Focus Stock: A NICE Play in Security Management
As one of the two primary suppliers of enterprise interaction tools and services, NICE-Systems (NICE; $29), should benefit, in our view, from a stricter regulatory compliance environment and a growing need for customer retention tools amid a softening economic climate. We also see a strong growth opportunity related to the company's video security offerings, as government and public agencies shift towards proactive security management given the growing threat of terrorism.
As NICE's analytic offerings are designed to improve business and employee performance and enhance security and public safety, we see its products as somewhat recession resistant. Operating metrics from the 2008 second quarter seem to support our thesis, with the company posting a book to bill ratio above one and a record-high backlog with a value of two quarters worth of potential sales. NICE has also raised its 2008 revenue guidance twice already this year, a stark contrast to peers that are lowering revenue expectations amid declining operating visibility. Moreover, the company continues to hire aggressively, which indicates the need to support future growth opportunities.
We view the balance sheet as strong, with $442 million of cash and investments, or more than $7 cash per share, and no long-term debt. We see strong cash flow generation in 2008 at an average of more than $25 million per quarter, aided by our forecast for higher profitability on increased software sales. We believe the company will continue to use its cash to pursue selective acquisitions, particularly in the security sector, in an effort to expand its geographic presence and increase its client base.
With its expanding customer base and what we see as significant market opportunities, we believe NICE can post sales and earnings growth above peers over the next two years. While we expect the company to ramp up operations and hiring to handle business growth, we believe it can use its operating leverage to expand its long-term operating margins toward the 20% range by year-end 2009, above the peer average.
The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy). Based on our valuation analysis, which is detailed later in the report, our 12-month target price for the stock is $40.
Headquartered in Israel, NICE-Systems is a leading provider of solutions that capture, manage, and analyze unstructured multimedia content. The content includes calls to contact centers and back offices, video captured on closed circuit television cameras, radio communications, e-mail, and instant messaging. Products and related software applications contribute approximately 60% of company revenue, while professional services account for the rest. The company's solutions are deployed at over 24,000 customers, including over 85 of the Fortune 100 companies. International sales accounted for 48% of 2007 revenue, up from 46% in the prior year.
The company's major customer markets include the enterprise segment (75% of sales), made up mainly of financial services, outsourced service providers, and telecom, and the public safety and security segment (25%), which includes air traffic control, homeland security, and public transportation. Within the enterprise segment, solutions can largely be categorized into three value proposition groups: compliance and risk solutions (50% of enterprise revenue), operational efficiency solutions (20%-30%), and customer retention solutions (10%-20%).
Regulatory pressures have increased for corporations and public organizations worldwide driven by both accounting and security concerns. The company's compliance and risk solutions help businesses, primarily contact centers and trading floors, mitigate the risk associated with compliance and fraud. NICE also offers operational risk compliance, fraud detection and anti-money-laundering solutions for financial institutions as a result of its 2007 Actimize acquisition.
Operational efficiency solutions include the company's workforce management software, which helps optimize complex staffing needs, as well as its agent coaching program that materially reduces training costs. We believe these solutions are particularly attractive for contact centers, where approximately two-thirds of costs are employee-related. With the potential to materially lower business costs, NICE's products offer an attractive return on investment for businesses, in our view.
Customer retention solutions provide enterprises with advanced business intelligence capabilities that analyze incoming calls and data for quality assurance checks. Through various types of software, including word spotting, talk pattern analysis, and emotion detection, businesses are able to gain insight from customer interactions, in almost real time, as to what their target markets want and why, and more importantly, what actions to take. We believe an increasing number of enterprises are beginning to realize the strategic importance of analyzing customer interactions at the contact center.
Security products consist of voice and digital video platforms and applications, multimedia logging solutions, and lawful interception products. Products are primarily focused on homeland security, first responder organizations, transportation and law enforcement agencies. NICE enjoys a large installed base of the leading emergency centers around the world that are using its technology. We see strong growth potential for security products, with governments and corporations around the world investing billions of dollars to protect people and assets in light of the increased threat of terrorism.
The company employs an aggressive acquisition strategy to augment its organic growth. During mid-2006, NICE acquired IEX and Performix Technologies, leading providers of contact center performance and workforce management solutions. These acquisitions increased NICE's contact center business by over 30%, significantly adding new top-tier customers and expanding the company's product portfolio. In August 2007, the company acquired Actimize, a provider of transactional risk management software used to detect employee and enterprise fraud patterns. We think that Actimize can sustain 30%-plus sales growth over the next several years, significantly higher than NICE's organic sales growth rate. With these companies already successfully integrated into the company business model, we believe NICE has developed a proven track record for choosing prudent strategic acquisitions and providing real added value to shareholders.
Following an estimated 21% increase in 2008, aided by the full-year inclusion of revenues from Actimize, we see sales advancing 13% in 2009, on increased demand interaction analytics, workforce management, and legacy recording solutions, as well as strong video solution sales in the public safety and security market. We see the company benefiting from the proliferation of voice over Internet Protocol (IP) technology and the subsequent growth of IP-based communication interactions that will need to be recorded for compliance and security reasons. With a strong and growing backlog, we believe the company's sales visibility remains strong.
We forecast 2009 gross margins widening moderately from the prior year, to past the 65% level, reflecting an increase in higher-margin software sales, partly offset by industry pricing pressures. By our analysis, the company continues to execute on its operating targets despite continued U.S. dollar weakness vs. the Israeli shekel due to prudent hedging and tight expense control. We see 2009 operating expenses as a percentage of sales declining on the higher sales volume, as well as lower legal costs following the resolution of a patent dispute with rival Verint (VRNT.PK: Not Ranked; $22) in August 2008.
We believe the company can meet its long-term target for 20% operating margins by the end of 2009. Following higher interest income and taxes at a 20% rate, we project 2009 earnings per ADR of $2.05, up 21% from the $1.70 that we estimate for 2008.
Our 12-month target price of $40 is largely based on a forward price-earnings-to-growth (PEG) ratio of 1.1 times, in line with peers, using our three-year projected EPS growth rate of 18% for the company and our 2009 earnings per ADR estimate of $2.05. Our target price translates to a price-earnings ratio of 20, which represents an approximate 20% discount to the stock's median p-e multiple experienced over the past several years. We think the stock's current multiple will expand as NICE continues to exhibit strong execution and earnings growth in this difficult economic climate.
Our target price also translates to 2.5 times our 2009 sales per share estimate, slightly above peers, warranted, in our view, by NICE's above-industry-average gross and net margins. On a price-to-EBITDA basis, however, the stock trades at a notable discount to peers, despite our view of its impressive profitability ratios. Book value stands at roughly $18, albeit with more than half of this value represented in intangible assets.
We have a favorable view of NICE's corporate governance practices. The company's board of directors consists of seven persons, who, in our opinion, bring experience and diversity to the company. We view positively that the full board of directors and both the audit and compensation committees are comprised solely of independent outside directors and that there were no "related party" transactions.
We think that the company's executive compensation philosophy appropriately balances the business environment with the need to effectively attract and retain a high-caliber management team. During 2007, the aggregate compensation paid to or accrued on behalf of all directors and executive officers as a group, which comprised 21 persons, consisted of approximately $5.1 million in salary, fees, and bonus.
Risks to our recommendation and target price include a weakening enterprise spending environment, integration issues related to recent acquisitions, homeland security spending delays, higher expenses associated with fluctuations in the Israeli shekel, and the loss of a major distribution partner. In addition, given its location in Israel, any political instability in the Middle East could potentially disrupt business operations.