The Pros and Cons of an 8-Bagger

I (Jim here) have heard before that the members-only discussion boards provide the real value to Motley Fool Stock Advisor subscribers. Where have I heard that? On those very boards, of course (which, if nothing else, represents an interesting circularity of argument). I'm not sure I agree -- the newsletters are valuable for finding stocks I'd not otherwise see -- but I am a huge fan of the boards. You'll often find Fool staffers, including the folks who recommend the stocks in the first place, further discussing the merits of the company, taking on challengers with wit and wisdom, and fostering collective learning.

The following is excerpted (with some editing) from this thread (free trial required) on the subscriber discussion board for Quality Systems (Nasdaq: QSII  ) . In the thread, I'm taking on Fool co-founder Tom Gardner (gulp!) in an informal edition of Dueling Fools. I start with the notion that Quality Systems has become very fully valued, but Tom stresses the importance of avoiding the sell-too-early valuation trap and missing out on the truly great businesses.

Jim's challenge
Tom has three selling criteria:

  1. Business prospects have changed for the worse.
  2. Management is suspect.
  3. The valuation is absolutely crazy.

When it comes to Quality Systems, I believe we have one stunning success, one pick 'em, and one failure.

The good
Quality Systems hits the business prospects ball out of the park. With great execution, burgeoning demand, great NextGen products, strong growth, and widening margins, what's not to love?

The OK
Management is more of a conundrum. Operating management has just plain executed, and the growth numbers and profitability ratios speak well to this point. Yet I have some concerns about management's ability to convert reported burgeoning sales to cash. The ratio of accounts receivable (AR) growth/sales growth stands at 1.57, and although I flag as problematic anything above 1.25, this flag is yellow rather than red because the ratio is down from the past two quarters. The ability to convert AR to cash is trending in the wrong direction, as measured by days sales outstanding (DSO), moving from a low of 105 days in the past three years to the current high of 142. Finally, a quick look at cash flow from operations (CFFO) shows that while year-over-year net income (the start line for CFFO) rose 56%, CFFO rose only 16%. Moreover, fully 17% of reported CFFO came from a tax benefit from exercised stock options. This is definitely not an operating item, but because of accounting rules, it gets thrown in anyway.

That said, management is still doing well. They're fighting hard to keep up with growth, and I suppose that's good.

But, as all Fools are apt to be aware by now, there were some pretty serious reservations about the board of directors (BOD) and the manner in which they chose to ramrod through their proposed slate of directors, push out substantial shareholder Ahmed Hussein as director, and grant new and generous option packages to operating management (and themselves). There is still ongoing legal activity from Mr. Hussein's side. Rather then rehash the arguments, find them here, here, and here. In short, the BOD is fractious, splintered, and too concerned with rewarding themselves. This is the pick 'em.

The ugly
On crazy valuations, I think that today's level for Quality Systems is fitting us for a soft, padded room. Quickly comparing relative multiples using month-ending prices (from May 2000 to October 2005), and rolling trailing-12-month (TTM) financial results, we're at record levels across the board:

P/S P/E* P/FCF** EV/EBITDA EV/FCF
Mean 3.7 28.1 23.5 12.4 19.6
Median 3.2 24.8 21.6 10.4 17.1
Maximum 9.7 55.4 51.8 29.2 48.6
Minimum 1.2 15.6 10.1 4.9 6.9
Current 11.2 58.7 63.7 33.0 60.2
*Diluted.
**Free cash flow (FCF) defined here simply as FCF = CFFO - Capital expenditures.


There is no doubt that Quality System's returns have been spectacular -- buyers at the two Stock Advisor recommendations have earned 600% and 700%, respectively. But those incredibly outsized returns have come from two sources. First, company execution. Owner earnings increased from $6.3 million at the time of the original recommendation to $18 million today -- a 183% gain. Second, the market has been willing to pay a high multiple to get in on this growth -- enterprise value to owner earnings (EV/OE) increased 193%. It is unreasonable to expect a similar multiple expansion going forward, if only because investors two years from now would have to pony up more than 170 times EV/OE. That's just not likely.

Quality Systems is a great company in a great space. I hope the company will grow into its valuation and continue to execute its business plan. However, new investors need to beware of the current price. If the company doubles its FCF in the next two years, while the market readjusts to only pay 30 times for FCF, the stock will go nowhere.

Tom's counter
Jim, we will agree to disagree. My mind is completely open to the rightness of your conclusion. I, too, see the multiples relative to where we were a few years back. But back then this was an unproven company with a new emerging revenue line. The market knew nothing about Quality Systems -- and what it saw wasn't inspiring. Growth rates were slower as Quality Systems' NextGen electronic medical records software grew within an otherwise unspectacular business.

Today, the federal government is clamoring for more efficiency and accurate record keeping in health care. This comes simultaneous to the mother of all demographic shifts. Add to these an accelerating revenue line (having in effect shed the core business growth rates a long while back). Throw in a sterling balance sheet, and this just isn't a stock I would sell.

A few years back I sold Whole Foods (Nasdaq: WFMI  ) in a similar situation. It was riding a major demographic wave, with a management team that had proved itself, a fine balance sheet, and industry leadership -- yet there was also dilution and a high valuation (more than 40 times earnings for a 20% grower). The stock fell 25%. I felt great. Since then, Whole Foods has more than tripled, and this scores as a major blunder on my part.

Is Quality Systems is a deep bargain here? In the short term, no. But when I look out five years, I expect these shares to beat the market's return. The biggest change to my investment approach over the past few years has been to force myself to look longer-term in my valuation work. Had I not made that adjustment, I certainly would have sold Moody's already, and maybe even UnitedHealth (NYSE: UNH  ) more than a year ago. Instead, I held what I think are truly great companies and -- at least in the past year -- have been rewarded to the tune of 200% and 300% returns in little more than three years.

Mind you, I will still sell because of major valuation concerns -- but that'll be when I think the valuation has gotten truly wacky. In the case of Quality Systems, today it's a $1.2 billion company that is consistently beating Street estimates. In this climate, with this market size, I see no reason to dispute growth estimates of 28% to 32% per year through 2010. I was seriously punished in the 1990s for disbelieving long-term 25% or more growth estimates for Dell (Nasdaq: DELL  ) , Bed Bath & Beyond (Nasdaq: BBBY  ) , Paychex (Nasdaq: PAYX  ) , and Cisco (Nasdaq: CSCO  ) . I vowed to myself not to make that mistake again when I feel I have a truly wonderful situation.

I believe Quality Systems could be valued at $3 billion by the close of 2010, when I believe it'll be delivering a run rate of around $100 million in owner earnings. I think it is more than just possible that it will become a 20-bagger for those who hold through from 2003 to 2010.

The Foolish bottom line
Where do you stand on Quality Systems? Maybe you don't know yet. If you're interested in reading the entire exchange in detail (yes, there's much, much more), consider taking a 30-day, no-obligation test-drive of Motley Fool Stock Advisor. Tom and his brother David's recommendations are besting the market by an incredible 40 percentage points since the newsletter's April 2002 inception. And while you'll enjoy immediate access to all of their research, you'll also be able to interact with the thousands of knowledgeable and dedicated Stock Advisor message board users. The exchange above is just a sample of how subscribers are able to use the newsletter's resources to do even better than the brothers' scorecard.

Jim Gilliesowns shares of Quality Systems (although probably not for long, as he's also short $55 December 2005 calls). Tom Gardner owns shares of Cisco. Dell, Best Buy, UnitedHealth, and Whole Foods are also Stock Advisor picks. The Fool has adisclosure policy.


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