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A Good Story for Open Text

By Scott Kessler The amount of data and other electronic information generated by businesses, governments, and institutions has grown to mind-boggling proportions. And organizing all of it is quite a job -- as is ensuring that users can employ it effectively. In Standard & Poor's opinion, content management has become an increasingly important element of software infrastructure. And we think Open Text (OTEX

; recent price, $37), a leading developer and provider of collaboration and content-management software and services (often simply referred to as enterprise content-management, or ECM), is poised to extend its lead in this key segment.

We believe Open Text is a compelling investment opportunity, based on its leadership in what we consider the attractive areas of collaboration and content-management solutions, proven ability to gain market share through sales efforts and acquisitions, and our view of its appealing valuation based upon our methodology, detailed below. The stock carries the highest ranking from S&P's Equity Research Services: 5 STARS, or buy.

Open Text's collaboration software enables users to communicate and work together on projects regardless of their location or affiliation. The main functions generally include managing and sharing files, assigning and coordinating tasks, and maintaining team and project information.

WHERE'S THE INFO? Large global enterprises with employees dispersed throughout different offices and countries are finding that promoting more efficient collaboration enhances productivity -- and the quality of work produced. In addition, companies are continuing to look for ways to work better with their partners, suppliers, and customers.

Businesses produce massive amounts of info, the volume of which is increasing at an astounding 200% per year, according to one ECM software company. Much of this content is lost or misplaced, and often must be completely recreated. Typical knowledge workers spend about 40% of their time just looking for the information necessary to do their jobs, according to the same ECM outfit.

As a result, in S&P's opinion, content-management solutions have become an increasingly important element of software infrastructure, not only to better organize information but also to enable companies to comply with new regulatory requirements for storing and accessing certain types of content (such as broker/client communications and medical records).

FASTER GROWTH. Content management accounts for both structured data (which can be managed by a relational database and fits into rows and columns) and unstructured information (such as documents, photographs, presentations, Web sites, e-mail, instant messages, and audio recordings). S&P estimates that unstructured content constitutes about 80% of most organizations' info.

We believe growth in Open Text's primary markets -- collaboration and content-management software -- will notably outpace that of the overall software industry over the next several years. Market research firm IDC has forecast that worldwide revenues for collaborative applications will increase from $396.5 million in 2003 to $651.5 million in 2006 -- an average annual growth rate of over 21%. Content-management software revenues are expected to rise from $3.2 billion in 2003 to $4.6 billion in 2006, accounting for yearly growth of 15%.

In the aggregate, IDC projects that revenues from collaboration and content-management software will increase at over 15% per year over the next three years. We believe these estimates might prove quite conservative, and we expect growth closer to 18% to 20% from 2003 to 2006.

BIG GERMAN DEAL. According to IDC, Open Text was the world's leading collaborative software vendor (by revenues) in 2002, with a market share of 28.1% -- more than double that of its closest competitor. It was also one of the top 10 content-management software vendors. We believe Open Text's acquisitions of portal-software company Corechange in February, 2003, and rich-media (content which may include graphics, animation, and sound, and is often interactive) presentation company Eloquent in March, 2003, have contributed to market-share gains this year.

And we think its pending purchase of German Web-content and business-process management firm Gauss Interprise will continue that trend. We expect the Gauss transaction, valued at $11 million in cash, to close in the fourth quarter, pending necessary regulatory and shareholder approvals.

Open Text's flagship product is Livelink, which enables users to find and retrieve digital information, work together in creative and collaborative processes, perform group calendaring and scheduling, and distribute or make available to users various types of content (across the Internet or other networks). The company believes that Livelink is the only software available that provides a comprehensive and fully integrated collaboration and knowledge-management platform for major global companies. The latest version, Livelink 9.2, was released in August. Later that month, Open Text announced its agreement to buy Gauss to broaden the software's capabilities.

SAVVY ACQUIRER. We believe Livelink is distinguished from competing products because it's built for the Internet (with resulting advantages in scalability) and is easy to install and customize (which could contribute to a quicker return on investment for customers). Open Text also offers consulting, training, and technical-support services to enhance the easy implementation of its software.

