FOOL ON THE HILL
A Tech Survivor

Not every tech company is in the dumps. Group 1 Software generated impressive revenue growth in the most recent quarter, in spite of the difficult economy. The company has $6.85 per share in cash and trades at a very low multiple to its free cash flow. Because of its low market capitalization, Group 1 is outside of Wall Street's radar, but this is precisely the type of opportunity that individual investors can take advantage of.

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By Matt Richey (TMF Matt)
September 10, 2002

It's been a tough year for most corporate software providers. Companies such as Oracle, PeopleSoft, and Siebel have all faced sharply lower sales in recent quarters. In an environment where IT budgets are tighter than ever, one has to be impressed with Group 1 Software's (Nasdaq: GSOF) recent results. With 12% revenue growth in the most recent quarter, and only a 3% decline in revenue for the trailing 12 months, Group 1 is demonstrating remarkable staying power during this recession. That's why I'm excited about the stock's prospects at a current valuation of only 6.5 times free cash flow.

Some background: Group 1 Software provides data-quality software to corporate clients. The company's software applications help more than 2,000 businesses to better and more efficiently market their products and manage their customer relationships. Group 1's position in the data-quality software market is solidified by two significant strategic alliances. One of these was established this year, in the March quarter, when Group 1 displaced a competitor to become Pitney Bowes' (NYSE: PBI) document composition vendor of choice. In addition to the Pitney alliance, Group 1 is the only data-quality software vendor that is a premier software partner at Siebel Systems (Nasdaq: SEBL), the leading customer relationship management vendor.

Regular readers will recall that I first wrote about Group 1 in March. Since then, the stock has barely moved. It was at $13.28 then; it's at $13.50 now. Not even once during that period did the stock drop below $13. I don't subscribe to technical analysis, but this says something for the stock's resilience. More importantly, Group 1's flat-line stock performance bested the S&P 500 by more than 20% over those six-months. A 0% return never looked so good.

After watching the stock for so long, I finally decided to buy shares recently at $13.70. The catalyst for my purchase was my strong impression of the most recent quarter. Group 1 generated impressive revenue growth in a tough environment, doubled the consensus analyst expectation for earnings per share, and added to its already substantial cash hoard.

These strong results convinced me that Group 1's business has a good shot of riding through the remainder of this recession with no further undue hits to revenue. Also weighing into my decision to buy was the fact that management issued a conservative level of employee stock options last year (only 2.3% of diluted shares outstanding), thus alleviating a concern I voiced in my earlier article.

Let's take a look at the recent quarter's results, and I'll show you what stood out to me in making my decision to buy.

On July 30, Group 1 Software reported record fiscal first-quarter revenue of $23.4 million, up 12.1% from the year-ago quarter. Over the past year, Group 1 made a few small acquisitions, but even if these had been included in the year-ago quarter, revenue growth would've been only a touch lower at 11.2%.

Of particular note in the quarter, Group 1's revenues from software license fees increased 37.5%. This is noteworthy because license fees reflect the front-line demand for Group 1's products. Such strong license-fee growth is a sure indication that Group 1's business is healthy. Strong license sales also ensure a steady stream of maintenance revenue in future quarters.

The company's strong revenue growth set the tone for every other financial metric. Of the $23.4 million in revenue, Group 1 retained $6.1 million in free cash flow. This impressive cash flow retention was partly the result of improved collection efforts. Days of sales outstanding (DSOs) declined to a record low 50.5 days, down from 77.2 days a year ago. A declining level of DSOs is always an encouraging sign that sales are not being made based on lenient payment terms.

On the balance sheet, the story is cash -- there's gobs and gobs of it. As of June 30, Group 1 had $51.6 million in cash and equivalents, less $4.0 million in short- and long-term debt, which yields net cash of $47.6 million, or $6.85 per share. Cash alone accounts for half of the company's market cap! I love companies that generate lots of cash and carry little debt. A cash-rich balance sheet gives Group 1 the flexibility to initiate a dividend or repurchase shares. Personally, I'd like to see the company begin buying back shares given the valuation, which is now mouth-wateringly low.

Like I said at the outset, Group 1 trades for only 6.5 times free cash flow. But let's break it down a bit further. Over the past year, Group 1 generated free cash flow of $14.5 million. If we back out the interest income, the "operating free cash flow" is $13.6 million, or $1.96 per share. Assuming the company can deliver upper-single digit growth, Group 1 deserves a free cash flow multiple of around 15, in my estimation. The company is on track to grow revenues by 10% this year, so free cash flow growth should be able to at least keep pace with revenue. Applying the 15x multiple to $1.96 per share yields business value of $29.40. Add to this the net cash per share of $6.85, and you get a total intrinsic value estimate of $36.25.

If my assumptions are even remotely on target, it's a sin for management not to aggressively repurchase shares or initiate a dividend. I think either may be in the cards within the coming year. The company has so much cash now that it practically can't avoid one of these options.

By the way, if you're interested in other attractively priced software stocks (and there are several out there these days), you should consider subscribing to The Motley Fool Select. The about-to-be-published issue includes a special feature on software stocks at value prices.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he owned shares of Group 1 Software. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.