Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of Value Slant .

Top Image Systems (TISA) is a NADSDAQ-listed Israeli enterprise software company. TISA makes automated data capture solutions to control the flow of document based data through an enterprise. In a simple example, their software can extract data from from a scanned invoice and feed that data into the company’s accounts in their enterprise software system.

 

TISA has undergone a turnaround in the last three years. Founder Izhak Nakar returned to an active role in TISA in 2009 when he purchased 20% of the company from a large institutional holder. Since then he has been acting as “Active Chairman” in a CEO-like role along with CEO Ido Schechter. Their turnaround strategy has moved TISA away from low margin hardware and third party software to focus on their core eFlow software platform. They have also focused on realigning the cost structure by closing non profitable offices and ramping up utilization of third party distributors. The strategy has succeeded. In 2008, TISA did $32 million in revenue with 53% gross margin and negative operating income margin. For 2011, TISA is on track for $28.5 million in revenue with 61% gross margin and 13% operating margin.

TISA looks like a cheap stock. Based on a fourth quarter in line with the prior three quarters (on the higher end of conservative company guidance), TISA should do $3.6 million in EBIT in 2011. The company eliminated its remaining debt in the third quarter. D&A is about equal to the very minimal capex (about $300 thousand), and TISA has NOLs to shield income from taxes for at least several years. So EBIT should basically be equivalent to free cash flow. There are 11.1 million diluted shares outstanding for a market cap of $23.5 million at $2.11 a share. There is no debt and $3.3 million in cash on the balance sheet. Netting out the cash that comes to a 17.8% free cash flow yield.

While TISA has much competition, they are operating in a rapidly expanding niche of enterprise software that has continued to grow through the recession, and is expected to continue to expand at a 9% growth rate. Document management software has a rapid and demonstrable return on investment. (TISA management claims there is usually a 6-12 month payback.)

The major difficulty for small makers of enterprise software tends to be sales and distribution. They can have software that is better than the bigger players, but they just cannot get their product in front of potential customers as effectively as bigger companies can. TISA has pursued a smart strategy in this respect by focusing on a few targeted areas:

  • Banking- secular trend of increased regulation forcing banks to better manage document flow
  • Digital mail room- a product that auto-manages a company’s email correspondence with customers
  • Integration of TISA products into the platforms of larger enterprise software partners such as Xerox

TISA is not trying to be all things to all customers, and their focused sales strategy should help them compensate for the lack of a huge sales force. Now that the expense structure has been cleaned up, TISA can focus on top line growth.

While TISA is a cheap stock with no fatal flaws, I am worried mainly about the sustainability of the top line. I think this is probably the major item holding the stock back right now. Quarterly revenue jumped from the $5 million range in 2010 to $7 million in 2011, but it has been flat for the last three quarters. TISA does have 25% of revenues coming from recurring maintenance fees, but the rest is from one-time software and service sales that tend to be lumpy for small enterprise software companies. A few big projects ending could have a large impact on revenues. TISA management says the sales pipeline has grown from $70-80 million to $100 million over the past year, but it is hard for an outside investor to have conviction that they will keep up their win rate in a crowded marketplace.

Another concern is expense creep. Now that TISA is focused on top line growth, they will have to invest more into sales and that of course carries the risk that they will not increase revenues in line with that increased investment. TISA is trying to expand into the US market where they traditionally have not had much of a presence with most of their sales coming from Europe. Sales and marketing expense jumped to $2 million in Q3 from the $1.5 million range while revenue remained almost flat. Additionally, management pay appears excessive as they are basically paying two CEOs. Schechter and Nakar will earn about $1.2 million combined this year, which is a third of EBIT.

There has also been some questionable capital allocation. The company had been working to pay off $15 million in convertible debt issued in December 2006. While TISA has been able to pay off most if through cash from operations, they did a 1.4 million share private placement at $2.00 a share in June to pay off the remainder. As the debt was only bearing interest at LIBOR+.3% I am unclear as to why they were in such a rush to pay off the remaining $5 million. Issuing stock so cheaply seems to be a very expensive way of getting rid of cheap debt.

Without any hard catalysts, TISA is cheap to current cash flows but still essentially a bet that management can continue to grow revenues.

Disclosure: No position.