NICE Ltd. (NICE) is an Israel-based company producing solutions for enterprise Contact-Center-as-a-Service (CCaaS) and financial crimes and compliance. NICE is one of those quiet dependable stocks that don’t get much attention. The last Seeking Alpha article targeting NICE was written in January by myself. Before that this precious company hadn’t been covered since 2017. This company hasn’t disappointed, with its stock price up 13% since my previous article publication versus the S&P 500 change of -8%.
(Source: Seeking Alpha)
I must confess that NICE isn’t one of my favorites in terms of high-growth stocks, but revenue growth, strong free cash flow, and strong balance sheet with $480 million in cash and cash equivalents will keep this company going throughout the pandemic and even a prolonged global recession. In addition, NICE, unlike many other CCaaS stocks, has a reasonable valuation. Therefore, I feel that a bullish rating is appropriate.
NICE is Breaking Out
NICE is a stock on the move with a recent breakout to an all-time high in spite of the shaky start to the week for digital transformation stocks. NICE is up more than 50% in two months, from ~$110 to a recent $185.
(Source: Yahoo Finance/MS Paint)
Certainly, with guidance withdrawn, it is impossible to predict how NICE will perform for the remainder of 2020, but the company has a strong balance sheet and good free cash flow. NICE should be in good shape once the pandemic scare subsides and global growth restarts.
The Rule Of 40
One industry metric that is often used for software companies is the Rule of 40. The rule provides a single metric for evaluating both high-growth companies that aren’t profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule. Analysts use various figures for profitability. I use the free cash flow margin.
The rationale for the Rule of 40 is as follows. If a company grows by more than 40% annually, then you can tolerate some level of negative free cash flow. But if a company grows by less than 40%, then it should have a positive free cash flow to make up for the less-than-ideal growth. This rule accommodates both young, high-growth companies as well as mature, moderate-growth companies. The 40% threshold is somewhat arbitrary but typically divides the digital transformation stock universe in half, separating the best stocks from the so-so ones.
For a further description of the rule and calculation, please refer to a previous article I have written.
The two factors required for calculating the Rule of 40 are revenue growth and free cash flow margin. NICE’s annual revenue growth is 8%. The company’s TTM free cash flow margin is a decent 20%.
(Source: Portfolio123/MS Paint)
Therefore, the Rule of 40 calculation for NICE is as follows:
Revenue Growth + FCF margin = 8% + 20% = 28%
Its score is lower than the necessary 40% needed to fulfill the rule of thumb, suggesting that this company has work to do to achieve a healthy balance between growth and profitability. The Rule of 40 is a rule of thumb and not an absolute criterion. When a company fails on this metric, I like to examine the SG&A expenses in order to get a feeling as to whether the company is living beyond its means.
NOTE: The SG&A expense margin includes R&D expenses.
In the case of NICE, the SG&A expense margin is 48% of revenue intake. This level of expense is quite reasonable and suggests a high level of maturity for a growth stock. I believe that NICE isn’t spending an excessive amount of money or excessively issuing SBC. NICE is well-positioned for the pandemic and recession.
There are numerous techniques for valuing stocks. Some analysts use fundamental ratios such as P/E, P/S, EV/P, or EV/S. I believe that one should not employ a simple ratio, and the reason is simple. Higher-growth stocks are valued more than lower-growth stocks, and rightly so. Growth is a significant parameter in discounted cash flow valuation.
Therefore, I employ a technique that uses a scatter plot to determine relative valuation for the stock of interest versus the remaining 150+ stocks in my digital transformation stock universe. The Y-axis represents the enterprise value/forward gross profits estimate, while the X-axis is the estimated forward Y-o-Y sales growth.
The plot below illustrates how NICE stacks up against the other stocks on a relative basis based on forward gross profits multiple.
(Source: Portfolio123/private software)
A best-fit line is drawn in red and represents an average valuation based on next year’s sales growth. The higher the anticipated revenue growth, the higher the accepted valuation. In this instance, NICE is positioned slightly above the best-fit line, suggesting that the company is modestly overvalued on a relative basis relative to its peers, but is not so far overvalued to prevent giving the stock a bullish rating.
There are several risks that investors should consider before investing in NICE. First of all, I view the current stock market action to be reminiscent of the Dot.com era, immediately prior to the crash starting in 2000. Back then, I quadrupled my investments in a few months. Technology stocks were hopping. But it wasn’t long before the market turned into a disaster, and the same could happen here.
While NICE is not vastly overvalued, some of its software peers are. Companies such as Zoom (ZM), Shopify (SHOP), Atlassian (TEAM), and Coupa (COUP) are extremely overvalued. These high stock valuations could lead to a market crash and NICE would likely get swept along with the crowd.
While I believe that NICE is navigating the current economic environment nicely, the company’s guidance for the remainder of the year has been withdrawn. As time goes on, customers may start to default on their subscriptions, or request to renegotiate the terms of their agreements.
Summary and Conclusions
NICE is breaking out to all-time highs, even as other digital transformation stocks are experiencing a pullback. This bullish price action suggests that there is more to come. NICE is a strong company with a free cash flow margin of 20% and $480 million in cash and cash equivalents on the books. Because the revenue growth of 8% is on the low side, NICE fails the Rule of 40 and is not one of my favorites. But NICE is exhibiting characteristics of maturity such as a fairly low SG&A expense margin, one of the reasons I believe that this company will do well in the coming recession.
The stock movement is strong, the company’s fundamentals are strong, and, in my opinion, the stock price, although modestly overvalued, is not sufficiently overvalued to prevent investment in the stock. I expect that NICE will benefit from the work-from-home mandate and come out of the current market conditions in a strong position to grow along with other digital transformation stocks.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.