Analysts see 39% upside potential

Open text (OTEX) (EAST: OTEX) designs, develops, markets and sells enterprise information management software and solutions.

It includes Customer Experience Management (CEM), Digital Process Automation, Enterprise Network, Enterprise Content Management, Discovery, Security, Artificial Intelligence (AI) and Solutions analysis.

Open Text is a strong, profitable, analyst-backed company. However, when quantifying its competitive advantage, I get mixed results.

Does Open Text have a competitive advantage?

There are several ways to quantify a company’s competitive advantage using only its income statement. The first method is to calculate the Earning Power Value (EPV) of a company.

The value of earning power is measured as adjusted EBIT after tax divided by the weighted average cost of capital, and the value of reproduction (the cost to replicate/replicate the business) can be measured using the total value of assets of a business. If the earning power value is greater than the reproductive value, then a firm is considered to have a competitive advantage.

For Open Text, the calculation is as follows:

EPV = Adjusted Earnings EPV / WACC

$8,963 million = $744 million / 0.083

Given that Open Text has a total asset value of $10,200 million, it can be said that it has no competitive advantage. In other words, assuming no growth for Open Text, it would take $10,200 million in assets to generate $8,963 million in value over time, which doesn’t is not ideal.

The second way to determine if a company has a competitive advantage is to look at its gross margin, as it represents the premium consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.

If a company does not have an edge, new entrants will gradually take market share, leading to lower gross margins as price wars ensue to stay competitive.

In the case of Open Text, its gross margin has increased over the past few years, from 72.5% in fiscal 2017 to 75.3% in the last 12 months. Therefore, the evolution of its gross margin indicates that a competitive advantage is present in this regard.

Risk analysis

To measure the risk of Open Text, I will first check if financial leverage is an issue. To do this, I look at its debt to free cash flow ratio. Currently, that number is 4.8x.

Overall, I don’t think debt is currently a material risk to the business as its interest coverage ratio is 4.7x (calculated as EBIT divided by interest expense). In other words, it can cover its annual interest costs 4.7 times more than using its operating profit.

However, there are other risks associated with the business. According to Tipranks’ risk analysis, Open Text disclosed 48 risks in its latest earnings report. The highest level of risk came from the Finance & Corporate category.

The total number of risks has decreased over time, as shown in the image below:

Analyst Recommendations

Open Text has a strong buy consensus rating based on three buys and one block awarded in the past three months. The average Open Text price target of $51.50 implies an upside potential of 38.8%.

Final Thoughts

Although Open Text has no theoretical competitive advantage, it is still a profitable business with an expanding gross margin. In addition, the valuation appears attractive since analysts are counting on an upside potential of 39%.