Australia | May 28 2013
-Resilience in the face of spending cuts
-Capital management potential
-Major cloud initiatives key to growth
By Eva Brocklehurst
Software developer Technology One ((TNE)) stands out. The economic doldrums have affected a wide range of companies, not just retailers and resources, and IT is one area which has felt the impact of reduced spending. So brokers greeted the first half results tentatively and were positively surprised.
Technology One is one of the few software companies to almost entirely undertake research and development domestically. There is a small offshore facility, in Bali, which is used to support back-office functions. There are no plans to increase the scale of this in the near term, because of concerns about compromising product and service quality. CIMB expects Technology One to expense around $36 million in R&D this year, which gives rise to tax breaks, and lowers the tax rate to the low 20% levels. This means shareholders are not able to receive fully franked dividends at this stage.TNE raised the interim dividend by 10%, to 1.77c, partly franked at 85%.
The company has extended its R&D tax concession review to include 2008-10 and expects to see franking below 100% in FY13. UBS notes there's no special dividend or capital return mentioned but TNE is reviewing potential capital management options. It will not make a special dividend payment until dividends can be fully franked. An update on the most tax efficient way to return cash is expected in the next six months.
The balance sheet is strong. Operating cash flow was ahead of profit and cash conversion was 103%. The company is intent on improving profit margins and these have finally started to rise. The company aim to lift margins back towards 25% over the next five years and managing the cost base will be critical to this outcome. BA-Merrill Lynch has described the company's cost control as stellar and the cash generation the highlight of the results. Macquarie hails the annual licence fees, which grew very strongly at 18% and reflect good customer retention.
The second half looks to be very strong across local councils and the education sector, with no signs of any slowing in conversion to date. Macquarie observes there are no state or federal government contracts coming though and the upcoming election is probably having an impact there, but there are a number of contracts which should drive growth in the second half as opposed to a heavy reliance on one or to lumpy ones. The company's guidance is for 10-15% profit growth in FY13 and the brokers seem happy with that. Of course it does assume no further deterioration in the economic climate.
Major initiatives are new products, such as Mobile Solutions, as well as continued investment in the Ci2 cloud and the UK investment. In order to demonstrate the cost efficiencies of moving to the cloud with Ci2, TNE will operate its own corporate head office on the cloud. The initiative requires less IT staff on the premises. Hardware/software will be hosted in the cloud utilising Amazon's data centres and there is no more need for an off-site disaster recovery centre, given back-ups are at multiple data centres. Management estimates around $1-2m of cost savings in 2014. Given the scalability of the model derived from wholesale cloud hosting and the fixed cost of Ci2 development there is ample longer-term margin upside, in UBS' view.
At issue is the pace of the adoption of cloud computing by business and government agencies. For customers the adoption is a transformational and capital budget decision. They can reduce IT and business risks, avoid up-front capex, but lose control of hardware and perhaps accept limited customisation. Cost savings result from reduced head count, lower servicing costs and capex for self-maintained IT infrastructure with improved system stability and recovery capability. Moelis suspects R&D expense growth will now decelerate because the initial building of the cloud enterprise suite is now complete and a level of critical mass has been achieved. R&D expense should grow at an average compound rate of 8% or less per annum over the next five years versus the historical compound growth rate of 15% per annum.
The UK business continues to feel the effects of the GFC and Technology One is a relatively new player, competing against the entrenched multinational contingent. Moelis is yet to be convinced of the long-term sustainability of TNE's operation in that region. In contrast, there is a good pipeline of contract opportunity in Australia and New Zealand, despite the subdued environment and this, in Moelis' view, reflects the company's exposure to the more resilient segments of the market, such as health and local government. TNE benefits from minimal exposure to the more pressured sectors such as manufacturing and retail. The UK's drag on profits is also the one area of concern for Macquarie. There is a significant turnaround required before this can turn a profit. Nevertheless, the sheer size of the UK market and the limited losses to date means, in Macquarie's view, the company can afford to be patient.
BA-Merrill Lynch has decided, after having a Buy rating for three years that a Neutral rating is now more appropriate. This is largely because the valuation has expanded to 17 times the 2-year forward price/earnings ratio and there are a lack of catalysts, so the stock is likely to be range-bound. This does not take away from the fact that the stock is supported by strong margin leverage, cost controls and cash generation. The move to Neutral is also based on the fact that the second half has more weighting and risk to the software licence outlook, and this could be a challenge in an election year.
On the FNArena database Technology One has two Buy and two Hold ratings. The consensus target is $1.76, having risen from $1.64 yesterday, and suggesting 6.8% upside to the last share price. The dividend yield on consensus FY13 earnings is 3.5% and for FY14 it is 4.0%.
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