Progress Software - A GARP Story With No "Guh"

By Stephen D. Simpson, CFA | January 06, 2012 AAA

On more than one occasion, I have joked that so-called growth at a reasonable price (GARP) investors eventually have to choose sides and go with the "guh" (that is, growth) or the "arp" (value discipline). That's especially true in technology, where investors are not all that often interested in rewarding value-priced stories that lack growth. With that in mind, Progress Software (Nasdaq:PRGS) can indeed claim that these shares are undervalued, but without a better growth trajectory it may just not matter.

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No Growth This Quarter
Progress Software is in the middle of a business transition, but the new growth opportunities are not materializing fast enough to offset the erosion in older platforms. Revenue fell 6% this quarter, with a 14% drop in license revenue (essentially new business). Worryingly, the company's sizable maintenance revenue saw a 1% decline.

With no top-line momentum, operating leverage is cutting the wrong way. Gross profits fell 8% this quarter, and operating income plunged 42%, even though the company had lower "one time" expenses this quarter. General and administrative expenses (G&A) were up 19% and product development spending was down 7%. Simply put, spending more on the home office and less on new products in an environment where the traditional business is sagging badly just doesn't seem like prudent management. (For related reading, see Operating Leverage Captures Relationships.)

Worrying About the Maintenance
For some time now, Progress Software bulls could base part of their investment thesis on the company's sizable maintenance revenue streams. This is basically an annuity that the company can reap from its installed base and its largely consistent, captive revenue - until or unless the client switches away from Progress platforms.

To that end, the 1% drop is disturbing. Does this mean that Progress has lost enough business to rivals like IBM (NYSE:IBM), Oracle (Nasdaq:ORCL), Microsoft (Nasdaq:MSFT) and TIBCO (Nasdaq:TIBX) that it has finally started chewing up this lucrative stream? It may also be a symptom of increasing penetration from open source rivals like Red Hat (NYSE:RHT) or Apache where the argument can be made that switching costs are low (since open source providers basically give away the software) and the maintenance costs are similar.

Waiting for the Transition to Pay off
Progress is in the midst of trying to transition away from the shrinking Application Development Platform (ADP) business and towards a more enterprise solutions-oriented product suite. This makes sense. Enterprise solutions is a growth market and there is certainly a need for real-time visibility into core processes in industries like finance, e-commerce and transportation.

Unfortunately, everybody else knows that too. Most of the rivals that are chewing up Progress' tailing revenue in ADP (Oracle, IBM and Microsoft) are also moving into this market as well, and more nimble rivals like TIBCO and Informatica (Nadsaq:INFA) are growing substantially faster. Although Progress has made some sound decisions on the M&A front, the risk is that it may be too little too late. (Hopefully by reading this article you are at least a bit wiser in the wacky world of M&A terminology. For more, see Mergers and Acquisitions: Understanding Takeovers.)

The Bottom Line
Progress management offered guidance for the next quarter that was about 10% below where the analysts had been (and there are relatively few analysts following this name) and about 10% below the prior year's level. While Oracle recently indicated that they were seeing tougher times in the IT market, the fact is that Progress' old business is eroding faster than they can build up the new.

Any value in Progress Software shares is predicated on growth. If the company maintains this past fiscal year's free cash flow margin but sees ongoing 5% revenue erosion hereafter, the stock is worth about $13.50 - well below today's price. Admittedly, it takes only mid-single-digit revenue growth assumptions to drive a more compelling target, but at this point it seems unlikely that investors will flock to this name absent some reignition on the top line.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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