Small Caps | Jul 26 2012
– Technology One to deliver solid earnings growth in coming years
– Yield also attractive
– A meeting with management sees BA-ML lift its target
By Chris Shaw
In the view of BA Merrill Lynch, the next two to three years in Australia will be characterised by a severe shortage of companies capable of generating double-digit earnings per share growth and offering a dividend yield significantly above the long-bond rate while remaining in a net cash position.
One stock that fits all these criteria for BA-ML is Technology One ((TNE)), a software company specialising in enterprise business solutions and software development services. A meeting with management has only served to confirm a positive outlook in the broker's view.
At the meeting Technology One confirmed guidance for FY12 net profit after tax growth of 10-15%, which is in line with BA-ML's forecast of 12% growth for the period. Recent business momentum has been solid, as a large licence sale has recently been secured and a large local government deal has partially flowed in the 2H12 period.
At the same time as contracts are progressing well, BA-ML notes management at Technology One is keeping a solid lid on costs. This offers some potential for margin leverage, stemming from both the research and development side as well as from sales and marketing.
What should also support margin growth in BA-ML's view is the ability of Technology One to increase its offshore headcount from 40 now to around 70 over the next two years. This will allow for a further broadening of the product suite through the use of lower cost R&D talent from overseas.
Looking ahead, BA-ML expects consistent gross and operating margin improvement through FY15 thanks to a combination of increased support revenue, relative reductions in sales and marketing spend versus software growth and R&D leverage from utilising an offshore delivery centre.
An increase in post sales support as a proportion of revenues for Technology One should also improve margins in the view of BA-ML. This should see Technology One improve from relatively low product gross margins relative to peers.
Productivity improvements in Technology One's sales force also offer some potential upside, as the higher sales and marketing spending of recent years should start to deliver improved results.
Earnings forecasts reflect this, as BA-ML expects earnings per share (EPS) for Technology One of 6.8c this year, rising to 8c in FY13 and 9.4c in FY14. This compared to consensus EPS forecasts according to the FNArena database of 7.2c for FY12 and 8.2c for FY13.
Yield is also expected to be attractive, as BA-ML expects dividends of 7.5c this year and 8.7c in FY13, which equates to a yield in that year of 7.25%. Dividends are anticipated to be fully franked. Together this implies a total shareholder return of more than 40% based on BA-ML's revised price target of $1.57, up from $1.44 previously.
BA-ML's price target is well above the consensus price target for Technology One according to the FNArena database of $1.32. Other targets range from RBS Australia at $1.16 to UBS at $1.30.
On BA-ML's forecasts Technology One is trading on a FY13 earnings multiple of 13.7 times. This is premium to its mid-cycle multiple and the Small Industrials sector, but the earnings growth expected in coming years justifies the premium in the broker's view. Globally the stock looks cheap relative to peers based on return on invested capital expectations.
Among other brokers offering coverage, both UBS and Macquarie rate Technology One as a Buy, reflecting both reasonable valuation for the stock at current levels and expectations of solid earnings growth as new products and services continue to be added to the product range of the company.
The dissenter is RBS, who rates Technology One as a Hold on valuation grounds. In RBS's view, while the growth outlook appears solid this is priced into the stock, meaning limited upside from current levels.
Shares in Technology One today are higher in a relatively flat overall market and as at 10.45am the stock was up 2c at $1.22. This compares to a range over the past year of $0.91 to $1.26 and implies upside approaching 10% relative to the consensus price target in the FNArena database.
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