You hear it all the time: we live in a consumer-driven economy. When consumer sentiment slides, so too do sales of the biggest stocks on Wall Street. But focusing exclusively on companies that sell to individual consumers is a sure way to miss out on one of the biggest revenue categories out there... enterprise sales.

Selling to businesses is big business indeed. And the small software company I´m going to tell you about today stands to profit big in 2010 stands to profit in a large way from it. Here´s everything you need to know about our latest small-cap play...

Pervasive Software (NASDAQ: PVSW) is an international software and services company with two primary product and service lines. The first is the Pervasive PSQL database engine, which generates about two-thirds of revenue. The second line of business is data integration, which consists of the Pervasive Data Integrator (DI) product as well as the Pervasive DataSolutions subscription service.

PSQL is an embeddable database engine, meaning that applications that use it do not need to access an external database. This product is marketed on two points: ease of maintenance and cost. PSQL is designed to be “self-tuning”, which means there are no database administrator or optimization tweaks necessary, and the price tag is maintained below similar competing offerings from companies like Sybase (NYSE: SY) or Microsoft (NASDAQ: MSFT).

These factors make PSQL an attractive alternative for small-to-medium size businesses (SMBs) that do not have the personnel or financial resources of large firms.

Data integration, on the other hand, is essentially the process of joining together data from one source into another source. For example, there is a demo on Pervasive’s website that describes how Intuit (NASDAQ: INTU) used Data Integrator to create import routines to suck data into Quickbooks from competing product’s save formats. The company´s DataSolutions service consists of integration tasks outsourced to Pervasive’s employees.

Technical details aside, Pervasive’s business has a lot of attractive qualities, and I wrestled with the notion of holding this one as a potential future pick.

First, the company has exceptional financial characteristics. The balance sheet is outstanding, with over $40 million in cash (nearly half of market cap) and no debt. Operating margins are getting a nice boost too. While historically they have been under 7%, recently they have shot up into the mid-teens on the back of lower amortization costs from the 2004 purchase of Data Junction and larger and more profitable PSQL license deals.

While the second factor may be unsustainable, reduced amortization costs should keep margins much higher than the 5-year trailing average. Free cash flow generation has been somewhat volatile, with margins ranging from 25% to below 10%. Long-term, I expect about a 15% free cash margin, as the company’s offerings are priced below competitors and operating margins are much slimmer than the 30% numbers we see from larger software/service companies.

Pervasive’s competitive position is fair. Obviously, the firm is dwarfed by some of its primary competitors as far as financial, technical, and marketing resources go, particularly in embeddable databases. The data integration business has a better profile. Most of this kind of work is performed by in-house technical staff on an as-needed basis, but Pervasive’s solution allows for both quicker, more accurate, and more flexible implementations. Over a year holding period, I don’t see competition being a major issue, but Pervasive does not have any long-term moat advantages like high switching costs or regulatory protection.

Growth is the question mark here. The company’s recent history (past five years) has been one of stagnant revenue growth and a stagnant stock price in a tight range from $4-$5, a range it currently is in the upper end of. Revenue is almost exactly flat over that period. Margins have improved dramatically over the past 18 months, and management has bought back shares at a rate of 5.4% a year, which has juiced per-share bottom-line profits. I expect share repurchases to continue to contribute to earnings per share growth, given the company’s strong balance sheet.

Can revenue grow? I believe it can. In fiscal 2009, Pervasive showed signs of life, signing several large PSQL deals and growing sales 11%. The data integration products appear to have good potential, particularly with the emerging software-as-a-service trend, where firms outsource their business process software.

The legacy data has to be ported, and Pervasive’s solution is the best available. DI also opens some of these emerging data management solutions up to firms without large technical staffs. Cost-sensitivity is paramount in the current economic climate, an advantage for PSQL. It appears that the catalysts for growth are there, we just haven’t seen them yet. This gives me pause, especially considering that Pervasive has been offering DI products since 2004.

The forward earnings yield (EBIT / enterprise value) on this stock is 16%, which is very cheap. If Pervasive can show reasonable growth trends, there is good potential for solid gains in the stock.

For "Magic Formula" investors, it is a good choice for a new position.

Sincerely,
Steve Alexander
MagicDiligence.com

January 7, 2010