Bet on Business Intelligence, but Not This Stock

I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer, too. But some growth stories are inevitably better than others. Hence this regular series. My goal? Out the Fakers, elevate the Breakers, and examine the growth stories stuck in between.

Next up: Actuate (Nasdaq: BIRT). Is this business intelligence specialist growing sustainably enough for your portfolio? Let's get right to the numbers.

Foolish facts

Data current as of Feb. 20.

Actuate is the highest rated application software stock in CAPS. Impressed? You should be. This is an industry that includes Adobe and salesforce.com, among others.

I get the draw. Not only is Actuate a key player in the highly important business intelligence market, it's also cheap compared to Wall Street's expectations for earnings growth. Specifically, the stock trades for less than 10 times next year's average profit estimate and about half of what analysts expect the company to earn over the next five years, resulting in a 0.58 PEG ratio.

Lower is better when it comes to the PEG, and 0.58 is pretty low. The risk is that it's a relative measure. Buy when analysts are being too generous with their estimates and you'll pay in losses when the mirage fades. And that may be a problem here, too.

Why? According to Earnings.com data, Actuate has an inconsistent history when it comes to meeting and beating analyst expectations. In Q3, the company beat the consensus by $0.06 only to fall a penny short the next quarter.

As a growth investor, I prefer situations where analysts are routinely wrong on the low side. Take Baidu (Nasdaq: BIDU), which has crushed estimates by a combined $0.17 over the past four quarters. Because analysts have a history of lowballing estimates for China's search king, its 0.91 PEG ratio looks like a legitimate discount. By comparison, Actuate's PEG looks like wishful thinking.

The elements of growth

Source: Capital IQ, a division of Standard & Poor's.

A closer look at the financials doesn't do much to alleviate my fears, either. There's no pattern to draw from:

• Growth investors like me love straight-line accelerating revenue growth leading to accelerating profit growth. We have neither here. Revenue was up last year but at the expense of normalized profits. Cash from operations improved from the year prior to about equal with the company's ... 2007 performance.
• Pricing power is also something we like to see, or in lieu of that, excellent cost management leading to higher margins. Here again, there isn't much good news to report. Gross margin is up from 2008 but down from last year. Lower prices may have fueled revenue growth.
• We also like businesses that collect quickly. Fortunately, there's good news here. Receivables fell as revenue grew, no doubt contributing to the recovery in cash from operations.
• Finally, dilution has remained mostly in check thanks to Acuate's ability to self-fund through cash flows. The company produced more than $21 million in free cash flow last year, according to Capital IQ data.

Competitor and peer checkup

Source: Capital IQ. Data current as of Feb. 20.

IBM and SAP are the growth stories here, and for good reason. Not only are they the owners of two of the world's best-known BI suites -- i.e., Cognos and BusinessObjects -- but they're also well-diversified in terms of products and geographic sales. Actuate and MicroStrategy don't have that advantage.

And yet history may not mean much when it comes to evaluating Actuate's prospects. The company scored highly in a recent survey of companies looking to adopt BI on mobile devices. That's important. Noted BI market researcher Howard Dresner estimates that, by 2013, at least 25% of all users will consume BI data exclusively on a mobile device. Actuate should benefit from the shift.

Grade: Unsustainable
So will others. Qlik Technologies (Nasdaq: QLIK), notably. If I had to choose between Qlik and Actuate, I choose Qlik for its in-memory processing system and growing fan base. Financially, these characteristics translate into better gross margins (i.e, 89.4% for Qlik versus 83.3% for Actuate) and higher free cash flows (i.e., $30.9 million for Qlik versus $21.2 million for Actuate). I see this gap widening as business users take to QlikView on their iPhones and iPads in increasing numbers.

Do you agree? Disagree? Let us know what you think about Actuate products, valuation, and competitive positioning using the comments box below. You can also ask me to evaluate a favorite growth story by sending me an email or replying to me on Twitter.

Interested in more info on the stocks mentioned in this story? Add Actuate, Baidu, IBM, MicroStrategy, Qlik Technologies, or SAP to your watchlist.