Good software companies have no problem spinning off cash. They require little working capital, generate high margins, and don't need to constantly plow money into property and equipment. So this kind of business should demand a premium, right?
Not if you're business software provider Geac Computer
This is where two special items come in. First, the company's earnings are understated because of a charge known as "amortization of intangible assets." This deals with the accounting treatment of acquisitions and doesn't represent an expense the company will ever have to pay. The company also has a large cash balance. While a portion must be held to service deferred revenue (where the company has been paid upfront for a service that it will provide later), the remaining cash can go toward buying back shares. These two factors allow the company to look cheap despite the soon-to-increase tax rate.
Let's adjust for the unusually low tax rate and amortization charge to see if the company is still undervalued. To make this calculation using fiscal 2005 earnings, add back the amortization expense ($9.2 million) and apply a conservative 35% tax rate. The higher tax rate would have knocked down the reported earnings to $63 million, from $77 million.
Now consider the company has $188 million in cash and a negligible $4 million in long-term debt. The company needs to hold about 75% of its deferred revenue in cash; this equals just over $85 million. Subtract this from the company's cash balance and conservatively take out another $20 million to service accounts payable. Let's assume the remaining cash -- just over $80 million -- is used for share buybacks. This would reduce the company's market cap to around $665 million. Take this number and divide it by the adjusted earnings from above, and the resulting P/E is just under 11, still very attractive despite the higher tax rate.
Remember that P/E ratios are just a starting point. Calculating the true value means discounting future cash flows to the present. Unfortunately, this is very difficult in the fast-changing software industry. Not only that, but there is increasing competition that could squeeze future margins, as well. The competition ranges in all sizes, from Sap
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Fool contributor Matt Thurmond doesn't own shares of any company mentioned in this article.
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