Better Buy: Enghouse (TSX:ENGH) vs. Constellation Software (TSX:CU)

Stocks Enghouse Systems (TSX:ENGH) and Constellation Software (TSX:CSU) are trading near their all-time high. Have investors priced these stocks correctly?

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As COVID-19 took the form of a pandemic and disrupted several economies across the globe, several investors sold their stocks and flocked to defense stocks. Now, defense stocks are the ones that are not too sensitive to overall market movements.

In other words, a defense stock has a beta (a measure of market volatility) of less than one. Some software stocks emerged as defense stocks, as their recurring revenue brought visibility into future earnings. Shares of Enghouse Systems (TSX:ENGH) and Constellation Software (TSX:CSU) have a beta of 0.56 and 0.72 as they are resilient to a market event. But a low beta doesn’t mean the stock momentum is weak.

Enghouse is a smaller company with a market capitalization of $3.4 billion, but it has a higher average trading volume of over 153,000. Constellation has a market capitalization of over $32 billion, but it has a lower average trading volume of over 61,000.

The two stocks outperformed the market by growing around 20% year-to-date. Company-specific fundamentals are driving this stock price momentum.

Stock Returns Constellation Software Enghouse Systems TSX Composite Index
Year-to-Date 19.0% 23.1% -9.2%
1 year 31.9% 84.6% -4.2%
5 years 187.0% 124.1% 3.8%
10 years 3640.8% 1266.8% 34.2%

The COVID-19 pandemic has a positive impact on Enghouse

Enghouse acquires software providers that serve verticals like contact centres, telecom, logistics, and geographic information systems. Its core vertical is contact centres from which it earns more than 50% of its revenue. Last year, it acquired video-conferencing vendor Vidyo and cloud-based video service provider Espial.

These acquisitions benefitted Enghouse during the pandemic-driven lockdown as the trend of remote working trend gathered pace. Its latest addition, Dialogic received a perpetual license order in the second quarter of fiscal 2020.

The new order-win increased the overall company’s revenue by 58% year over year to $141 million. Dialogic’s media processing software supports real-time video conferencing and collaboration applications across all devices.

Enghouse’s hardware and professional services segments took a hit as the lockdown postponed onsite installations and upgrades. The pandemic had a mixed impact on Constellation, which has exposure to many different verticals.

While some of its customer industries benefitted, some were negatively affected by the pandemic. Those customers whose businesses were affected might cut costs, which could lead to delays or cancellation in software purchases and software maintenance contracts.

Company-specific fundamentals remain strong

Enghouse and Constellation depend on acquisitions to boost revenue. They acquire small companies and support them with their vast sales and marketing teams created through several acquisitions.

A portfolio of related software products under one umbrella allows cross-selling and offers enhanced customer support to existing customers. But the organic growth generated from cross-selling forms a small portion of their revenue.

The two companies focus on acquiring providers that generate high recurring revenue from maintenance contracts. In the case of Enghouse, it also earns recurring revenue from software services hosted on the cloud.

Higher recurring revenue improves profit margin and cash flows, which the two companies reinvest to fund new acquisitions. This reinvestment creates a compounding effect on their returns.

Between fiscal 2015 and 2019, Enghouse’s revenue rose at a CAGR of 6.7%, but its adjusted EBITDA increased at a CAGR of 10.7%. Its adjusted EBITDA margin improved from 25% to 30% during this period. It has $167 million in net cash, which gives it ample liquidity to undertake new acquisitions.

Constellation stopped reporting adjusted EBITDA from 2019 onward. Its revenue and adjusted EBITDA rose at a CAGR of 12.7%, and 16.8% between fiscal 2014 and 2018. Its adjusted EBITDA margin improved from 21% to 25%. It has US$216 million in net cash, giving it ample liquidity to undertake new acquisitions.

Which is a better buy: Enghouse or Constellation

Both Enghouse and Constellation have low beta and strong fundamentals, which will help them withstand the crisis and continue growing through acquisitions. When deciding on which stock to buy, valuation plays an important role.

Enghouse is trading at 49 times its earnings per share, while Constellation is trading at 76 times its earnings. Enghouse is fairly valued, whereas Constellation is trading 36% above its fair value. From the valuation perspective, Enghouse is a better buy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Puja Tayal has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Constellation Software. The Motley Fool recommends Enghouse Systems Ltd.

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