Shares of application development platform Progress Software (PRGS -0.54%) shed 5% of their value on Wednesday following the company's fiscal third-quarter 2020 earnings report, which it filed after markets closed on Tuesday.

Progress' top line continued to exhibit anemic growth. Revenue increased by 3% over Q3 2019, to $109.7 million. And while the organization updated its revenue outlook for the current fiscal year, the positive revision amounted to just a slight upward nudge. At the midpoint of the range, the new guidance aims for 2020 revenue of $440 million, against the previous midpoint target of $430 million.

Nonetheless, even as shareholders expressed mild disappointment with the company's slow top-line growth, Progress revealed trends that are certainly moving in the right direction.

Illustration: A man stands on a giant arrow, looking through a spyglass pointed at a dollar sign.

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Operating leverage is growing

Progress may be watching its sales stall in a pandemic-constrained year, but its profits are soaring due to lower expenses. Cost of revenue this quarter declined by 29%, to $14.8 million, although this was more a function of lower amortization of acquired intangible assets than cost control. Gross margin derived a big boost from the drop-off in amortization, jumping roughly 600 basis points to 86.5%.

Management did exercise cost discipline in regard to operating expenses, however. Sales and marketing expenses and product development expenses dipped by 12% and 11% against the prior-year quarter, respectively, while general and administrative expenses held flat. As a result, operating expenses declined by roughly 12%. 

Due to the higher gross margin and slimmer expenses, operating income more than doubled to $33.2 million against $16 million in Q3 2019. Net income jumped 77% to $24 million, and diluted earnings per share rose in tandem by 77%, to $0.53.

It's notable that this isn't a single-quarter trend. Progress has been generating operating leverage, squeezing more profits out of slighter revenue, throughout the fiscal year. In the first three quarters of 2020, revenue has advanced a modest 8% over the comparable period, to $320 million. But profit has leaped by 99%, to $62.1 million.

An earnings expansion lever

In early September, Progress announced the pending acquisition of DevOps (software development operations) specialist Chef for $220 million in cash. Progress has made strategic purchases a core part of its long-term growth strategy, and according to CEO Yogesh Gupta, Chef fills many of the company's acquisition target requirements. Chef offers a stable base of recurring revenue, complementary technology to Progress' products, and a high customer retention rate of 95%.

Chef's products will be used to enhance Progress' software automation tools, and the acquisition is expected to be accretive to earnings in the first quarter of fiscal 2021. Chef boasts roughly $70 million in annualized recurring revenue, and is projected to contribute $5 million to $7 million to this year's sales, pending an expected October closing of the transaction. 

The Chef merger follows last year's similarly sized purchase of secure data transfer software provider Ipswitch for $225 million in cash. Progress wants to double the size of its business within five years, and bolt-on, earnings-accretive acquisitions of companies like Chef and Ipswitch provide a path to achieving this goal, especially in the context of its recent sub-par organic revenue growth over the last few years.

With the dust barely settling on this quarter's earnings, investors are likely already looking forward to next quarter's earnings report, when the software-as-a-service (SaaS) provider will issue its outlook for the new fiscal year. While shareholders have been skeptical of its prospects as of late -- shares are down 9% year to date -- a rebound from COVID-19-induced sales pressure coupled with strong projections on sales from recent acquisitions could provide a catalyst to Progress' share price. For now, long-term advocates can take comfort in Progress' sharply rising profitability.