Dark Horse Bucks the Trend

Quality Systems is a little-known health-care software provider quietly doing fabulous business, even in this difficult economic environment. The company earns kudos for its solid revenue growth, expanding profit margins, tight working capital management, and high return on invested capital. At around 13 times free cash flow, plus $4.56 in cash per share, the stock is a bargain.

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By Matt Richey (TMF Matt)
August 20, 2002

I almost titled this article, "A Company That Doesn't Suck." Over the past few months, I've written about several companies with dastardly financials and overvalued stocks. I've written so many of these articles, in fact, that I've earned the nickname "grim reaper" around the office. While I don't want to risk my new reputation, not every company is in the dumps. I've found a number of companies doing good business with reasonable stock prices.

One of my favorites is Quality Systems (Nasdaq: QSII). You probably haven't heard of this company, nor has most of Wall Street. Quality Systems is a small, California-based provider of health-care information systems. It's a thinly traded small cap that's too illiquid for most mutual funds. I first presented the company to Fools in the June issue of The Motley Fool Select, our monthly publication of rigorously researched stock ideas.

Founded in 1974, Quality Systems was an early leader in productivity-enhancing software for group dental practices. After going public in 1982, the company branched into software for medical practices. Then in the mid-1990s, the company made two smart acquisitions that gave it an inroad into the now-burgeoning electronic medical records (EMR) business. Quality Systems has an electronic solution for almost anything a physician currently does on paper -- which is, of course, much more economical.

EMR is a quietly booming business at Quality Systems. The company's medical software division, NextGen, grew revenues by 23% in the most recent quarter. One of the primary economic reasons EMR is gaining traction with medical practices is that it significantly reduces the need for physicians to use transcription services. After a patient visit, a physician typically uses a voice dictator to take notes. Then, the physician must pay for those notes to be transcribed into the patient's record. These transcription services can cost anywhere from $6,000 to $20,000 per year, per physician. With NextGen's EMR product, transcription can be eliminated entirely. And that's just one of many benefits of storing medical records electronically.

Quality Systems has quadrupled its revenue over the past decade, growing from $11.7 million in 1993 to $44.4 million in the past year. Today, with around 700 clients, the company has $45.8 million in trailing annual revenue. Looking ahead, Quality Systems management considers the EMR market "very underpenetrated," with potential annual revenue of $2 billion. That's a big number and should be considered a rough guess of the market's potential. But if the company were to capture just 10% of that figure, the resulting $200 million in annual revenue would represent more than 300% growth from the current revenue base. Clearly, there's plenty of room to grow.

Growth to date shows every sign of a company in the early stages of tapping a large market. Over the past four years, revenue growth has averaged around 10% annually, but recently growth has begun to accelerate as EMR has taken off. In the most recent quarter, ended June 30, Quality Systems' total revenue grew by 12.8% to $12.3 million. The EMR-focused NextGen division accounted for 65.8% of that sum, with the remainder generated by the company's QSI dental division. And as I mentioned earlier, NextGen's revenue grew 23% in the quarter.

What I really like about this story is that as NextGen becomes a larger and larger percentage of the business, the company's overall growth is likely to accelerate. Also, I admire how the company has exhibited high-quality growth. It's one thing for a company to grow, but it's another for a company to grow economically. In the most recent quarter, Quality Systems not only grew revenue, but also expanded its profit margins, improved its working capital management, and increased its return on invested capital (ROIC). Each of these areas deserves mention:

1. Expanding profit margins: One of the best aspects of a growing software business is the ability to scale revenue faster than the largely fixed base of expenses. That's what's happening at Quality Systems. What results are profits growing much faster than revenue. The net profit margin for the quarter expanded to a record 13.2%, up from 11.5% a year ago. Even more dramatically, the free cash flow margin expanded to a record high of 25.6%, up from 13.3% a year ago. Obviously, free cash flow tends to be lumpier from quarter to quarter, compared to net income, but it's still a wonderful development. Looking beyond the most recent quarter to the trailing 12 months, we see that the positive trend remains intact, with a free cash flow margin that's grown from 15.4% a year ago to the present 17.3%.

2. Excellent working capital management: One of management's focuses in the past year has been improving accounts receivable collection. Faster collection of invoiced sales results in significant improvement to the company's cash flow. Part of the reason the free cash flow margin has seen such a boost is because of the company's efforts to collect quickly on invoiced sales. During the past year, the number of days invoiced sales have remained uncollected (i.e., days of sales outstanding) has declined from 112 days to 97 days. This is both a sign of excellent capital management and an assurance that the company isn't stretching for sales by offering lenient payment terms.

3. Increasing returns on invested capital: The software business is inherently light, requiring little in the way of expensive equipment or machinery. As such, a successful software shop like Quality Systems is fantastically profitable. The calculation for Quality Systems' return on invested capital (ROIC) works like this: Net operating profit after-tax for the past year amounted to $5.3 million. Divide that figure by average invested capital of $13.95 million, and you get ROIC of 38.0%. Not only is this a phenomenal level of profitability, but even better is that Quality Systems' ROIC has been improving year after year. ROIC in fiscal 2001 was 19%, up from 13% in fiscal 2000, and up from only 3% back in fiscal 1999. These increasing returns on invested capital signify that the business is becoming increasingly productive and increasingly economically valuable. The net result of a high-ROIC business is that a lot of free cash flow is being generated.

And yet even with the business firing on all cylinders, the stock hasn't kept up with the value being created. For most of 2002, the stock has been hovering around $16. The company has $1.26 in trailing free cash flow per share, which means the stock is priced at only 12.8 times free cash flow. Plus, with no debt and $28.9 million of cash in the bank, the company has $4.56 in net cash per share.

In my estimation, a business of this quality should justify a free cash flow multiple of at least 20, which would put the stock at around $25. And with continued strong growth prospects in the years ahead, $25 might only be the beginning. Hopefully, the company's board will reach the same assessment and begin to use some of its cash hoard to buy back stock at the current low price.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he held shares of Quality Systems. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.