Business software company and Hidden Gems recommendation Pegasystems (Nasdaq: PEGA) turned in yet another disappointing quarter yesterday -- its third in a row. Year-on-year comparisons remain hobbled by the fact that the company has parted ways with First Data Resources, a division of First Data Corp. (NYSE: FDC), a move that, perversely, was intended to open up new markets for Pegasystems, and new opportunities to profit from its self-designed business process management (BPM) software.
Because we already have results for three quarters of the year under our belts, let's skip the quarter-on-quarter comparisons and go straight to the nine-months view. Comparing year-to-date results with the first three quarters of 2003, revenues declined 8%. That may not look too bad, but take note of the components of the overall revenue stream: Higher-margin licensing revenue declined 38%, while lower-margin services revenue rose 38%. In other words, over time, the company appears to be replacing higher-margin business with lower-margin (read "less profitable") business. Not a promising trend.
The margin numbers bear that out, with overall gross margins declining slightly from 73% to 72.4%. Combine that with the fall in revenues and rise in marketing expenses as the company tries to replace revenues lost from its split with First Data, and overall operating margins collapsed from 18.5% to 5.5%. The final proof, of course, is in the profits: Whereas last year, Pegasystems pulled down $0.40 per diluted share for the first nine months, this year that fell 70%, to $0.12.
Moving on to the cash flow statement, the damage looks less severe, but only slightly so. Pegasystems requires only minimal capital expenditures to keep its business running, so cash from operations is almost synonymous with free cash flow (FCF) here -- and cash from operations declined 63% year on year. Total free cash flow for the first nine months of 2004 came in at just $5.5 million (suggesting a run rate for the year of about $7.3 million).
With an enterprise value (EV) of $190 million and a forward EV/FCF of 26, even if the five-year projected growth rate of 20% shown on Yahoo! (Nasdaq: YHOO) Finance materializes, and even if free cash flow ticks up next quarter due to the closing of two "large revenue transactions" cited in the earnings release, the best one can really say here is that Pegasystems may be fairly valued. But regrettably, it bears little resemblance to the fine piece of horseflesh we saw when Hidden Gems recommended it in July 2003.
When's the last time you saw a newsletter service go back over a year to tell you one of its recommendations is performing poorly? What's more, when's the last time you saw a newsletter stick around and give a slow performer some time to find its stride? Both happen with remarkable regularity at Motley Fool Hidden Gems, where we give our picks the benefit of the doubt, but at the same time give you the news straight when they're not meeting expectations. Try Hidden Gems for a full month right now, for free. No obligation. No charge. No hassles if you decide it's not for you.
Fool contributor
Rich Smith
has no interest in any of the companies mentioned in this article.
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