Progress Software (PRGS) is one of those “legacy” technology companies that has largely been forgotten by the markets in the wake of much more exciting and faster-growing software companies. The company, whose flagship product is an app development (PaaS) platform that helps other companies develop applications and web interfaces, has largely been unable to grow in the face of fierce competition.
The company just reported Q2 results, however, that surprisingly exceeded expectations. As a result, shares jumped ~4% – a rare reaction for a company whose earnings frequently disappoint growth-oriented investors.
I last wrote on Progress Software more than a year ago, and rejected the stock as a value trap (in the intervening year, Progress has underperformed the S&P 500 by nearly ten points). Now, however, I see a path to this stock gaining on two counts:
- Raised expectations. On the back of a stronger-than-expected Q2, Progress has raised its full-year outlook, owing especially to improving operating margins. This potential for margin growth makes Progress’ below-market P/E multiple look attractive.
- Path to growth via M&A. Progress has signed on a new head of corporate development, and has a target to double the business within five years.
Progress won’t be a multi-bagger winner like more recent IPOs might be, but there’s now a value argument to be made. Keep an eye out for an entry point in this name.
Let’s touch first on Progress’ recent fundamental strength. The company’s revenues were relatively flat year-over-year at $100.4 million, but that came in three points stronger than Wall Street’s expectations of $97.0 million (-3% y/y).
The company called out strong execution by its sales teams in the quarter, while also noting that the company’s high mix of recurring revenue (81% of Progress’ top line) helped to stabilize its revenue visibility. Anthony Folger, Progress’ CFO, noted as well that the company’s customer retention rates remained high.
The company’s pro forma operating margins also rose one point to 39%, up from 38% in the year-ago quarter. The company was able to exercise expense discipline in the wake of the coronavirus; on a GAAP basis, operating expenses reduced by -10% y/y, driven by reductions in sales and marketing expenses.
This strength in the quarter prompted Progress to raise its full-year outlook. The company bumped up its revenue outlook by $5 million on both ends of the range (worth one point), while also boosting its full-year operating margin by one point to 40% as well.
Especially given the expansion in Progress’ operating margins, the company’s P/E ratio at 13.7x based on the midpoint of Progress’ FY20 pro forma EPS range, below the broader market, looks attractive.
Refocusing on an M&A growth strategy
Of course, a cheap valuation isn’t reason enough to buy a stock – there needs to be a path to growth as well. For Progress, whose organic growth has been largely muted over the past several years, the potential for growth lies in a renewed M&A strategy.
In May, Progress appointed a new head of corporate development, Jeremy Segal, to lead its new M&A binge. Prior to joining Progress, Segal led M&A at two other notable public tech companies, LogMeIn (LOGM) and Akamai Technologies (AKAM). The company has an overall goal to double the size of its revenue within five years:
Source: Progress 2Q20 earnings deck
Progress believes that the current market environment plays well into an expanding M&A strategy, particularly because target valuations have fallen. Here’s some helpful commentary from CEO Yogesh Gupta on the Q2 earnings call on the company’s M&A strategy:
We are targeting businesses that are complementary to ours in terms of product, audience and growth profile and which also meet the following financial criteria. One, they have high levels of recurring revenue with excellent renewal rates. Two, which after synergies will deliver operating margins consistent with our margin structure. And most importantly, we generate a return on invested capital that is above our weighted average cost of capital. […]
The current disruption in global markets has favorably impacted our M&A outlook in multiple ways. First, we have begun to see a decline in valuation expectations from companies considering the sale. This should provide a greater opportunity for us to find the right assets at the right valuation. Second, more investors are now faced with the decision of whether to invest more heavily in their portfolio companies during these uncertain economic times, or alternatively, whether to explore a sale. While each business will consider its unique circumstances, we expect to see more deals come to market during this time of uncertainty. Finally, we believe the increased economic uncertainty may result in fewer competitors who can match our financial strength, making Progress a more attractive and credible acquirer for these assets.”
We also like the fact that Progress has ample liquidity on its balance sheet to allow it to execute an ambitious M&A plan. As of the end of May, Progress had $203.6 million of cash on its balance sheet. The company is also free cash flow positive – in the first two quarters of fiscal 2020, the company generated $71.7 million of FCF, up 11% y/y. We note as well that, thanks to the company’s strong cash flow generation, Progress’ net leverage ratio has consistently fallen over the past several quarters, down to just 0.5x as of the end of Q2 (most banks consider a ~3x leverage multiple to be a “highly leveraged” company). This gives Progress plenty of borrowing capacity to chase M&A targets.
The prospect of extended lockdowns has fueled the rally in tech stocks to the point where many companies, especially software stocks tied to the remote-work trend, have runaway valuations. Progress Software has a completely different profile than most other software companies: below-market P/E-based valuation, rich operating margins, and growing free cash flows. Low leverage and ample balance sheet cash give Progress Software decent runway to grow via M&A. Keep an eye out for an entry point in this name.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PRGS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.