Valuing shares of Cognos (NASDAQ:COGN) is tough. The company sells business intelligence software that is supported and upgraded by tens of millions in research and development costs every year. While Acme Brick doesn't worry about a competitors' upcoming release of "brick version 2.1," software can upgrade in the blink of an eye, and new technology can kill future cash flows. Fast-changing industries aren't my preferred investment, but for those who can't get over the excellent economics and high growth, this company is worth a look.
Much like Geac Computer (NASDAQ:GEAC), a software provider I covered earlier this week, Cognos is based in Canada and trades on both the Nasdaq and the Toronto Stock Exchange. The company has more than 23,000 customers ranging from Boeing (NYSE:BA) to 7-Eleven (NYSE:SE), and competes with formidable competitors like SAP (NYSE:SAP) and Oracle (NASDAQ:ORCL).
The first half of the decade has been good to Cognos; revenues have grown at a compounded rate of 16% over the last five years. In its first-quarter report released last week, the company said its revenue growth was only slightly lower, at 15% over Q1 of FY 2005. Operating income was worse, however, with less than 1% growth due to a lower gross margin. Net income jumped 18% quarter over quarter, but this was mostly due to an abnormally low 12.2% tax rate.
At the end of the quarter, the company had $496 million in cash on the balance sheet and no debt, almost ensuring that management will be looking to acquire smaller software companies. During the last three fiscal years, Cognos has generated $377 million in free cash flow (operational cash flow minus capital expenditures and additions to intangibles and other assets) and spent $206 million on acquisitions. This is a significant investment for the company and an important factor in valuing the shares. If the company overpays, investors pick up the tab.
While valuing the company's ongoing acquisitions can be difficult, predicting the future of the industry is much harder. An investment at the current price point offers more of a high-risk, high-reward scenario. Cognos can reap huge cash flows from sales, but it's tough to predict what those will be 10 years from now. While some have a knack for the software industry through unusual insights or experience, many investors should avoid it. The potential for high growth is there, but the prospect of increasing competition or new technology brings a sobering downside.
Fool contributor Matt Thurmond doesn't own shares in any of the companies mentioned in this article.
