Integrated Research Limited (ASX: IRI) Valuation and Updates

Weekly Update: Integrated Research A Strong Buy
Monday January 9, 2012

What better way to get back into the swing of the sharemarket than a pleasing trading update from Integrated Research (ASX: IRI), our very first Share Advisor recommendation?

Integrated Research (ASX: IRI) expects profit for the six months ending 31 December 2011 to be in the range of $3.1 million to $3.6 million, compared to $2.4 million for the equivalent prior period. An increase in IP Telephony licence sales was the main driver.

For those counting at home, that translates into profit growth of between 29 per cent and 50 per cent. Eat your heart out Myer (ASX: MYR).

Pleasingly, the profit was above Dean’s forecast. Yay! It’s also encouraging to see the continued growth in IP Telephony.

As a reminder, the growth in IP Telephony is a large part of our investment thesis. When a company’s fastest growing revenue stream becomes its largest, earnings growth can exceed expectations for many periods as analysts slowly reassess the company. As the following chart highlights, IP telephony is now IR’s largest revenue stream.

IR earnt $5.1 million in the second half of 2011, so trailing twelve month earnings are now in the range of $8.2 to $8.7 million or 4.9 to 5.2 cents, or a P/E of around 10.

IR also announced last week the issue of 1.55 million performance rights with an exercise price of zero — employees can convert these rights into shares at any time before late 2014 for no cost.

It’s always important to keep an eye on the outstanding share count. In IR’s case, shares outstanding have remained constant at around 166 million since 2006. These performance rights represent less than 1% of shares outstanding. So dilution is not a concern.

With the founder and Chairman, Stephen Killelea, owning 57% of shares I am confident the board will continue to act in the best interest of shareholders.

Somewhat surprisingly, IR shares hardly moved today. This fast growing company continues to fly under the radar. At a trailing 12 month P/E of just 10 and dividend yield of 8.4 per cent, IR is a strong buy.

Current valuation 10 Jan 2012
A reverse DCF valuation (discounted cash flow) and a Benjamin Graham style valuation both show that the market is pricing zero growth for Integrated Research (IR). That’s an unlikely outcome.

Selecting the right tools for the job is an important step when valuing a company. With a current price of around $0.48, IR could be considered anywhere from fairly valued to significantly undervalued. My view is it’s undervalued. If you don’t know the best tool(s) to use then a weighted average may be used, discounting the extreme valuations the most.

For a high dividend paying, low P/E, software company with growth opportunities, and strong margins and ROE, my tools of choice are the even ones below (counting left to right).

Wide bars are main valuation range, skinny bars are less likely, outside that range is even less probable. But always remember, less probable happens. I’ll provide a fuller description of the above valuation methods another day, assuming members are interested.

In general, I don’t focus on valuation. It’s simply one step in my investment process. Although valuation can be the main thrust of my picks and is always important, it was not the primary reason for recommending IRI.

Fastest growing revenue stream is now it’s largest

 Multiple revenue streams provide good growth options 

Weekly Update 2 Comments (19 December 2011)

Any subscriber interested in IR or technology more broadly, will enjoy this Foolish podcast. 30 minutes in, Venture capitalist Paul Holland discusses the future of technology. His first pick, Sunnyvale California company MobileIron, is based on its BYOD (bring your own device) software. BYOD and BYOApplication are just one of IR’s growth opportunities.

Subscriber Brian kindly sent us his valuation of IR and supporting files. He used price to sales multiples from recent U.S. software acquisitions to value IR at $1.30 to -$1.90. I heavily discount any valuations that are more than double the current price. The probability of that size mis-pricing is very low, and always dependent on a series of Ifs. But I was biased to like Brian’s relative valuation. My acquisition valuation was also my highest estimate.

While those prices could eventuate if we get two to three excellent halves with strong growth, I’m not counting on that happening. Steady growth is fine by me. With multiple revenue streams and good to exciting product growth profiles, except for HP Nonstop, IR has an excellent risk/return profile.

Here’s Brian’s email, it deserves a larger audience than one.

In October 2011 JP Morgan Chase issued a note on the acquisition of Autonomy by Hewlett-Packard (H.P.) referring to the large premium paid by H.P. In their note JP Morgan quoted the multiples for which previous software deals were transacted. I have attached an extract from Dealbook on this matter. I have applied these multiples to the trailing revenues of Integrated Research for year ended 30 June 2011 and have come up with a valuation per share for their software business of a minimum of A$1.31 and a maximum of A$1.91. This valuation does not take into account revenue from consulting and the net tangible assets of the corporate structure such as cash on deposit. As Integrated Research is a true global company with many blue chip clients I believe these multiples are relevant to the software business of Integrated Research. I have also attached my workings on the valuation of the business.

As you have noted the potential for growth for Integrated Research is substantial. This month Integrated Research will be expanding their communications management tools to support Microsoft Lync which as the Chairman, Steve Killelea, said at the recent AGM “will greatly increase the size of its addressable market.” Taking into account the current value of its global software business and its strong potential for growth the shares in Integrated Research look ridiculously cheap at around 48 cents.

Based on JP Morgan Chase’s quoted multiples, Brian used a price to sales (P/S) ratio of 6 to 8. I think that is a tad ambitious. While great companies or those with great expectations can sport a high P/S, and deep pocketed U.S. tech companies can afford to pay a high multiple, as Brian observed, IR is an Australian software company. As such, it is unlikely to achieve such a high P/S multiple.

The mean EV/Revenue (fancy schmancy P/S) of the Australian tech companies that I follow is 2.4. Applying that multiple to IR gives a value of 64 cents. If growth transpires, then a P/S of 3 to 6 could come into play. IR Currently trades on a P/S of 1.5.

I prefer to focus on the downside and let the upside take care of itself. I’ve found that a focus on the upside fosters the axis of evil emotion, greed. As greed is a more frequent and asset specific emotion than fear, I find it harder to control and therefore, prefer to avoid it.

Disclosure: Dean is long IRI.