Enghouse Systems (TSE: ENGH) (EGHSF) develops enterprise software solutions. It operates through the Interactive Management Group and Asset Management Group segments.
The Interactive Management Group segment offers customer interaction software and services that are designed to provide customer service, increase efficiency, and manage customer communications.
The Asset Management Group segment provides a portfolio of products to telecommunication service providers, fleet management, and public safety software solutions for various industries. The company was founded on November 23, 1984, and is headquartered in Markham, Canada.
Enghouse is a very well-run business with strong industry tailwinds, a disciplined growth strategy, and an attractive valuation. As a result, we are bullish on the stock.
Growth Catalysts
Enghouse Systems operates in the contact-center-as-a-service (CCaaS) industry, which is expected to grow at a compound annual growth rate of 16.4% from 2021-28. This means that the total market size will grow from $4.07 billion in 2021 to $11.76 billion in 2028.
Not only does this act as a secular tailwind for the company, but it also demonstrates that the industry is very healthy and expected to become a much larger part of the economy. Therefore, if the company could simply maintain its market share, it should be able to grow at a similar pace.
Indeed, Enghouse has grown its revenue over the past 10 years at a compound annual growth rate of 14.3%. However, it operates in a very competitive industry, which makes it hard to maintain a consistent market share.
As a result, the company has overcome this hurdle by acquiring smaller companies. Enghouse can be considered a serial acquirer, meaning that acquisitions are a big part of its growth strategy. In fact, the company spends tens of millions of dollars each year on acquisitions.
The danger of this strategy is that often, companies take on a lot of debt in order to fund the purchases of competitors. Although it increases revenue and earnings in the short-to-medium term, it has the potential to stunt growth in the long run because future cash flows have to eventually go towards paying off the debt.
In addition, it can sometimes cause companies to run into serious financial troubles during periods of economic slowdowns due to the crippling interest payments. Luckily for Enghouse investors, the company has had no debt on its balance sheet for at least the past 10 years.
In fact, acquisitions have been funded entirely by the company’s free cash flow. This shows that management has been running the company very responsibly and acting in the best interest of shareholders.
Enghouse: Creating Value for Shareholders
Another way to demonstrate how well management has been running the company is by looking at its efficiency metrics. More specifically, we want to look at its return on invested capital and compare it to its weighted average cost of capital.
The difference between these two metrics is known as the economic spread, which is defined as follows:
Economic Spread = Return on Invested Capital – Weighted Average Cost of Capital
The idea is very simple; if the return on invested capital is greater than the cost of that same capital, then the company is creating value for its shareholders through well-thought-out projects. Otherwise, the company is destroying value and would be better off simply investing money into risk-free bonds.
For Enghouse Systems, the economic spread is as follows:
Economic Spread = 18.8% – 8%
Economic Spread = 10.8%
As a result, the company is creating value for its shareholders, adding to the argument that management is efficiently allocating capital. This strong fundamental performance has been reflected in the company’s stock price since the end of the Great Recession.
The price climbed from around C$2 per share over a decade ago to a high of near C$80 per share during the pandemic. However, the company has since lost more than half of its value, which we believe presents a great opportunity for long-term investors.
Valuation
Despite the solid fundamentals of the company, its current market cap is C$1.76 billion. To put that into context, analysts expect free cash flow to be C$156.5 million by October 2023.
This implies that the company is only trading at an 11.2x forward price-to-free-cash-flow multiple. For a business with no debt that has a history of solid revenue growth, this seems like it’s too low.
Also, the valuation is even more appealing when factoring in the company’s net cash position of C$214.8 million. This brings its enterprise value down to about C$1.54 billion, giving it a 9.8x forward enterprise-value-to-free-cash-flow multiple for Fiscal 2023.
The net cash position can be used for future acquisitions or share buybacks, which will increase earnings growth. In fact, the company recently renewed its buyback program; it is now allowed to buy back 7% of its float until May 1, 2023. It can even pay out another special dividend, as it did in 2021.
Dividend
For investors that are focused on dividends, Enghouse offers a ~2.3% yield when annualized. Although it is not a high yield, it is not bad when considering the fact that the company’s main focus is to continue growing.
In addition, the current yield is higher than its historical average, as shown in the image below:
The spike in the dividend yield in 2021 is due to the C$1.50 special dividend mentioned earlier. Excluding that, Enghouse’s normalized dividend yield is at highs. Thus, investors that want a mix of growth and income can pick up shares at a greater yield than investors have received in the past.
Wall Street’s Take
Turning to Wall Street, Enghouse Systems has a Strong Buy consensus rating based on three Buys, one Hold, and zero Sells assigned in the past three months. The average Enghouse Systems price target of C$50.61 implies 60.3% upside potential.
Final Thoughts
Enghouse operates in a highly competitive and fast-growing industry. Nevertheless, it has managed to thrive due to its disciplined growth strategy and excellent returns on its invested capital.
Thanks to the recent sell-off in the market, the stock is now trading at an attractive valuation that could potentially reward shareholders with a long-term horizon.
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