RBC research looks at defensive tech plays

Here is a very interesting piece out of the software research team at RBC Capital Markets. There are some good nuggets in the note for enterprising fund managers, and a couple of M&A ideas that we’ve highlighted before as well (see prior post “Takeovers to come“, April 15-07). Although buying stocks might seem insane these days, many firms – even some tech firms – will be producing free cash flow next week, next month and next year, regardless of what is happening at Countrywide Financial, for example.

Market Pullback Favours Acquisition Business Models.

Investors are recommended to accumulate stocks with positive fundamentals and acquisition-driven growth models (>25% of FTM growth from acquisitions) who benefit from recent valuation pullbacks. The pullbacks typically result in more rational acquisition valuations for strategic buyers.

Recommended Acquisition-Driven Stocks.

Stocks with positive fundamentals and acquisition-driven models in our coverage universe include: CGI Group (T:GIB.A/N:GIB, OP, C$14.00 target), Open Text (Q:OTEX/T:OTC, OP, $28.00 target), Constellation Software (T:CSU, OP, C$31.00 target), and Emergis (T:EME, SP, C$7.50 target). These companies offer defensive investment opportunities, with a healthy proportion of recurring revenues, diverse and stable customer bases, solid balance sheets and stable cashflows. They avoid overpaying for acquisitions, and prefer accretive transactions.

Favoured Acquisition-Driven Stocks

CGI Group (T:GIB.A/N:GIB, OP, C$14.00 target):

• We rate CGI Outperform on: 1) growth recovery following deteriorating performance; 2) sustainable EBIT margins; 3) attractive risk-reward profile; 4) attractive valuation, below peers.

• Has grown through series of acquisitions (more than 27 since 1994) with the most significant being US-based AMS (for C$586M at 0.7x FTM P/S, below peers) in 2004. Acquisitions (tuck-in and strategic) remain a crucial component of CGI’s 4-pillar growth model.

• With AMS and other restructuring complete and debt at optimal levels (17.7% net debt / capitalization below 18-20% optimal) and recently expanded credit facility to C$1.5B (from C$1.0B), we expect CGI to pursue acquisitions in US or Western Europe.

• We estimate CGI generates more than C$400M+/year cash flow from operations, with adequate capital capacity (C$421M net debt, with C$518M used of C$1.5B credit facility) to finance a strategic acquisition.

Open Text (Q:OTEX/T:OTC, OP, $28.00 target):

• We rate Open Text Outperform on (1) stronger than expected synergies from the Hummingbird acquisition; (2) lower integration risk than IXOS; (3) attractive valuation at 11x FTM P/E; and (4) acquisition upside.

• Despite stumbling over its IXOS acquisition in Oct 2003, investors should not overlook its 9-year history of more than 24 successful acquisitions, demonstrating the ability to integrate products, staff and customer bases, as well as executing on crossselling opportunities.

• Subsequent to its $489M Hummingbird acquisition that closed in October 2006, Open Text is expected make more acquisitions for customer base, technology or relationships. A prudent acquirer, Open Text bought Hummingbird for 17x FTM P/E or 1.8x FTM P/S, and typically pays 1-2x P/S.

• OTEX has $160M cash, $400M debt, with $100-150M cashflow. We expect aggressive debt repayment to improve capital flexibility and continue its acquisition model. In the short-term, we expect OTEX to make ‘tuck-in’ acquisitions such as Q3/F07 $4M purchase of Momentum Systems, a consultancy with links to US government buyers.

Constellation Software (T:CSU, OP, C$31.00 target):

• We rate Constellation Software Outperform on (1) long-term value creation through Constellation’s Acquire, Manage, and Build strategy driving LT Shareholder value and 20% LT revenue/EBITDA growth; (2) attractive SME market opportunity with competitive barriers; (3) prudent ROIC focus; and (4) strong effective management and board.

