Integrated Research is a diagnostic software company that derives a significant portion of its revenues selling licenses to a software package called Prognosis. Prognosis essentially measures the performance of a user’s internal software, providing real time monitoring, troubleshooting and insight to critical IT infrastructure. IR also offers consulting services for “design and deployment of customised enhancements and extensions.” 88% of revenues are recurring, with a retention rate of around 95%.

Previously, I had owned stock in Integrated Research for around 3 years and came away with some tidy long-term gains (in part, because I was enough to trim high $3’s), however following disappointing results last year I elected to sell all my shares.

I think that the long-term traction of the product itself is something that will keep the business viable through tough times with Integrated Research boasting current licensing to over 1000 companies in over 60 countries, including 125 current constituents of the Fortune 500 index, however the realisation that came to me last year was just how vulnerable the company’s earnings may be in any downturn. The company had reported for FY18, flat revenue numbers and low single-digit EPS growth, however this result was buoyed by a record 1st half. The company blamed its second half trouble on cyclically lower investment within its European segment, particularly the infrastructure division. The concern here for me is that reliable earnings and a robust revenue base formed a key pillar of my initial investment thesis. With this in question, I struggle to see that the company should demand the 26-30x price to earnings multiple that it has historically carried. EPS growth rates in the low teens of recent times do little to sway my opinion. The threat to this interpretation is the suggestion that a large part of the company’s issues were derived from trouble experienced by Avaya throughout the period, however this was not a new problem, first coming into play in January of 2017.

Currently, with a strong 1H19 behind it and a much more reasonable 19x earnings multiple, I think it is possible that shares represent value at today’s prices however my opinion on the company’s economics have somewhat changed. I am beginning to see Integrated Research as a top “bottom-of-the-cycle" play with a potential for lumpy earnings in difficult times, not the robust growth machine I had previously thought the company to be. I have adjusted discount rates accordingly, and will be sitting this one out for the foreseeable future.

Valuation: considering FY20E free cash flow of $25.4m, 8% growth rate, 5 year forecast period, 3% terminal growth rate and 8% discount rate (previously 6%) implies a valuation of $2.43 per share.