Last week we used Computer Programs and Systems (CPSI, Financial) as a company with a “market” moat as well as corporate moat. The day the article was published CPSI issued its fourth-quarter earnings and the stock dropped by 14% in one day. Ramimarciano wrote later that day – quite correctly – that anyone serious enough to listen to me was down a significant amount. And we truly understand where he/she was coming from. Nothing is as frustrating and mortifying than purchasing and recommending a stock and then have it drop significantly on the same day. Talk about humbling. There aren’t enough corvus brachyrhynchos for such a pie.
That said I replied to Rami with the following statement:
"As a long term value investor we would look at a one day return (either up 14% or down 14%) as an interesting data point – nothing more or nothing less. How Wall Street reacts to corporate earnings is their own interpretation and response. We simply look at our assumptions and test to see if our investment thesis is still valid.”
I thought we would take this week’s column to do just that – test to see if our investment thesis is still valid and explain why we purchased additional shares after the price drop.
Our investment thesis
When we first discussed CPSI we commented the company represented a true compounding machine. To put more meat on the bones of such a statement, our thesis was represented by the following facts and assumptions (in December 2014):
- At a price of $61.58/share we believed the company was trading at roughly an 18% discount to fair value. Our assumptions were for 8% growth in 2015, 9% growth in 2016 and 10% growth from 2017-2024.
- The company had a return on capital of 58%, return on equity of 51% and return on assets of 39%. Average weighted cost of capital was 8.3%.
- The company had no debt, cash and short-term securities of $34.5M and free cash flow of $25.4M.
- Gross margins were 46%, net margins were 16% and the PEG ratio was 1.08.
- The company paid an annual dividend of $2.28 per share which came to a roughly 3.8% yield.
These five assumptions/facts were the essential framework for our investment case. Combined with the market evaluation as outlined in last week’s article (“Analysis of a Market Moat”) we believe CPSI represents a great long-term investment that should produce adequate returns to our investors.
A reappraisal of our investment
After the fourth-quarter earnings call (and Ramimarciano’s succinct review), we wanted to test our key assumptions and review our valuation of the company. I thought it might be best to review the five criteria listed above and see if the initial investment thesis is intact.
Valuation
The fourth-quarter call altered our financial estimates in one very particular way – our estimates for 2015 are too high and we will reduce these to reflect delays caused by MU2 delays. On the conference call CFO David Dye explained:
“Our full year financial guidance for 2015 calls for gross revenues of $196 million to $206 million and net income of $2.62 to $2.77 per share. This guidance is based on a 25% to 30% year-over-year decline in system sales, a 7% increase in support and maintenance and a 15 plus percent increase in TruBridge revenue. In 2016, we anticipate resuming year-over-year growth in system sales revenue along with continued growth in support and maintenance in TruBridge revenue, which as a result of continued expense controls would result in a 10% to 15% top-line and a 20% to 25% bottom-line growth in 2016 over 2015”.
In regards to our long-term estimates for revenue and free cash flow growth, CFO Dye added:
“As we have stated many times since going public in 2002, our primary financial focus is on long-term growth. As such, we strived to grow both the top and bottom lines of our company at a compound annual growth rate of 10% over any 5- and 10-year period. Inclusive of 2014, our 10-year gross revenue in EBITDA CAGR is 9% and 15% respectively and our five year revenue in EBITDA CAGR is 10% and 16% respectively. While we are disappointed in our 2015 outlook, we are confident that with resumed growth in 2016 and beyond, CPSI will experience the same positive long-term result over the next 10 years, but we enjoyed over the previous decade.”
Utilizing these estimates we reduced our model to reflect 2% growth in 2015, 6% growth in 2016, and 10% growth for 2017-2024. Utilizing a 10.5% average cost of capital (significantly higher than its current 8.5%) and a 3% terminal growth we reduce of estimated intrinsic value from $75 per share to $71 per share. At a current price of $50.38 as of February 4, 2015 this represents a roughly 28% discount to fair value.
Corporate Returns
We expect some margin compression in 2015 as revenue slows down and is not matched by cuts in the cost structure. CEO Boyd Douglas pointed out the company has never laid off any staff and it has absolutely no intentions to do so in the future. They are willing to invest for the long term even if this means forgoing short-term earnings numbers. Management plans to continue spending in areas of future growth that may have little or no short term impact on the revenue side. Accordingly, we estimate gross margins to decrease to 41% in 2015 before ramping back up to 43% in 2016 and 45.5% in 2017. Net margins will correspondingly decrease in our estimates to 11% in 2015 before bouncing back to 13% in 2016 and 16% in 2017. Return on equity and return on assets are expected to dip to 35% and 27% respectively in 2015 before rising to 44% and 33% in 2017.
Corporate Financials
We expect the company will remain debt free through 2024 while boosting its cash position from $40M in 2015 to $55M by 2020. We estimate free cash flow to be stagnant in 2015 at roughly $35M and rise to $89M by 2024.
Corporate Dividend
On the conference call the company announced it was raising its dividend from $2.28/share to $2.56/share (a 12% increase) bringing its yield to roughly 5.1% as of February 4, 2015.
Conclusions
CPSI represents a company we love to hold for the long term. Its fourth-quarter earnings call produced a 14% drop in valuation when in our model it decreased our estimated intrinsic value by only 9.5%. Add this to the fact we believe the company was already trading at an 18% discount to fair value and you get a fantastic company trading at a very cheap – and discounted – price. Accordingly we added to our position by 20% on Monday, February 22nd, 2015.
Monday’s call – and its new estimates for 2015 – do nothing to break the investment thesis for the company. Still sporting a free cash flow yield of 12.5%, a PEG of 0.97, a yield of 5.1% combined with no debt and a significant market moat, we see CPSI generating more than adequate returns over the long term.
Value investing is never a linear activity. We expect our investments to increase and decrease over the short term. If our investment thesis is intact and the stock drops significantly, it is likely we will add to our investment. Ultimately we will be measured on whether we bought low and sold high (or held for even higher) and created profits in excess of a general index fund. Purchasing CPSI at a discount to fair value – and averaging down our purchase price will – in our estimate – produce such results.
As always we look forward to your thoughts and comments.
