"Value" is perhaps the most baggage-laden word in the investment dictionary. Far too often, value is equated with words like: "slow," "boring," and "old." Worst of all, those descriptors are thought to apply both to value companies and value investors!
Why is that? Probably because, in the investment community, value is forever being labeled as the opposite of growth. This is a sad distortion of the truth. (Thanks a lot, mutual fund marketers!) In reality, growth is a component of value -- and a darn good one.
Today, I'll show you how a fast-growing company can actually be a "value stock." Our specimen is Quality Systems
To briefly review, Quality Systems helps medical practices scrap paper files and manual systems, replacing them with computer automation. This software automates not just the administrative back office, but also the exam room -- computerizing everything from appointment scheduling to medical records.
In essence, Quality Systems offers a complete electronic overhaul of everything that happens in a doctor's office. The benefits include lower costs, reduced risk of error, greater ability to capture all chargeable revenue, and improved quality of care for patients. It's why, as I've explained over the past two weeks, electronic medical record (EMR) software is in hot demand.
Sparkling financials, reasonable multiples
The rising demand for Quality Systems' software is immediately evident in its financial statements. In calendar 2002, the company earned revenue of $51.7 million, up 19.8% over the year prior. Most of this growth comes from the company's medical subsidiary, NextGen, which last year grew 33% and accounted for two-thirds of overall revenue. The other subsidiary, QSI (dental), is a great cash cow but basically isn't growing. The upshot, however, is that with each passing quarter, the medical business is becoming a larger and larger percentage of the overall company, which, in turn, accelerates Quality Systems' overall growth rate.
Another important aspect of Quality Systems' growth is that as the client base grows, so does the company's stream of reliable, recurring maintenance revenue. Each year, existing clients pay Quality Systems a fee for ongoing service and updates. In 2002, software maintenance fees were about 47% of total revenue.
The company's high-margin software revenue translates into significant free cash flow (FCF). In 2002, Quality Systems generated FCF of $8.85 million, or an outstanding 17.1% FCF margin. The company has no debt, so all this cash flow is rapidly piling up on the company's balance sheet -- to the tune of $33.1 million, as of year-end '02. A cash hoard like that produces a good bit of interest income, but even backing that out, Quality Systems generated $8.41 million of FCF purely from operations.
Turning to some basic valuation multiples, at Friday's closing price of $23.43, the company carried a market cap of $150 million. Backing out the cash from the market cap, you get an enterprise value (EV) of $116.9 million. Taking that figure divided by pure operational FCF of $8.41 million (so as not to double-count the value of the cash), you get an EV/FCF of only 13.9. That's a tidy 25% discount to the comparable S&P 500 P/FCF of 18.6.
What's the growth potential?
Such a low EV/FCF is a strong signal of value. But to really figure out how much value, we need to assess Quality Systems' growth potential -- specifically, the growth outlook for the NextGen (medical) subsidiary, which is benefiting from the strong industry-wide growth in electronic medical records (EMR).
Only recently has EMR technology become a mainstream consideration for private physician practices. Doctors are a careful bunch, and thus understandably reluctant to shell out big bucks for technology. With Quality Systems' average package running about $250,000, it's currently a feasible investment only for larger physician practices, meaning those with 10 docs or more. How big a market is this? Pretty big -- an estimated 4,779 practices by 2005 (according to company estimates).
Let's crunch some numbers here, and try to figure out the peak size of this market for NextGen. Here are my assumptions:
- Full market adoption in 10 years from now, 2013.
- No growth in the number of large physician practices after 2005 (constant 4,779).
- Average replacement cycle of 10 years.
- Peak market adoption by large practices of 90%.
- Quality Systems' peak market share of 70%.
- Average system price of $250,000.
- Annual maintenance revenue equal to 15% of annual revenue (per company estimates).
I've tried to be neither overly conservative nor overly aggressive in these assumptions. Probably the most debatable among these, however, is my belief that NextGen will eventually capture 70% of its market. That sounds aggressive. But keep in mind that Quality Systems is already the leader in the large-practice physician market. Also, technology markets are notorious for eventually consolidating around a single leader. That's basically the gist of why I think 70% market share is feasible for the current leader.
Putting all these assumptions together leads to estimated 2013 NextGen revenue of $188 million. That would be five-fold growth over the next 10 years, or 18.5% annually. Based on my study of the industry, that doesn't seem unreasonable.
So that's my 10-year growth assumption for the NextGen division. My assumption for the QSI division is for continued flat revenue. Layering those two together -- 18.5% annually for NextGen and 0% annually for QSI -- my estimate for overall company growth comes to 13.6% from 2003 to 2008, and 16.0% from 2009 to 2013. (The reason the growth rate accelerates is because as NextGen grows, it exerts a larger and larger influence on the company's overall growth rate.)
Beyond 2013, any estimates of growth are a shot in the dark, so I aim to be extra conservative. My assumption is for 5% growth from 2014 to 2023, and 3% thereafter.
One final word about these growth estimates: I'm assuming that free cash flow will grow at the same rate as revenue in all periods. If anything, this could prove conservative, as software economics typically allow for higher margins as the business grows.
Translating growth potential into fair value
OK, we now have all the necessary figures at hand to calculate an estimate for Quality Systems' fair value. Using a discounted cash flow (DCF) model, I start with base FCF from operations of $8.41 million, or $1.31 per share. From there, the key inputs are as follows: the growth rates I just outlined, a discount rate of 11%, and estimated annual stock option dilution of 2.5% for the next 20 years.
Tapping those numbers into my model, I come up with business value of $31.22. To that, I add cash per share of $5.18, which sums to a total fair value of. drum roll. $36.39. That's more than 50% higher than Quality Systems' current price. (For a detailed explanation of these steps, see Nine Steps to Valuation.)
When it comes to DCF-based estimates of fair value, I sometimes like to do a gut check by looking at the implied EV/FCF multiple. In this case, that's business value of $31.22 divided by FCF from operations of $1.31 -- a multiple of 23.8. That's a modest 28% premium to the S&P 500. For a young software company with lots of growth ahead, that doesn't seem too out of whack.
Is there a margin of safety?
So, we've established that the upside potential here is excellent. But what's the risk if my growth assumptions go up in flames? That's another way of asking, what's the margin of safety? To answer that, I like to reverse-engineer a company's valuation and see what type of growth is baked into the current price.
The process here is just the opposite of the DCF exercise we just went through. But this time, instead of inputting growth rates and then seeing what fair value emerges, we input the current stock price and see what growth rates are necessary to justify it. When I do this for Quality Systems, I find that growth over the next 10 years only needs to average out to 7% annually (assuming the same 5% rate for 2014 to 2023 and 3% thereafter).
What does this mean? As long as the company pumps out FCF growth of at least 7% annually, the stock's value won't be in jeopardy. That's not too tall a hurdle, in my opinion.
Matt Richey ([email protected]) is a senior analyst for The Motley Fool. At the time of publication, he held shares of Quality Systems. For Matt's best stock ideas and exclusive in-depth analysis each month, check out our newsletter, The Motley Fool Select , where Quality Systems was originally presented in June 2002. The Motley Fool is investors writing for investors.
