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3 world-beating ASX small caps to buy today (Part I)

Recently, I wrote about 3 cheap small cap stocks that I believe will comfortably outperform the market over the next five years. One of those picks, Hansen Technologies Limited (ASX: HSN), is a mission critical software developer and benefits from high profit margins, sticky customers and recurring revenues. In a series of three articles I will reveal three more ASX listed software businesses that share these attractive qualities.

Objective Corporation Limited (ASX: OCL) provides document management software to the public services sector and more recently to the financial and healthcare sectors. 80% of its revenue is derived from the Asia Pacific region, with the rest sourced from the growing European segment.

Products

Objective has three key products that are delivered through the cloud. Enterprise Connect Management (ECM) is its main product and allows large organisations to manage all their physical and electronic records. It is responsible for 88% of group revenue and is the only product that is profitable.

The other two newer products are aimed at the financial services and healthcare industries as well as the company’s traditional public sector customer base. Objective Connect is designed to enable secure content sharing and Objective Keystone is used to manage document creation and authorisation. Objective is targeting profitability for these two divisions in the next couple of years which would provide a meaningful uplift to overall profits.

Track record

Objective’s share price has risen 659% in the past five years. Meanwhile, it has paid 14.25 cents in dividends, representing a further 70% return for those lucky enough to pick up shares back then. CEO Tony Walls founded the business in 1987 and still owns around two thirds of the company. This comes as no surprise given plenty of evidence suggests that founder-led companies tend to outperform.

The company has grown revenues from $8 million in 2001 to $50 million in 2015. Meanwhile recurrent revenues are up to $27 million from $8 million in 2006. This has been achieved in part through a strong commitment to R&D to ensure that Objective’s products remain the best on the market.

This strategy continues to pay off. In February, Objective won a contract with the National Blood Authority which selected Objective Connect to help it with its goal of safely supplying blood to Australians. More recently, Objective won a large $10 million contract to deploy ECM to 75,000 users across the Department of Defence’s IT network.

Financials

Profits and revenues fell for the first half of 2016. Revenue was $22.8 million, down from $24.0 million and net profit after tax (NPAT) fell to $1.5 million compared to $1.7 million in 2015. Management stated that the weak first half result was due to a delay in some customer contracts and that it expects profitability to be skewed towards the second half of the year in line with previous periods.

NPAT was $4.5 million in financial year 2015 but free cash flow, defined as operating cash flow less investing cash flow, was much higher at $8 million thanks to a $5.7 million increase in unearned income. In the first half of 2016 free cash flows were $2.9 million, also comfortably exceeding NPAT of $1.5 million.

The company spent 24% of revenues on R&D in the first half of the year and adopts the conservative approach of expensing all this cost rather than capitalising it on its balance sheet. This means that profits may understate the true free cash flow of the business because some of that R&D spend (for example that attributable to new products) should deliver incremental returns in future years.

Valuation

Objective has a market capitalisation of $142 million and had $19.8 million in cash and no debt as at 31 December 2015. Therefore, it trades on a demanding enterprise value-to-earnings ratio (EV/E) of 27 based on 2015 results.

However, if free cash flow is a better representation of the financial performance of the company then the ratio becomes just 15.

My guess is that somewhere in the middle of these two figures is about right. Even if you don’t believe that the free cash flow figure is sustainable, one could argue that some of Objective’s high R&D spend should be attributed to future growth.

A 4 cent dividend payment for this year would imply a dividend yield of 2.6% and Objective is currently operating a share buyback scheme which will help to further improve earnings-per-share (EPS).

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Motley Fool contributor Matt Brazier has no position in any stocks mentioned. The Motley Fool Australia owns shares of Hansen Technologies. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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