RealMoney Silver - PMTC Looks Cheap, But for Good Reason

PMTC Looks Cheap, But for Good Reason
By Bill Trent
RealMoney.com Contributor
11/6/2007 11:07 AM EST

Parametric Technology (PMTC) develops software used for product lifecycle management and enterprise content management. With a P/E of approximately 15 times and a 5.3% free cash flow yield, Parametric appears cheap relative to other technical software developers.

However, its earnings quality has historically been low and it faces more severe competition than some of its peers. With earnings quality improving and the valuation favorable, Parametric certainly bears watching. But for now, Dassault Systemes (DASTY) and Ansys (ANSS) have sufficiently better prospects to justify their higher valuations.

Compared to companies like Ansys, which develops highly technical products and has relatively few competitors, Parametric has significant competition in each of its business segments.

PLM competitors include Dassault, Siemens (SI) subsidiary UGS, Autodesk (ADSK) and Agile Software. The company also competes with larger enterprise-solution companies such as SAP (SAP) that have entered the PLM market and offer solutions integrated with their other enterprise software applications.

Competitors in the ECM space include EMC's (EMC) Documentum, IBM's (IBM) FileNet and OpenText (OTEX) .

Parametric suffered mightily during the tech downturn, but the company has been engineering a turnaround since 2004 based on improved profitability and a return to growth. Current consensus growth estimates for the next five years are just 7%, or half the rate expected for the industry.

The lower growth estimates are part of the reason for the cheaper valuation. However, they also make for a lower bar to clear, and the recent reversals of its deferred tax valuation allowance are a signal that the company is likely to earn sufficient income in future years to use tax losses from prior periods.

There are a few other issues that cause me to believe Parametric's low valuation is justified. For example, 58% of revenues are derived in North America, which faces an uncertain near-term economic outlook.

Another issue is earnings quality. Gross margins have been declining due to a higher percentage of revenue being derived from consulting and training rather than license and maintenance revenue. A bad-debt charge-off in 2006 and increased customer financing activity are other signals that earnings quality may be low.

To get a feel for overall earnings quality, I calculated the accrual ratio, or the change in net operating assets divided by average net operating assets. This ratio describes the percentage of earnings contributed by discretionary accounting items rather than actual cash flows. An ideal accrual ratio would fluctuate around zero. Parametric's has been all over the map, though it has been improving for several quarters.

Source: Zacks Research Wizard, William A. Trent

If Parametric continues to improve its earnings quality, or if it gives back some of the stock gains it enjoyed post-earnings (or preferably both!), it could become an attractive buy candidate. In the meantime, interested investors may find an option play worthwhile.

The January $17.50 puts were trading recently at a bid-ask of 50 cents and 75 cents. If you could write the option for 60 cents, it would offer a 3.1% return over 2½ months on the money at risk, which annualizes to nearly 15%. You'd be forced to pay $17.50 for the shares if they drop between now and then, but the option premium would give you an effective price of just $16.90. At that price, the 6% free cash flow yield would probably be enticing enough to justify a buy anyway.