Enghouse Systems is my Top Pick, this portfolio manager says

The stock may be down plenty over the past year and a half but investors should be thinking about Canadian software roll-up Enghouse Systems (Enghouse Systems Stock Quote, Charts, News, Analysts, Financials TSX:ENGH), says portfolio manager Chris Blumas of Raymond James Investment Counsel. Blumas thinks Enghouse is well-positioned to take advantage of the current buyer’s market for software companies.

“Enghouse is a really, really neat company. They’re an enterprise software company and what they do is essentially acquire other software companies, so part of their business revolves around the existing products they have in generating organic growth and they also go out and do acquisitions,” said Blumas, who nominated Enghouse as one of his three Top Picks for the 12 months ahead on a BNN Bloomberg segment on Thursday.

One of a number of Canadian software consolidators along with names like Constellation Software and OpenText, Enghouse focuses on acquiring companies in the contact centre, video communications and network communications spaces. The company saw a surge in revenue over 2020 from its Enghouse Interactive subsidiary and in particular its Vidyo video conferencing solution, but that growth made for tough year-over-year comparisons.

Enghouse finished off its fiscal 2021 at the end of October, for example, with the results delivered in December and featuring full-year revenue of $467.2 million compared to $503.8 million for fiscal 2020. Net income for the year was $92.8 million compared to $98.6 million a year earlier and adjusted EBITDA was $168.5 million compared to $176.8 million in fiscal 2020.

“Similar to the second and third quarters of 2021, the comparatively higher revenue last year was driven primarily by the previous year’s significant increase in our Vidyo business that has returned to levels more consistent with pre-COVID volumes,” Enghouse said in a December 16 press release. “Revenue for the quarter was negatively impacted by $4.4 million as a result of foreign exchange as the Canadian dollar strengthened against the U.S. dollar and Euro.”

Nevertheless, Blumas sees lots of upside to owning Enghouse here, where its share price is off by about 45 per cent from its highs set over the third quarter 2020. 

 “Enghouse benefited a little bit disproportionately [during the pandemic] because one of their main products was a video conferencing product where the demand spiked during COVID. That product demand has moderated a little bit and that has made revenue growth a little bit more challenging,” Blumas said. 

“Also, because of the pandemic they haven’t been able to complete as many acquisitions. In terms of their acquisition criteria, they’re fairly rigid in terms of the hurdles they’re looking for, so their business had a little bit of weaker operating performance and they’re sitting on a whole bunch of excess cash,” he said. 

“And so I think this is a business that is very, very well positioned for a choppy environment. There are a number of shareholder-friendly actions they can take. They can buy back their shares, they can do a special dividend, they can get back on the acquisition track as valuations in that software space have have come down. So I think this is a business that has a lot of optionality,” Blumas said.

Enghouse completed three acquisitions over its fiscal 2021, but the company appears ready to rev its M&A engines. Enghouse said in its Q4 2021 press release that the market for acquisitions in the technology space “continue to be priced at prohibitively higher valuations that do not support our return-on-investment objective,” yet in his quarterly comments in the Q4 conference call CEO Stephen Sadler said the winds look to have shifted. Sadler pointed to economic stimulus measures which brought a lot of cash into play and drove up prices, but with those measures now out of the way and with interest rates rising (making the funding of acquisitions more challenging), the market may look better in the new year.

“Valuations, and this is just our view, in the year have been expensive, for many reasons. One, you have got a lot of money floating around chasing things. But that seems to be changed lately. Stimulus has dropped. People are talking about interest rate increases. They are also looking at how do we pay this money back, which means taxes — you hear it all the time in the U.S. — are going up, but every country is talking that way. You do have to pay for the money that was spent. So, we believe that you put all those factors together, it makes the acquisition environment better. And we see that going into 2022 as a reasonable possibility of what will happen,” Sadler said.

The $2.3-billion market cap Enghouse finished the 2021 calendar year down 21 per cent, while so far in 2022 the stock is down a further 14 per cent. 

Blumas says ENGH’s valuation is comparatively inexpensive and even though its video conferencing business isn’t likely to see that pandemic-inspired growth, the company is still on a solid foundation.

“If you look at the free cash flow yield it’s north of five per cent,” he said. “There was just a massive spike in pandemic demand [for video conferencing], and so in the end that has moderated and their revenues were off by about five per cent year-over-year.”

“It was tough to sustain, and not all of their products are software-as-a-service and some of them still do license sales which are lumpy and bumpy [but] I think this is a business that should find its footing sometime fairly soon because it does depend on acquisitions and the acquisition market is a lot more attractive this year than it was last year,” Blumas said.