If there is such a thing as a defensive growth stock in the IT sector, then Verint Systems (NASDAQ:VRNT) might be it. Along with its rival NICE Systems (NASDAQ:NICE), Verint has put in a very consistent performance this year. Both companies are leaders in customer-interaction and analysis solutions, and both look set for good earnings growth in the future. Verint recently followed NICE in reaffirming its 2013 guidance, and those of you looking for a relatively safe option within tech should consider the stock carefully.
End demand looks good...
The market reacted well to Verint's strong second-quarter results, even though it kept its full-year guidance unchanged. It was a similar story with NICE's second-quarter results delivered earlier in the reporting season. While the market may appear to be overly rewarding these companies for merely hitting guidance, there are deeper reasons why it is right. Essentially, there are a number of positive trends in the sector that help increase their longer-term earnings potential.
- Customers are demanding more value-added data-analytics solutions.
- Big data is starting to be used across all kinds of data channels, and companies will need to capture and integrate data from things like call centers, websites, social media, video etc.
- Verint and NICE have strong, installed bases with their hardware-capture solutions, and they have an opportunity to sell data analytics into them because customers value buying solutions from one vendor.
- Companies can still generate growth -- even in a weak economy -- by better analyzing their existing customers.
- Solutions to prevent money laundering, fraud, and other crime are seeing secular growth prospects because criminals are also using technology to become more sophisticated.
- Governments are increasingly pressured to use surveillance and intelligence gathering in order to monitor terrorist threats.
The points above relate to end-market demand, but the type of demand is also likely to positively change their earnings potential.
That demand is likely to help Verint's operating metrics
First, on its conference call, Verint predicted gross margins to be flat this year. You shouldn't read too much into this, because longer-term, the prospects for margin expansion are significant. Increasing demand for higher-margin analytics solutions implies that gross margins should increase in the future. Quoting from the recent conference call:
So overall, we still have about 50-50 mix between capture products and analytics. But clearly, we are growing our analytics portfolio. Analytics is growing at higher growth rates, which kind of shifts the overall growth rate of the company.
Verint is benefiting from analytics, and NICE has the bonus of a deal with IBM (NYSE:IBM) that integrates IBM's analytics solutions within NICE's solutions. This is a particular benefit to call centers and financials, sectors in which NICE is strong. IBM gets the benefit of tapping into NICE's installed base, and the latter gets to offer its customers the kind of analytical solutions that they require in the "big-data" world. It's a win-win scenario.
Second, even though it kept its full-year revenue-growth forecast at 6% to 7% and its EPS target at $2.75, the underlying picture did get better. Verint disclosed that it was seeing larger orders this year compared to last year.
What you need to understand is that these larger orders are likely to take longer to generate revenue, particularly if they contain a large services component. In other words, there won't be an immediate effect, but in the longer term, earnings and cash flow will be enhanced by booking larger orders now.
Long-term prospects look good, and it's reasonable to expect margin expansion going forward. Moreover, if Verint and NICE can continue to grow revenues in the 6% to 7% range, then assuming an earnings growth rate in the double digits seems reasonable. Moreover, both companies are highly cash-generative. For example, Verint has converted more than 250% of its net income into operating cash flow over the last three years. This cash-flow conversion is likely to increase in future years as services and analytics grow as part of the revenue mix.
If NICE can hit free cash flow of around $125 million, and Verint hits its target of $100 million, then both stocks will trade on a free-cash-flow-to-EBITDA ratio of 5.9% and 4.3%. NICE looks cheaper on this basis, although both stocks look attractive for the long-term investor.
Lee Samaha has a position in NICE Systems. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.