FOOL ON THE HILL
Value in a Software Stock?

Not every software stock trades at an astronomical P/E multiple. We've uncovered a pint-sized software company with a track record of growing sales, consistent profits, high ROIC, a low Flow Ratio, and plenty of cash on the balance sheet -- all trading for only 6x free cash flow. Not all is rosy, of course, but the value may be compelling nonetheless.

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By Matt Richey (TMF Matt)
March 26, 2002

Like two weeks ago, I'm venturing once again into micro-cap country. It's in this sub-$200 million market cap range where I continue to find some of the best values. Try this one on for size: a software company with a track record of growing sales, consistent profitability, and a stock selling for 6x free cash flow, plus $5 per share in net cash. Sound interesting? Read on.

But before I introduce you to this company, I need to repeat my warning from last time: The micro-cap arena contains some of the stock market's best bargains, but also some of its worst scams. It is possible to sidestep most of the real minefields, but only by doing thorough, detailed research. I'll do my best to present as much useful information as I have space to, but it's entirely up to you to double-check my facts and then go deeper in your own research.

All right, without further ado, let me introduce you to Group 1 Software (Nasdaq: GSOF). Founded in 1981 and publicly traded since 1990, Group 1 is a provider of marketing software solutions to over 2,500 clients, including a roster full of blue-chip names like AT&T, Charles Schwab, GEICO, L.L. Bean, MCI WorldCom, Wal-Mart, and Wells Fargo. None of the company's clients represents over 10% of revenues. Over the past year -- which, by the way, was a tough year for Group 1 -- revenues totaled $92 million, on which the company generated pre-tax operating income of $7.9 million, net income of $6.2 million, and free cash flow of $9.7 million.

The Biz
Group 1 develops software applications that help businesses to better and more efficiently market their products and manage their customer relationships. The company's offerings can be broken down into four categories:

• Data Quality Products allow clients to verify and enhance their customer and prospect data with relevant geographic and demographic information.
• Marketing Automation Solutions mine a client's customer information in order to help marketers develop the right message for the right audience and thereby maximize the success of any marketing campaign.
• Direct Marketing Applications help clients to reduce their direct mail costs and speed delivery by standardizing addresses, eliminating duplicate addresses, validating postal codes, and coding and presorting mailings in order to maximize postal discounts.
• Customer Relationship Communications Solutions allow clients to personalize their customer communications (such as bills and statements) by delivering highly targeted messaging to a customer's preferred channel, whether it's printed document, the Web, email, or fax.

Group 1 rolls up these four product categories into two operating segments: the Enterprise Solutions Division (56% of trailing annual revenue; includes Data Quality, Marketing Automation, and Direct Marketing) and the Customer Relationship Communications Division (44% of trailing annual revenue).

Investment Merits
There's a lot to like about Group 1's business. First and foremost is the strong economics of the software model. This is a high-margin business and over the years Group 1 has consistently delivered gross margins north of 60%, including a margin of 64.6% this past year. Group 1's finances also benefit from the advantages of receiving up-front cash at the time of sale, even though much of what it sells -- software maintenance and service -- won't require an outlay of expenses for up to a year.

Two analytical metrics that offer evidence of Group 1's strong business model are the Foolish Flow Ratio and Return on Invested Capital. The Flow Ratio measures a company's ability to efficiently manage its working capital, the primary goal of which is to hold onto as much cash as possible, for as long as possible. With Flow Ratios, anything below 1.25 is pretty good and the lower the better. Over the past eight quarters, Group 1's Flow has never been higher than 0.67, and it was down to 0.55 at the end of the most recent quarter. Return on Invested Capital measures how well a company uses the capital at its disposal to generate operating profits. Over the past year, measured against the average amount of capital invested in the business, Group 1 generated a 23% return.

This company has been turning in strong results for years. In fiscal 1995 (ended 3/31/95), the company earned $5.1 million in operating income (pre-tax) on $37.9 million in sales. By last year (ended 3/31/01), the company was up to $12.1 million in operating income on $93.3 million in sales. That's a compound annual growth rate of 16.2% for sales and 15.5% for operating income.

Through its strong operating results, Group 1 has earned positive free cash flow every year since fiscal 1998. The company has so steadily accumulated cash that it currently stands at $35.8 million (net of $8 million in debt and preferred stock), or $5.24 per diluted share. On a $13.40 stock, net cash represents 39.1% of the company's market capitalization.

One last attribute worth mentioning is the company's share repurchase program, which was smartly announced on September 19, when the stock had fallen to $10. This program authorized the repurchase of up to $10 million worth of shares.

Investment Demerits
"So what's not to like?" you ask. Well, several things, actually. First of these is the inherent unpredictability of Group 1's results, especially during slow economic times. Like other big-ticket software companies, Group 1 can dramatically miss earnings estimates when end-of-quarter deals don't close in time.

This situation has been especially bad during the difficult economy of the past year. On August 1, management was calling for fiscal 2002 (for the year ending 3/31/02) revenue of $102-105 million and earnings per diluted share of $1.05 to $1.08. One quarter later, on October 31, those numbers were marked down to revenue of $97-99 million and earnings of $0.88 to $0.95 per share. And again, one quarter after that, on January 28, management admitted that revenue would likely come in at only $88-89 million with earnings per share of $0.59 to $0.66 -- barely more than half what was originally anticipated.

Other factors to consider with this company are the substantial stock option grants that have been issued and that threaten to materially dilute shareowners. At present, Group 1 has 6.8 million diluted shares outstanding, up from 5.4 million in March 1995. It was in that year the company authorized the issuance of 1.5 million options. This 1995 option plan has been augmented by an additional 300,000 shares in each of 1999, 2000, and 2001. Currently, there are 387,000 potentially dilutive stock options that will become dilutive if the stock moves above $16. That would represent dilution of an additional 5.7%. The potential for ongoing dilution because of the board of director's excessive option grants should be considered carefully before investing in this company. (By the way, I totally agree with Whitney Tilson that the prevailing misuse of stock options is a travesty.)

Valuation and Conclusion
Today, the average S&P 500 company trades for 27x trailing annual free cash flow (FCF). By contrast, Group 1 trades for only 6.2x FCF. Another way to look at the valuation here is to compare the enterprise value (market cap + debt - cash) to free cash flow less any investment income (so as not to double-count the value of cash). On this basis, the stock trades for 7.5x "operating FCF." On a conservative basis, it seems that the company should be able to at least grow at a rate that keeps pace with its option dilution of 5-6% per year. That means an investor's potential return would be equal to the inverse of the 7.5x EV-to-operating FCF multiple (that's 1 divided by 7.5), or 13.3%.

Looked at another way, I think a company like this should trade for closer to 12x its operating FCF, plus any net cash per share. That would be $13 (12x operating FCF of $1.083 per share), plus the $5.42 per share in net cash, which yields a fair value estimate of $18.42.

Again, this is just a first look at this company. For those of you who think there's potential in this stock, I hope you'll build on what I've presented here. It'd be great if someone could listen to the January 28 conference call, and then report their findings to our Fool on the Hill discussion board.

By the way, there are plenty more of these types of small-cap value opportunities out there. That's why for the foreseeable future I intend to devote a significant number of my columns here in the Fool on the Hill space to the investigation and analysis of  small- and micro-cap stocks. Not every one I present here will be a worthwhile investment, but we'll learn a lot of lessons along the way and hopefully uncover a gem or two.

Matt Richey welcomes your feedback at MattR@fool.com. At the time of publication, Matt did not own shares of Group 1 Software. For a view of Matt's personal portfolio, see his profile. The Motley Fool is investors writing for investors.