Business software company and Hidden Gems recommendation Pegasystems
Because we already have results for three quarters of the year under our belts, let's skip the quarter-on-quarter comparisons and go straight to the nine-months view. Comparing year-to-date results with the first three quarters of 2003, revenues declined 8%. That may not look too bad, but take note of the components of the overall revenue stream: Higher-margin licensing revenue declined 38%, while lower-margin services revenue rose 38%. In other words, over time, the company appears to be replacing higher-margin business with lower-margin (read "less profitable") business. Not a promising trend.
The margin numbers bear that out, with overall gross margins declining slightly from 73% to 72.4%. Combine that with the fall in revenues and rise in marketing expenses as the company tries to replace revenues lost from its split with First Data, and overall operating margins collapsed from 18.5% to 5.5%. The final proof, of course, is in the profits: Whereas last year, Pegasystems pulled down $0.40 per diluted share for the first nine months, this year that fell 70%, to $0.12.
Moving on to the cash flow statement, the damage looks less severe, but only slightly so. Pegasystems requires only minimal capital expenditures to keep its business running, so cash from operations is almost synonymous with free cash flow (FCF) here -- and cash from operations declined 63% year on year. Total free cash flow for the first nine months of 2004 came in at just $5.5 million (suggesting a run rate for the year of about $7.3 million).
With an enterprise value (EV) of $190 million and a forward EV/FCF of 26, even if the five-year projected growth rate of 20% shown on Yahoo!
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Fool contributor Rich Smith has no interest in any of the companies mentioned in this article.