Thursday, October 6, 2011

Pros Holdings ( NYSE - PRO ) -- The Price is Right

Pros Holdings (PRO $14.00) is the leading provider of pricing and margin optimization software.  The company's systems combine huge databases with advanced mathematics to help large enterprise customers manage complex product lines.  The technology takes a wide range of inputs into account to set prices dynamically.  In the past many companies could handle pricing decisions without significant computer analysis.  The advent of worldwide competition, commodity price swings, floating exchange rates, and a host of other factors have made those decisions increasingly difficult.  Pros' scientific approach enables its customers to keep pace in a fast changing world so they can better maximize their return on sales.

The company got its start in the airline industry.  That area continues to be its largest segment.  All of the major American carriers have their own pricing systems and are likely to stay beyond Pros' reach.  But the company has been very successful with Far East carriers.  It also handles pricing for several smaller American and European carriers.  Several years ago Pros diversified into the manufacturing, distribution, and leisure industries.  Industrial customers tend to use simpler versions of the company's technology, although their return on investment in Pros' software tends to be at least as high as more transaction oriented users.  At this point the average selling price is in the $2.0 million vicinity.  Pros generates recurring revenue by selling more products to existing customers and by collecting annual maintenance fees which average 20% of the current price.

Margins were crushed during the 2008 recession.  New business dried up.  Add-on sales were scaled down.  But Pros decided to keep moving forward to improve its competitive advantage.  Growth in spending on R&D and sales personnel was maintained at the long term trend line.  Prior to the crash pretax margins were in the 25% range.  Last year they were about half that level.  Now that sales have perked up they are beginning to expand again.

Sales advanced 34% in the June quarter to $23.8 million.  Pros front loaded its sales force expansion this year so costs jumped as well in the period.  Even so, income improved by 80% to $.09 a share.  (See "Accounting Notes.")  International customers represent 60% of sales, so the recent downturn in worldwide economic activity threatened the company's momentum in the September period.  Order rates remained intact despite the storm clouds.  Large corporations generally are well capitalized these days.  Most seem willing to keep investing in products and technologies that produce superior returns.  Demand promises to remain solid even if the macroeconomic picture deteriorates further.  We estimate full year earnings will climb 40% to $.35 a share on a 28% improvement in sales ($95 million).  A stronger performance is possible.

A new cloud computing product recently was introduced.  That "software as a service" offering is aimed at smaller companies.  Pricing will be variable depending on usage but Pros is targeting average annual revenue per customer in the $100,000-$250,000 range.  Performance won't be as high powered as the company's top of the line systems.  But most mid-size customers probably won't require that much firepower.  The actual delivery mechanism might change over the long haul.  It doesn't necessarily have to be cloud computing.  But penetration of the mid-size market could amplify results substantially down the road, no matter how the technology is implemented.

We estimate 2012 earnings will keep rising and finish at $.45 a share (+29%).  Sales could attain $115 million (+21%).  Start-up costs associated with the cloud computing initiative may limit margin expansion.  Pros also has been willing in the past to give customers a break when they encounter tough times.  That's probably going to happen next year so price concessions may also prevent margins from widening to their full potential.  Still, despite the headwinds Pros could top our estimates.  The payback period on the technology is remarkably quick in most cases.  And companies have surplus cash to spend.

The long term outlook is promising.  The cloud computing business probably will keep overall margins from returning to the mid 25% level over the next 2-3 years.  Once it gets established, though, the potential for even greater margins will be created.  Plus, Pros has penetrated only 5%-10% of the potential market to date.  And that market is likely to keep expanding as companies in India, China, Russia, Brazil, and elsewhere scale up.  Maybe they'll have their own mathematicians.  Chances are Pros will capture a big share of the market, nonetheless.

In 2-3 years sales could reach $175 million to produce earnings of $.75 a share.  Applying a P/E multiple of 40x to those earnings suggests a target price of $30 a share, potential appreciation of 115% from the current quote.  Downside risk is moderated by Pros' acquisition potential.

( Click on Table to Enlarge )

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