Best Small Cap: Quality Systems

In the spirit of the Winter Olympics, which started Friday in Torino, Italy, The Motley Fool is pitting companies against one another. The writers will outline why their company is the best, and our very own panel of judges will decide the winner after a period of deliberation. Stay tuned for more!

It's been a tough week for Quality Systems (Nasdaq: QSII  ) .

A disappointing earnings report from last Thursday, in which the company missed Street expectations for earnings per share by more than 20%, chilled investors like the air in Torino. The stock is down more than 22% since. Ouch.

A quality competitor
But that doesn't say much about the underlying business. Quality Systems still makes some of the best software out there for automating doctor's offices, which, in turn, enables electronic health records. Indeed, Microsoft's health-care users group recently named its NexGen product Best in Class.

That's an important endorsement for health providers, who have several reasons to be buying record-keeping software. Here's the most important one: HIPAA, the Health Insurance Portability and Accountability Act of 1996. One of the key tenets of the act is to update information systems to protect confidential medical information. In other words, paper-based systems aren't just outdated, but if the Feds have their way, I'd guess that anything not digital will go the way of the dodo.

Past as prologue?
That's why I think this stock has been a beauty and could be again. Not that the company is without risks. The earnings miss and $4 million worth of deferred revenue arising from a contract with Siemens (NYSE: SI  ) make me wonder whether the days of 50% growth are gone for good. And last year's boardroom imbroglio remains unresolved, which, in turn, raises uncertainty, even if the showdown is occurring for all the right reasons.

Let's go to the scorecard
On to the numbers. But, first, a caveat: This is a very rough discounted cash flow analysis. Please don't take this as the final word. Instead, appreciate that I'm applying the Keynesian principle of trying to be roughly right, rather than precisely wrong. With that, let's begin with some facts:

  • Adjusted free cash flow for the trailing 12 months was $25 million.
  • There were 13.7 million diluted shares outstanding in the latest quarter.

The table below takes this data and then applies nine different valuation scenarios. The top row specifies discount rates -- required rates of return that account for the risks inherent in the business. The left vertical specifies growth rates -- the first number covers years 0 through 5, the second covers years 5 through 10, and the third covers the permanent (or "terminal") rate.

Discount Rates
Growth Rates 12% 13% 14%
30/20/4 $109 $94 $82
27/17/4 $88 $76 $67
25/15/3 $71 $62 $55


Obviously, there are some pretty bold assumptions in this analysis. Topping the list is the extraordinary 10-year growth rate. Not many companies can maintain 15%-plus growth for that long. There are two reasons why we should believe Quality Systems can.

First, software has historically been a very high-growth business, even before the bubble, particularly when a software package possesses the capability to change the "rules of the game." Microsoft, for example, was still growing by nearly 30% on the bottom line in 1997 -- more than 10 years after it first went public. Second, Quality Systems is one of the heavies in a business -- electronic health records -- that the Center for Information Technology Leadership says could save the health-care system more than $77 billion annually. Quality Systems has yet to book $150 million in revenue for a given year.

As for the discount rate, 12% may be aggressive, but Quality Systems has a leading, well-known position in a high-growth market -- one where growth might well exceed all expectations given the increasing role health-care services will likely assume, with the aging U.S. population. It also boasts more than $75 million in a pretty solid balance sheet. Both of these factors should help insulate the business from catastrophe.

If you accept my assumptions -- knowing there's no guarantee that the market will -- Quality Systems is cheap in most scenarios, and the median value -- $76 per stub -- expresses a margin of safety of 10%. Hardly perfect, but still decent.

Listen to your coach
In the end, it's all about feel. Instinct. And there are few with better instincts than Tom Gardner, who has netted a multibagger (twice) with this stock. He's still bullish on the long-term outlook for Quality Systems. (Take a risk-free trial to Motley Fool Stock Advisor to find out all the reasons why.)

The Foolish bottom line
Quality Systems is in a tough field for this Foolish competition. But the Soviet hockey team was tough in 1980, and the Americans upended them when it counted most. Similar miracles happen in the stock market daily. With ample cash flow, reduced expectations, and a proud history, Quality Systems has all the ingredients to also make it to the top of the podium.

For more:

Fool contributor Tim Beyers hasn't watched enough of the winter games. But, then again, the men's hockey tournament has only just begun. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. The Motley Fool has an ironclad disclosure policy.

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Related Tickers

10/24/2014 4:00 PM
QSII $14.17 Down -0.45 -3.08%
Quality Systems CAPS Rating: ****
SIEGY $109.34 Down -0.27 -0.25%
Siemens AG (ADR) CAPS Rating: *****

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