PROS’ valuation, I constructed a discounted cash flow model in my usual manner. In the model, I estimate PROS’ subscription revenue growth to continue at a very good level in coming years. For 2023, I estimate a revenue growth of 9.7%, in line with PROS’ guidance. After the year, I estimate PROS’ growth to accelerate in 2024 as a result of growth efforts and a growing part of the subscription side in the business – for 2024, I estimate a revenue growth of 18%. After the year, I estimate the growth to slow down in steps into a perpetual growth rate of 3%. Altogether, the estimated revenue trajectory represents a CAGR of 10.1% from 2022 to 2032.
For the company’s EBIT margin, I estimate a high amount of operating leverage through the growth. I estimate PROS to achieve a positive EBIT margin of 3.1% in 2025, which further leverages into an achieved margin of 23.1% in 2032; the estimate represents a very good cost control from the company. PROS has a very good cash flow conversion as a software company with some amortization and a very low amount of capital expenditures, which I account for in the model.
The mentioned estimates along with a weighted average cost of capital of 9.66% craft the following DCF model with a fair value estimate of $24.10, around 32% below the price at the time of writing. The stock seems to be overvalued with estimates that I see as reasonable – I wouldn’t expect PROS to outperform my estimates in a significant manner as a base scenario.
The used weighed average cost of capital is derived from a capital asset pricing model:
In Q3, PROS had $1.5 million in interest expenses. With the company’s current amount of interest-bearing debt, PROS’ annualized interest rate comes up to a figure of 2.04%. The company leverages a moderate amount of debt, and I estimate the company’s long-term debt-to-equity ratio to stabilize at 20%.
On the cost of equity side, I use the United States’ 10-year bond yield of 4.56% as the risk-free rate. The equity risk premium of 5.91% is Professor Aswath Damodaran’s latest estimate for the United States, made in July. Yahoo Finance estimates PROS’ beta at a figure of 1.14. Finally, I add a small liquidity premium of 0.4%, crafting a cost of equity of 11.70% and a WACC of 9.66%, used in the DCF model.
Takeaway
At the current price, it seems that the market is pricing in too much growth from PROS. I believe that the company can achieve a good amount of growth and an eventually good margin level, but not at the level that the markets seem to price in. My DCF model estimates PROS’ stock to be quite significantly overvalued with a promising revenue trajectory. As the stock seems overvalued, I have a sell rating for PROS for the time being.
For further details see:
PROS Holdings: Too Much Growth Is Priced In