It includes customer experience management (CEM), digital process automation, business network, enterprise content management, discovery, security, artificial intelligence (AI), and analytics solutions.
Open Text is a solid company that is profitable and has the backing of analysts. However, when quantifying its competitive advantage, I get mixed results.
Does Open Text Have a Competitive Advantage?
There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating a company’s earnings power value (EPV).
Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value (the cost to reproduce/replicate the business) can be measured using a company’s total asset value. If the earnings power value is higher than the reproduction value, then a company is considered to have a competitive advantage.
For Open Text, the calculation is as follows:
EPV = EPV adjusted earnings / WACC
$8,963 million = $744 million / 0.083
Since Open Text has a total asset value of $10,200 million, it can be said that it does not have a competitive advantage. In other words, assuming no growth for Open Text, it would require $10,200 million of assets to generate $8,963 million in value over time, which is not ideal.
The second method to determine if a company has a competitive advantage is by looking at its gross margin because it represents the premium that consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.
If a company has no edge, then new entrants would gradually take away market share, leading to decreasing gross margins as pricing wars ensue to remain competitive.
In Open Text’s case, its gross margin has expanded in the past several years, going from 72.5% in Fiscal 2017 to 75.3% in the past 12 months. As a result, its gross margin trend indicates that a competitive advantage is present in this regard.
To measure Open Text’s risk, I will first check if financial leverage is an issue. I do this by looking at its debt-to-free-cash-flow ratio. Currently, this number stands at 4.8x.
Overall, I don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 4.7x (calculated as EBIT divided by interest expense). In other words, it can cover its annual interest expenses 4.7x over using its operating income.
However, there are other risks associated with the company. According to Tipranks’ Risk Analysis, Open Text has disclosed 48 risks in its most recent earnings report. The highest amount of risk came from the Finance & Corporate category.
The total number of risks has decreased over time, as shown in the picture below:
Open Text has a Strong Buy consensus rating based on three Buys and one Hold assigned in the past three months. The average Open Text price target of $51.50 implies 38.8% upside potential.
Although Open Text may not have a theoretical competitive advantage, it is still a profitable company with an expanding gross margin. In addition, the valuation appears to be attractive since analysts are expecting an upside potential of 39%.