• An active acquirer with more than 55 acquisitions since its inception in 1995. Constellation acquires the #1 or #2 leader in a niche, expands market share, invests for organic growth and drives out undercapitalized competitors. More than two-thirds of Constellation’s 20% LT growth is expected to come from ‘tuck-in’ and strategic acquisitions.

• On its Q2 call, Management reiterated it has a healthy pipeline of acquisition targets, and seeks targets using specific criteria (IRR hurdle rate, key vertical markets, smaller size). Constellation historically pays 1x P/S for acquisitions.

• Constellation has est. $30-40M/year cashflow, and capital capacity ($11M cash, $20M credit facility) to sustain acquired growth, though may from time to time utilize leverage. Constellation’s Harris subsidiary acquired privately-held Quebec-based software vendor PG Govern in March.

Emergis (T:EME, SP, C$7.50 target):

• We rate Emergis Sector Perform on: 1) Valuation inline with peers; 2) Evolving risk/reward profile; 3) Few interim catalysts to drive growth above consensus. A pullback in market valuations may benefit Emergis’ acquisition strategy, strengthening its competitive positioning, pipeline, and opportunities.

• Since 2004, Emergis acquired 9 small Canadian health claims processing and solution companies for C$113M, using a disciplined acquisition strategy, to gain scale, add customer bases, increase market share and acquire technology.

• Emergis aims for acquisitions between 5-6x EV/EBITDA that are neutral or accretive to EBITDA in the first year (sometimes incurring interim EPS impact from amortization of intangibles and depreciation). In some cases, cost synergies from acquisitions have been substantial, as was the case with NDCHealth (C$5M/yr savings).

• Given Emergis’ prudent management and focus on shareholder value, we expect Emergis to target ‘tuck-in’ acquisitions such as DINMAR (C$32M) in July 06, Unikoan (C$15M) in July 07, and Informatique D.L.D. (C$12M) in Aug 07. Emergis may also consider a larger acquisition to strengthen market position or expand into adjacent markets.

• We estimate Emergis generates C$40-50M/year in cash flow and has healthy capital capacity (C$104M cash) to finance tuck-in and most strategic acquisitions.

Pullback May Increase Likelihood of Takeouts

Compression in valuation multiplies may increase the likelihood of takeouts of leading companies in attractive sectors by strategic or financial buyers. Potential candidates for takeout in our coverage universe include Cognos (Q:COGN/T:CSN, OP, $45.00 target), Business Objects (Q:BOBJ, OP, $51.00 target), Open Text (Q:OTEX/T:OTC, OP, $28.00 target), and Sierra Wireless (Q:SWIR/T:SW, SP, $23.00 target).

• Business Objects, Cognos. Following Oracle/Hyperion, SAP/Outlooksoft we expect further BI industry consolidation to continue. For example we see HP (who has been more active in software) and IBM (who we previously speculated would target Cognos) more active in making a BI acquisition. In our view, BOBJ and COGN represent the most attractive candidates. Based on ORCL/HYSL at 27x FTM P/E, we estimate BOBJ potential takeout valuation at $59-61/share and COGN at $52-54/share.

• Open Text. As the largest and only remaining independent ECM vendor, OTEX in our view remains an attractive takeout candidate following industry consolidation (IBM buys FileNet, EMC buys Documentum, Oracle buys Stellent). OTEX possesses cashflow, global customer base and EBIT margins ahead of peers. Precedent transactions, average 2.9x FTM EV/S and 23x FTM P/E, implying takeout valuation at US$31-33/sh. Possible acquirers include Microsoft, HP, Sun, Xerox, Toshiba, Hitachi, Fujitsu or Private Equity firms.

• Sierra Wireless. As a wireless modem vendor, we think SWIR is an attractive acquisition candidate, given continued growth in the 3G wireless markets and consolidation/competition in PC cards. With $90M cash ($3.37/share), a strong brand, global franchise, management, and wireless data engineering, potential acquirers include Nokia, Motorola and others.

