Canada Connection: Software? In Canada?
The last thing most small cap investors think of when they look north of the border is for opportunities is Canada’s emerging software industry.
Other than Corel Corp. (Nasdaq: CREL), once a titan in Canada’s equivalent of Silicon Valley outside the country’s capital Ottawa, Canada is not seen as a hotbed of high-technology. But oddly, it is becoming increasingly so. Since the famous worldwide high-tech meltdown in 2001, Canada’s industry has been struggling to recover. And, in recent years, it has recovered considerably. The Conference Board of Canada, the Ottawa-based equivalent of the New York-based board, said just recently in its review of the software industry that nearly two-thirds of emerging software companies reported profits last year, while computer and other technology hardware makers saw their profits soar.
"Profit levels for Canadian computer and electronic product manufacturers nearly doubled last year," it said. Profits hit C$2.1 billion in 2006, with the surge due primarily to dropping capital and material costs. This year, profit margins are forecast to reach 6%, which is just below where they stood during the tech boom (although in real dollar terms, far short of the C$4.3 billion the Canadians profited in 2001).
"This industry is smaller and leaner than it was at the height of the tech boom," says Louis Theriault, director of the Conference Board’s industrial outlook division.
Meanwhile, PricewaterhouseCoopers in Toronto said in a similar review of the fledgling industry that 63% of emerging Canadian software firms were profitable last year, adding that's "good news" and in line with the 65% in 2005, and 56% in 2004.
The report, based on its fourth annual survey of software firms, found that as in past surveys, chief executives officers of these firms continued to predict significant revenue increases for the year ahead.
"However, while the majority of CEOs reported revenue increases of at least 10%, many fell short of their forecast," they found.
But that all that proves to be an interesting dilemma for small cap investors interested in the Canadian software market. Unlike during the high-tech boom, few Canadian software companies expect to go public any time soon. In fact, PriceWaterhouse Coopers found, only 5% think they will. "An IPO is a large capital raise that allows you to take your company to the next level. This group of CEOs is interested in an earlier exit," said Peter Matutat, a partner and leader of PwC's emerging company practice.
"But it's hard to blame them. It's a challenging environment to be a public company these days. And there have only been a handful of Canadian software IPOs in the last few years."
Among the few Canadian software IPOs last year, Toronto based Constellation Software Inc. (TSX: CSU). raised about C$80 million and Corel, which markets WordPerfect, raised about the same when it re-entered the market after being bought in 2003 by a California company.
Instead, Canadian – and other software companies – are simply being bought by others. Last year, some 1,000 North American software companies were taken over. "The reality of what's happening in the marketplace is the big exits that are happening are coming through acquisitions," Matutat said.
But there are signs that a few more Canadian software companies may soon come to the public market. In early stages of IPOs, venture capital firms like to get involved. Last year in Canada, there were 12 venture capital funds looking at emerging Canadian software companies. They had together assembled about C$1.5 billion to invest, according to the private equity firm Edgestone Capital Partners in Toronto. (That pales, off course, to the C$4 billion that 55 Canadian fund managers had in 2001 to invest in the same industry. But that was a long time ago in this industry.) A unit of Toronto’s GMP Capital (TSX: GMP.UN), Edgestone said recently it plans to get more aggressive in the Canadian software industry by trying to C$150-million for its third venture capital fund. It has already done two venture capital funds in the past six years, the first at C$103 million, the second at C$108 million.
These two funds have made 23 investments and their performance ranks among the top 10% of venture capital funds in North America. Among some of its best investments were SlipStream Data, recently sold to famed BlackBerry maker Research In Motion Ltd. (Nasdaq: RIMM) for nine times what Edgestone put in, and Workbrain, which was taken over by Infor in April for C$227 million.
While venture capital firms try to pick winners – and ultimately take them public – there are a couple publicly traded possibilities in the Canadian market. Norman Levine, managing director Portfolio Management Corp. in Toronto, likes Constellation Software, a provider of software solutions to small and medium businesses. Levine likes about this company is that it flies under the radar of the large software companies such as Microsoft Corporation (Nasdaq: MSFT) and Oracle Corporation (Nasdaq: ORCL). Constellation currently trades at about C$24 after its IPO last May at $C17.
Another publicly traded small cap software investment opportunity is Montreal-based Hartco Income Fund (TSX: HCI.UN) which is not so much a fund but a company that buys other software companies. Formerly known as Hartco Corp., it says its network of companies offer “integrated computer solutions and multi-vendor telephone and cellular equipment.” Among its most recent acquisitions are Tesseract Software Ltd, Softwarehouse (West) Inc. and Vancouver Office Technologies Inc. Hartco is trading at about $C3.51, near the 52-week high of C$3.80 established last July. The 52-week low of C$2.46 was set in October.