We also anticipate that Open Text will continue to successfully pursue acquisitions to broaden its technology base, enhance its product offerings, and strengthen its sales and customer-support capabilities. It has proven to be a savvy acquirer and effective integrator of smaller companies over the past few years, in our opinion. Many attractive opportunities are still available for purchase, in our view, given the fragmentation of its markets and notable operational and regulatory challenges faced by some of its competitors.

Gauss Interprise is a good example of that, in our opinion. Its appeal included its Web-content and business-process management technology and 1,100 clients, including carmaker BMW and newspaper USA Today. However, Gauss had been losing money and burning through cash, causing customer concerns. We recently valued the pending acquisition at only about half our estimate of the German company's 2003 sales, which is a significant discount from the average of its peers, which include Interwoven (IWOV

; S&P rank 3 STARS, hold; $3), Stellent (STEL

; $9), and Vignette (VIGN

; $2). In our view, this transaction would not only enhance Open Text's solutions and customer base but also be accretive to earnings in relatively short order.

STEEP DISCOUNT. Standard & Poor's Core Earnings estimates for Open Text are $1.01 for fiscal 2004 (ending June) and $1.36 for fiscal 2005. These forecasts reflect estimated stock-option expense under accounting standard SFAS 123 of $8.9 million in fiscal 2004 and $9.6 million in fiscal 2005. We expect the impact of stock options as a percentage of net income to continue to decline. The company doesn't maintain a defined-benefit plan, so it has no pension-related expenses.

Despite the promise of ECM solutions and Open Text's recent quarterly results, which have been encouraging, in our opinion, the stock trades at steep discounts to its competitors, as well as the S&P 1500 Internet Software & Services and S&P 1500 Software industry indexes.

We anticipate that Open Text will be able to post revenue increases averaging 20% annually over the next three years. Despite modeling for a higher corporate tax rate in fiscal 2004 and 2005, we conservatively anticipate that EPS gains will be at least on par with this revenue growth projection due to notable expected margin expansion and only modest growth in the number of shares outstanding.

TWO TARGETS. Based upon our adjusted calendar year 2003 EPS estimate (which excludes amortization of acquired intangibles and investment gains or losses) of $1.40, Open Text recently had a price-earnings ratio of 26 and a p-e-to-growth rate (PEG) ratio of 1.3. In comparison, recent averages for the other ECM companies we cover, Documentum (DCTM

; 3 STARS; $21), FileNet (FILE

; 4 STARS, accumulate; $20) and Interwoven, were 75 for p-e and 3.6 for PEG.

The S&P 1500 Internet Software & Services Industry recently had a p-e of 68 and a PEG of 2.1. The S&P 1500 Software Industry recently had a p-e of 27 and PEG of 2.1. If Open Text traded at the recent PEG ratios of the S&P 1500 Internet Software & Services and S&P 1500 Software Industries, which happened to be the same, its stock price would be $59.


discounted cash-flow (DCF) model's assumptions include weighted average cost of capital of 14.7% and growth trending down gradually from 39% in fiscal 2004 to 24% in fiscal 2008. Based on our DCF analysis, the stock's intrinsic value is around $47 per share.

Based upon relative and intrinsic analyses, weighing our DCF conclusions more heavily, our 12-month target price for the stock is $50. We expect the shares to materially outperform the S&P 500 over the next 12 months.

RISKS REMAIN. We believe the stock trades at a substantial discount to its competitors, peers, and our target price in part because Open Text is based in Canada and isn't heavily followed in the U.S. However, we think its p-e multiple will expand as it continues to execute its business plan and achieve or even exceed its operating targets, and gains recognition for doing so.

Our projections, target price, and investment opinion entail risks. In our view, they include the following possible scenarios: disappointing or nonexistent economic growth in the U.S. and abroad, weaker-than-expected demand for Open Text's offerings due to a lower rate of recovery in technology spending, increasing competition in the form of development or acquisitions from much larger companies, such as IBM (IBM) and Microsoft (MSFT), and failure to effectively integrate recent acquisitions. Analyst Kessler follows Internet software & services and Internet retail stocks for Standard & Poor's Equity Research Services

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