Technology One Atop The Cloud, But At What Price?

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

-Special dividend potential
-Unclear re pure cloud impact
-Acquisitions strengthen service
 

By Eva Brocklehurst

Technology One ((TNE)) is a strong proponent of cloud-based solutions and its sales outlook is solid, albeit weighted to the second half. Despite the soft economic backdrop, which affects the broader IT sector, the company has witnessed increased activity from government verticals in the first half, as contractors are shed and more tailored solutions are sought. With high cash reserves and sufficient franking credits, management intends to assess the possibility of paying a special dividend at the full year result.

First half results surprised Morgans, as while profit declined 10% the interim dividend increased by the same amount. The broker does not usually place much store in the interim outcome because of the timing of lumpy contracts. FY15 guidance for 10-15% profit growth was delivered as usual, in line with expectations. Annualised revenue from the cloud business is up over 100% year to date and, while impressive, Morgans observes this is off a low base. 

FY16 should be the peak in cloud losses before profitability occurs over the next two to three years. Technology One’s Cloud 5.0 is to be released shortly. The company runs a six-monthly software upgrade cycle and the significance of version 5.0 is that it moves to a mass production model. Morgans notes there are large deals in train for which Technology One is the preferred supplier and margin expansion is expected in FY15. The company is targeting 25-30% margins in the long term and remains unperturbed about competition, confident in its ability to execute internally to deliver the margin expansion.

The business is solid but Morgans maintains that even a good business can be a poor investment if you pay too much. Technology One is approaching that stage and share price momentum should eventually weaken, providing a catalyst to exit the stock in the broker’s opinion. For now, Morgans has a Hold rating but highlights the substantial premium at which the stock currently trades, relative to peers and its own long-term performance.

Cheaper capital may have pushed equity risk premia lower but, even so, the stock appears pricey. The extent of Technology One’s premium to the market is rare but Morgans observes stocks can stay expensive for a number of years. In this instance the broker surmises the market may be pricing in either strongly accretive acquisitions, given surplus capital, or a takeover premium. Morgans sets a price target of $3.82.

Macquarie concurs that the majority of the outlook is captured in the share price and the issue is one of valuation rather than outlook, execution or the quality of the business model. Hence, a downgrade to Neutral from Outperform with a $3.65 target. The broker expects growth to continue as forecast, with considerable leverage once new products contribute to the bottom line, such as asset management, HR/payroll, property and stakeholder management solutions.

Revenue was weaker than Macquarie expected but was not helped by the cycling of a strong prior first half. Macquarie is not overly concerned about the weak cash flow, given the traditional seasonality of the business and a track record of delivering sustainable growth. The broker looks for conversion to rebound in the second half much like it did in the second half of 2014, as contracts settle in the September quarter.

That said, the UK continues to hold back profitability and the division is expected to incur a $400,000 loss in the full year. A significant acceleration in sales performance will be required before there is an improvement to profit margins, in Macquarie’s view. In Australia, state governments are embracing cloud technology and while the company has never had a strong presence in this market, Macquarie suspects this is a future opportunity. Further to this theme, the broker is also surprised to find larger organisations are embracing the cloud more so than smaller, more agile clients.

Customer numbers have more than doubled since September 2014, to 47, and management targets 80 by December. The proportion of clients opting for a pure cloud solution may be increasing but Macquarie is yet to be sure of the full financial impact. With the emergence of cloud computing the software-as-a-service fee may be spread over a longer period of time. Management may be confident it can book the full value of the licence revenue at the start of the contract but it remains unclear as to the underlying earnings implications and potential disconnect in the profit & loss ledger and cash flows.

The company is not chasing acquisitions but the recent acquisitions have strengthened the offering, Macquarie observes. Icon Software Solutions and Digital Mapping Solutions add intellectual property to service government clients and provide further leads for other Technology One products.
 

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