Exposure to Tightening Credit Markets

Some tech companies may be exposed to the tightening credit market through leverage used to finance acquisitions or pending LBOs. We believe Palm (Q:PALM, SP, $16.00 target) and to a lesser extent Openwave (Q:OPWV; SP, $6.50 target) have the greatest exposure.

Higher Exposure In Our View:

• Palm’s $400M debt pending. Palm is facing a pending $400M term financing re its pending Elevation Partners recapitalization ($9/sh or $940M dividend; $325M Elevation investment; $400M debt). The tightening credit markets may or may not impact terms (interest rate, pre-payment provisions, other) of Palm’s commitment letter; its Shareholder vote is Sept
12; deal closing is expected 1-2 weeks afterwards.

• Openwave. $150M convertible re-financing Sept 2008. With $137M net cash ($286M cash), OPWV is moving to limit its cash burn, and may sell assets (i.e. Musiwave) to re-pay its $150M, 2-3/4% convertible subordinated notes due Sept 9, 2008.

It is possible that deterioration in credit markets could impede OPWV’s ability to raise financing at favourable terms to repay the debt.

Lower Exposure In Our View:

• Open Text. We foresee minimal impact to OTEX’s $390M 7-year term loan to finance the HUMC acquisition. The term loan expires Oct 2013 and bears interest at LIBOR plus 2.50%.

• CGI. On August 13, CGI expanded the size of its 5-year unsecured credit facility to C$1.5B (from C$1B prior), which includes a C$250M accordion feature, to expand total capacity to C$1.75B. CGI has drawn C$518M on the facility. CGI’s ability to expand its credit facility comes from its financial outlook, revenue stability, cash flow, and balance sheet strength.

• Business Objects. BOBJ closed its $600M (€450M) convertible bond offering (Jan 2027 maturity) in May 2007. We foresee no short-term impacts to this financing.

Price Target Justifications

Business Objects (NASDAQ: BOBJ; Outperform, Above Average Risk; $51.00 target). Our $51.00 target is DCF-based (WACC of 11%, terminal rate of 5% and FTM net cash of $5.78/share) and represents 22x our FTM EPS.

CGI Group (TSX: GIB.A; NYSE: GIB; Outperform, Above Average Risk; C$14.00 target). Our C$14.00 target is DCF-based (WACC of 10%, 4.5% terminal rate, FTM net debt $0.46/sh) and equates to 17x FTM P/E, vs. 12-18x historical range.

Cognos (NASDAQ: COGN; TSX: CSN; Outperform, Above Average Risk; $45.00 target). Our $45.00 target is DCF based (WACC of 10.8%, terminal growth 5%, FTM cash of $7.63/shr) and equates to 21x our FTM EPS.

Constellation Software (TSX: CSU; Outperform, Above Average Risk; C$31.00 target). Our C$31.00 target is DCF based (WACC of 12%, 4.5% terminal rate, FTM net cash of $1.57/share) and equates to 19X our FTM EPS.

Emergis (TSX: EME; Sector Perform, Above Average Risk; C$7.50 target). Our C$7.50 target is DCF based (WACC of 11.5%, 4.5% terminal rate, FTM net cash $1.19/share) and equates to 21x FTM EPS.

Open Text (NASDAQ: OTEX; TSX: OTC; Outperform, Above Average Risk; $28.00 target). Our $28.00 target is DCF-based (11.2% WACC, 3% terminal growth rate, FTM net-debt of $2.43/share) and equates to 16x our FTM EPS.

Openwave Systems (NASDAQ: OPWV; Sector Perform, Above Average Risk; $6.50 target). Our $6.50 target is DCF based (12% WACC, 4% terminal rate, FTM net cash $2.75/sh) including sale of Musiwave at $65-75M ($0.80-$0.90/sh) and equates to 1.2x FTM EV/Sales.

Palm (NASDAQ: PALM; Sector Perform, Above Average Risk; $16.00 target). Our $16.00 target price is based on $7.00 ongoing fundamental value (DCF-based; WACC of 11.5%, terminal growth of 2%, and FTM net debt/sh of $0.73; or 0.7x EV/FTM Sales) plus $9.00 cash distribution.

