A NICE Way to Play the VoIP Boom

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From Standard & Poor's Equity Research

With these companies already successfully integrated into the company business model, we believe NICE has developed a proven track record for choosing prudent strategic acquisitions and providing real added value to shareholders.

As NICE's analytic offerings are developed to improve business and employee performance and enhance security and public safety, we see its products as somewhat recession resistant. We believe we're in the early stages of multimedia analytics and view NICE as best positioned to capture an increasing share of this growing market. In addition, we believe the pending merger between rivals Verint Systems (VRNT) and Witness Systems (WITS) will create near-term sales opportunities for NICE, as we believe those companies will have to work through product integration issues.

Financial Forecast

We view the company's balance sheet as strong, with $296 million of cash and investments, or roughly $6 cash per share, and no long-term debt. We see strong cash-flow generation in 2007, with an average of about $20 million per quarter, aided by our forecast for higher profitability on increased software sales. We believe the company will continue to use its cash to pursue selective acquisitions in an effort to expand its geographic presence and increase its client base.

With its expanding customer base and what we see as significant market opportunities, we believe NICE will post sales and earnings growth above peers over the next three years. While a ramp up in operations and hiring should help manage business growth, we believe operating leverage will help drive long-term operating margins toward the 20% range, above the peer average.

Following a 34% revenue increase in 2006, we see a 20% advance in 2007, reflecting accelerating demand for VoIP offerings in the enterprise market, and strong video solution sales in the public safety and security market. We believe increasing corporate regulations, such as the Sarbanes-Oxley Act and government spending on homeland security, will be key revenue drivers for NICE. With a strong and increasing backlog, sales visibility remains good.

Widening Margins

We're particularly optimistic about the growth prospects related to Nice Perform, the company's flagship enterprise product. Introduced in 2004, it gives companies advanced business intelligence capabilities rather than simply recording and storing incoming data, by employing various applications, including word spotting, talk-pattern analysis, emotion detection, customer surveys, and computer telephony integration analysis. The company aims to upgrade its large installed customer base to the new next-generation platform. During the fourth quarter of 2006, Nice Perform accounted for more than 20% of total enterprise division business, and orders more than doubled year to year.

We see 2007 gross margins widening more than 200 basis points to the 63% level, as an increase in higher-margin software sales should outweigh industry pricing pressures. Despite our forecast for aggressive hiring, operating expenses as a percentage of sales should remain essentially flat on the increased sales volume. Factoring in a higher share count following the company's December, 2005, secondary equity offering and a two-for-one stock split in May, 2006, we project 2007 earnings per American Depositary Receipt of $1.50, up sharply from the $1.17 posted in 2006. For 2008, we see earnings per ADR of $1.80.

Our 12-month target price of $42 is largely based on a p-e of 28 times our 2007 EPS (earnings per share) estimate of $1.50. Combined with our longer-term projected EPS growth rate of 15% for NICE, our target price reflects a p-e-to-growth ratio of 1.9, in line with peers. Our target price also represents four times our 2007 sales estimate, above peers, warranted, in our view, by NICE's above-industry-average gross and net margins.

Our discounted cash flow model indicates an intrinsic value of about $41. Incorporating a risk-free rate and equity risk premium of 5.2% and 5.5%, respectively, we derive a weighted average cost of capital of 11.5%. We forecast average cash flow growth of approximately 16% over the next five years, followed by a gradual decrease in growth to around 5% at year 16. In line with sustainable long-term growth trends in real gross domestic product, we assume a terminal rate of free cash flow of 3%.

Sound Philosophy

Our overall view of NICE's corporate-governance practices is favorable. The company's board of directors consists of eight people, who, in our opinion, bring experience and diversity to the board. We view positively that the full board of directors, and both the audit and compensation committees, are comprised solely of independent outside directors and that there were no "related party" transactions.

We think the company's executive-compensation philosophy appropriately balances the business environment with the need to effectively attract and retain a high caliber management team. During 2005, the aggregate compensation paid to or accrued on behalf of all directors and executive officers as a group, which comprised 22 people, consisted of approximately $4.9 million in salaries, fees, and bonuses.

No shareholder owns more than 13% of the shares outstanding. Two shareholders, FMR and Massachusetts Financial Services, own 12.5% and 8.7% of the shares outstanding, respectively. Company directors and executive officers own an aggregate of 2.5% of the shares outstanding.

In the Hot Spot

On the negative side, the board can increase or decrease its size without shareholder approval. Further, there's no disclosure of a policy that limits the number of other boards on which directors may serve.

Risks to our recommendation and target price include a weakening enterprise spending environment, a slowdown in VoIP deployments, integration issues related to recent acquisitions, homeland security spending delays, and the loss of a major distribution partner. In addition, given its location in Israel, any political instability in the Middle East could potentially disrupt business operations.

Ari Bensinger is an analyst following communications equipment stocks for Standard & Poor's Equity Research.