Technology One Cloud Impact Unclear

This story features TECHNOLOGY ONE LIMITED. For more info SHARE ANALYSIS: TNE

-Surprise special dividend
-UK growth a challenge
-Stock considered expensive
 

By Eva Brocklehurst

Technology One ((TNE)) offers strong earnings growth and exposure to the potential of cloud technology. Special dividends, which brokers suspected would be introduced in FY15, have been initiated. Still, many are not persuaded that the stock has a strong buy case, as questions remain over the impact on the company's revenue model of migrating customers to the cloud.

FY14 results were solid, with revenue up 8%. A final dividend of 4.21c and a special dividend of 2.0c bring the total for the year to 8.16c, fully franked, up 46% on the prior year. To Morgans, Technology One is a stock which consistently delivers above-market profit growth. The broker expects similar offerings in FY15 and considers the business is in a strong position, applying a 10% premium to valuation on the basis of market optimism. Still, the price/earnings ratio of 27 times looks expensive. Hence, a Hold rating is maintained.

The company has a suite of eight main products. For Morgans, the most interesting aspect of the results was that 80% of the FY14 profit was generated from two of these products, and 95% from three. Technology One expects to increase profit by around 50% over the next five years and the other six products will move from a small impact to being material contributors. Macquarie expects further leverage can be realised as these products make their contribution felt. As products become more mature they reach a point where profit exceeds licence fees. As at FY14, CPM, Financials & Supply Chain and Student Management have reached this point.

Profit margins are accelerating and the company aims to lift these back towards 25% over the next five years. To do this it will need to manage its cost base and achieve scale in cloud operations. Macquarie observes there are risks in moving to the cloud and the full financial impact is yet to be confirmed. The company's traditional solutions have involved a large proportion of revenue up front in the form of licence fees and the broker observes that using a SaaS (software as a service) licence means this payment may be spread over a longer period of time. Macquarie, therefore, reserves judgment on the full ramifications. Nevertheless, considerable leverage can be realised once new products are contributing to the bottom line and the broker retains an Outperform rating.

The company's growth strategy is on track, in UBS' opinion, despite a rather flat macro environment. The broker trims forecasts after the FY15 result to reflect the uncertainty around the medium-term impact of the cloud model pricing transition and consulting/implementation service revenue. This is offset by lower expense forecasts from ongoing R&D and tight control of costs. The main questions for UBS centre on the impact of the cloud/SaaS financial impacts. The impacts can be managed by recognising long-term contract revenue up front and controlling costs well, but the net drag on operating cash flow when moving to the SaaS model is harder to avoid, in the broker's opinion.

Technology One remains a relatively new entrant in the UK market and Macquarie observes it is yet to make headway in this geography. Making this all the more challenging is the fact the company is viewed as a higher risk by its customers because of its size versus global peers such as SAP, Oracle and Microsoft. Macquarie notes the company is well capitalised to invest further in the region but does not expect any acquisition to fast track growth is likely.

Bell Potter had flagged the special dividend as a possibility and was surprised it was delivered in FY14. The company did not provide specific FY15 guidance but tends not to do so until the first half result. Technology One has stated its current sales pipeline is weighted strongly to the second half, so first half results may be not indicative of the full year. Bell Potter makes changes in special dividend forecasts, increasing these to 2.5c for both FY15 and FY16. The broker retains a Sell rating because, with a price target of $3.00 the expected total return remains negative, even including the forecast FY15 dividend yield.

FNArena's database has one Buy and two Hold ratings. The consensus target is $3.21, suggesting 9.7% upside to the last share price. Targets range from $3.14 to $3.25.
 

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