Sierra Wireless (NASDAQ: SWIR; TSX: SW; Sector Perform, Above Average Risk; $23.00 target). Our $23.00 target is DCF based (12.5% WACC, 5% terminal rate and FTM cash $4.93/share) and represents 19x FTM P/E.

Price Target Impediments

Business Objects (NASDAQ: BOBJ). Risks to our price target include: Include slower than expected XI migrations, protracted execution issues, channel conflicts, sales force or turnover and uncertainty, larger than expected competitive impacts or pricing pressures, extending sales cycles and departure of key management personnel, adverse FX changes, and a general pullback in technology stocks.

CGI Group (TSX: GIB.A; NYSE: GIB). Risks to our target include: A general tech market pullback, pricing and/or margin pressure, unexpected competitive pressures, changes in technology or industry structure unfavorable to the issuer; unexpected pressure
from competitors, customers, suppliers, employees; tightening of the global IT service personnel labor market; litigation and regulatory risks; unexpected investments to achieve goals and maintain operations.

Cognos (NASDAQ: COGN; TSX: CSN). Risks to our target include: Include slower than expected C8 ramp-up, protracted execution issues, sales forecasting challenges, sales force turnover and uncertainty, larger than expected competitive impacts or pricing pressures, extending sales cycles and departure of key management personnel, general pullback in technology stocks, adverse FX changes, lumpy sales, dissipation of takeout premium, challenges in developing new products and markets.

Constellation Software (TSX: CSU). Risks to our target include: A general tech market pullback; competition and pricing pressure; acquisition integration risk on future acquisitions; availability of acquisition targets; competition for acquisition targets raising valuations; slower ramp of growth initiatives; protracted execution issues, and departure of key management personnel.

Emergis (TSX: EME). Risks to our target include: A general tech market pullback; competition and pricing pressure; tightening of the global IT service personnel labor market; considerable capital expenditures to maintain operations; acquisition integration risk on future acquisitions; unexpected delays in contract negotiations; errors in contract evaluation leading to adverse financial performance; possible loss of existing contracts under renegotiation; inability to win new contracts; slower ramp of growth initiatives.

Open Text (NASDAQ: OTEX; TSX: OTC). Risks to price target include: stronger than expected competitive impacts, merger-related key staff or customer attrition, acquisition integration stumbles, higher integration costs or costs (such as R&D or sales) may rise faster than expected, currency impacts, sustained investor scepticism (despite improving performance), product integration challenges, large deal close execution or ‘lumpiness’, maturing core products within a highly competitive, consolidating market.

Openwave Systems (NASDAQ: OPWV). Price target impediments include: reduced tech valuations; greater than expected competitive and pricing pressure on core businesses; unproven markets for new solutions, uncertain outcomes of litigation or regulatory proceedings, execution risks on signing systems contracts and closing large license deals; channel conflicts between carriers and handset partners; operating leverage.

Palm (NASDAQ: PALM). Impediments to our target include protracted inventory buildup, inability to sign new carriers, a general tech pullback, better than expected competitive traction at Palm’s expense; Product delays or market acceptance risks; Scale and execution risk; unexpected management or staff changes, inability to launch new products successfully. Palm faces execution risk from the pending launch of multiple smartphones in F07 on multiple operating systems, radio technologies, and expanding carrier distribution internationally. The launch of competitive devices may cause some ‘headline risk’ to Palm’s valuation multiple.

Sierra Wireless (NASDAQ: SWIR; TSX: SW). Price target impediments include: reduced tech valuations, ongoing shareholder actions, including lawsuits and possible other backlash (including unexpected related costs); faster than expected decline in competitive position, acquisition or merger risk if Sierra buys another company. Alternatively, upside to our target could come from Sierra being acquired or from an unexpectedly significant new MP or PC card contract secured over the next 12 months.

MRM