Software and services provider Amdocs Limited’s (NASDAQ:DOX) strategy to focus on telecom operators (telcos) and enterprises since 2013 has been successful, with the company consistently increasing quarterly revenues since then to $1.145 billion as shown in the blue chart below.
Earnings figures have also progressed as shown in the orange chart, thereby encouraging investors to put their money in the stock. As a result, after the stock gained 16% since the beginning of 2022, with the trailing GAAP price-to-earnings multiple appreciating to 19.5x.
Therefore, for people who want to invest at this stage, the purpose of this thesis is to assess whether the growth story can continue without forgetting the profitability, debt, and cash metrics.
I start with the value proposition Amdocs brings to communications service providers (“CSPs”).
Addressing the needs of CSPs
The company has managed to position itself in the right place in order to benefit from one of the telecom industry’s most pressing needs, which is to rapidly shift from a traditional data center environment to cloud-based operations. Its approach has been two-thronged.
First, from the technology standpoint, it has developed expertise around the cloud microservices architecture which allows the large and complex applications used by telcos to be separated into smaller components that are independent of each other and more simple to manage. Technologies like Kubernetes are then used to automate (orchestrate) specific functions in the BSS (Business Support Systems) and OSS (Operations Support Systems) which are used by telcos.
Along the same lines, applications are also continuously optimized, not only in terms of performance but also taking into consideration the consumption of compute and storage resources, so that at the end of the month, CSPs do not end up paying exorbitant amounts of money to public cloud providers (hyperscalers) like Amazon (AMZN) for its AWS.
In addition to technical performance and costs, Amdocs brings along a lot of automation features like auto-resolution (self-healing) in case of system downtimes. This helps telcos to reduce the number of man-hours required for troubleshooting purposes and is particularly relevant for companies that have been used to large teams operating their data centers shifting operations to become more nimble thereby saving on costs.
Empowered by such competencies, Amdocs is trusted by big service providers like AT&T (T) and T-Mobile (TMUS) as they have to convert thousands of applications to the cloud format. Amdocs has also proved instrumental in modernizing its clients’ consumer domains through digital transformation. Its ability to execute rapidly helped companies bring products to market faster and beat the competition. This explains its customer high win rate, as shown below.
Furthermore, digital transformations are essentially IT projects, which suffer from a large percentage of failure, namely 25%-85%. This is on the high side and is the reason Amdocs has a consultancy division that assesses how fast clients can become cloud-ready. Hence, advising customers about the way they can migrate IT workloads to the cloud is crucial to limit unnecessary expenditures. For this specific purpose, as part of its hybrid cloud management platform, the company has a FinOps (financial operations) module which focuses on the finest details of resource utilization which are normally not provided by hyperscalers.
Growth domains, profitability, and cash
In addition to the cloud, Amdocs is also focused on 5G, more specifically on the monetization aspect, namely through a five-year deal with a Tier 1 European operator for the implementation of its cloud-based policy control solution to support the deployment of a fifth-generation stand-alone network. It also has managed services contracts with Bell Canada (BCE) and a digital transformation project with VodafoneZiggo in the Netherlands.
On the other hand, the company’s gross profit margins, which are lower than the average for the IT industry by about 30%, have been stagnating around the 35% mark as shown in the chart below. This shows that cost of revenue is on the higher side, most probably as a result of investing in telco-like platforms which can be quite intricate given the number of network elements that are involved.
Diving further into the bottom line, the operating margins of 14.3% achieved in Q2-2022 are higher than the industry average. However, it declined slightly relative to the previous quarter due to more R&D investments and higher labor costs in a tight market impacted by wage inflation pressures.
Going forward and as per the executives, the company’s emphasis on operational excellence through the use of automation tools should gradually increase efficiency and offset the rise in costs of doing business.
Now, operating expenses include SG&A (sales and administrative), and these grew by 15.4% to $135 million in the latest reported quarter. Thus, the company is having to spend relatively more to drive sales and grow organically. This implies strong competition and in response, Amdocs has also opted for inorganic growth through M&A.
Valuations and key takeaways
In this respect, its agreement to acquire Mycom OSI, a provider of service assurance software to telcos, for around $188 million should further increase sales prospects, namely for 5G and enterprise assurance. This is about assuring reliability and high performance during mobile network roll-outs. Mycom also has an array of AI-driven operational solutions for NOCs (Network Operating Centers) with some big industry names like Vodafone (VOD) forming part of its portfolio of clients.
However, with capital expenditures averaging $54 million during the last four quarters and the cash acquisition of Mycom at $188 million, free cash flow (“FCF”) is likely to be impacted. Already, cash margin, which is the FCF divided by revenue, has fallen down under the 10% mark as shown in the above chart. Furthermore, the debt of $880.6 million as of the end of March is slightly above the $856.4 million of cash and equivalents.
Shifting to a positive note, the company grew at 9.2% on a year-on-year basis in Q3, which is way above what it achieved in the last three years. With the recent acquisition, it should grow faster, but, in this respect, Mycom’s sales are expected to add less than 1% to the combined entity’s revenue and only from fiscal 2023.
In the meantime, the company should execute on its growth strategy, helped by a record backlog of $3.89 billion, which is up 10% from the same period of 2021. As for the bottom line, expectations are for FY2022’s diluted EPS (on a non-GAAP and pro forma basis) to beat the amount of $4.81 obtained in 2021 by 9% to 12%.
Consequently, balancing out the growth, profitability, cash with debt, and after accounting for an upside of more than 12% since May 11, I consider Amdocs to be more of a hold at the present juncture. SA’s Quant ratings also point to hold as shown in the figure below.
Pursuing further, as a software provider to telcos and other large enterprises, Amdocs also pays dividends at a yield of 1.82%, and, with a payout ratio of 28%, the company has the capacity to pay more. This capacity will ultimately depend on its ability to generate more cash flow from operations out of project milestones being delivered faster to clients as well as unlocking more of the deferred revenue currently locked in the account receivables.
Finally, for those who are interested to invest in the stock, it is important to look for improvement in FCF when Q3 results are announced in the first week of August given that high inflation can rapidly erode the real value of cash.