Rudi’s View: It’s Special vs Cheap, But Who’s Most At Risk?

This story features TECHNOLOGY ONE LIMITED, and other companies. For more info SHARE ANALYSIS: TNE

By Rudi Filapek-Vandyck, Editor

From the moment one starts looking for that 'special' corporate quality on the ASX, it is but a matter of time before the focus zooms in on IT services provider TechnologyOne ((TNE)).

Last week's interim financial update provided plenty of input as to why this Brisbane-headquartered, $5.7bn market capped member of the ASX100 is hands down one of the highest quality companies listed on the local exchange.

Rather than dissecting the finer details from the H1 financials, not necessarily all positive, I think it is of much greater importance to explain, in broad terms, what makes this local gem of such high quality.

It might help others, like you maybe (?), to understand what exactly makes this company so special, which might also help in discovering other 'special' companies or rejecting their claims to similar greatness.

An Exceptional Track Record, What Is The Secret Sauce?

In a world that is eagle-eyed focused on growth, TechOne's track record has been exceptionally consistent, growing earnings per share at around 15%, year-in, year-out. It was this consistency that attracted the attention of a short report in 2020, claiming management surely was cooking the books, because, well, no company is able to grow at such consistency for such a prolonged time.

Well, it's 2024 now, and TechOne's still doing it. That malicious short report is long forgotten about, and the share price recently rallied to a fresh all-time record high, intra-day, above $18. When the shorters stood ready to attack in 2020, the price temporarily sank below $8.

The share price, up from below 50c in 2004, is only what is visible to investors every day. The real story that lays underneath is the business approach that prioritises building close relationships with customers, and then making certain the service and products provided suit their needs.

In the fable of the hare and the tortoise, TechOne very much resembles the tortoise. Growing 15% per annum doesn't seem extremely appealing when others can do 100% and more, but can they do it consistently over two decades? TechOne has, and the market has increasingly been paying attention.

When a company grows at a pace of 15% per annum, it doubles in size in less than five years. By 2009, that share price was ready to surpass $1. By 2014 it was trading above $3. By 2019 the price was above $7. At last week's interim release, management gave indications growth is likely to accelerate in the coming years.

Analysts, or at least most of them, got the message and are now projecting 17% EPS growth for the years ahead. Some continue to see potential for further upside surprises, in particular since the UK business hasn't genuinely started contributing just yet. The magic ingredient of the TechOne business achievement is customers are increasingly happy to purchase more products from the same company.

What is usually pointed out about TechOne, including by myself, is its customers, mainly local governments and higher education institutions, are extremely "sticky" with last week's published churn percentage of 1.8% somewhat of a shock. History sees this percentage seldom rise above 1%. Don't worry, management is confident that number will be back below 1% shortly.

TechOne is far from the only company that can rely on customer loyalty, but it has been able to turn that loyalty into a sustainable platform for growth by selling existing customers more products. Not sustainable, I hear you say? Management remains confident there's still a lot more that can be achieved from the same database of prospects and existing customers.

Consistent Investing Builds Success

There's an easy argument to be made the real growth driver stems from the company investing circa one quarter of its revenues in new product development and improved services year-in, year-out. It's these new products that lift the take-up among existing customers.

It's not difficult to see here is a circle of trust at work and TechOne does enjoy a positive reputation in its core markets, also illustrated by the fact the company seems to have established itself as provider of the highest level of cybersecurity among ERP peers in Australia; not an unimportant halo to wear when dealing with government and local councils.

What always strikes me when reflecting on quality success stories such as TechOne's is management's ability to incorporate long-term benefits in the specific business strategy. In TechOne's case, since implementing ERP systems at companies can be very cumbersome, expensive and potentially time-consuming, the company has decided to lower the barrier and take full responsibility for the system implementation, in exchange for a higher subscription fee over the duration of an initial five-year contract.

Potential negatives: costs and any operational mishaps are the company's responsibility at first, the subsequent financial benefits accrue later. It is this strategy management has taken to the UK where the market leader in UK Student Management is still relying on an old-fashioned on-premise software solution which surely must be looking as of Dinosaur-vintage against TechOne's cloud based, all-inclusive ERP suite of products.

The UK is a much bigger sized market than is Australia (by a factor of three) and repeating the success-story of the past two decades over there could well guarantee a much extended runway for growth, but management has to date stuck to its measured approach. TechOne's presence in the country was enlarged with the acquisition of Scientia in FY21. Last year management spent $2m on an acquisition that was not pursued (also a sign of quality).

It is widely believed management has some form of M&A on its mind, likely to add a new customer base or speed things up in the UK. Thus far, only circa 10% of TechOne's annual recurring revenues (ARR) are derived from the UK, but it's growing faster than elsewhere.

Not Everyone's A Fan

I could go on but maybe I should also point out not everyone is equally convinced about TechOne management indicating growth is most likely to accelerate in the years ahead. Morningstar analyst Roy Van Keulen, for example, has his doubts, arguing growth has been achieved on the back of increased government spending post-covid, but this won't last.

Van Keulen suspects TechOne will have to increasingly spend more to achieve incremental revenue growth. As retail broker Ord Minnett whitelabels Morningstar research, Van Keulen is responsible for that broker's Lighten rating alongside a fair value estimate of not more than $14.50.

And he's not the only one. Back in October 2022, analysts at Morgan Stanley initiated coverage on ten mid-cap and smaller cap ASX-listed technology companies, only to conclude the trio of Megaport ((MP1)), Hansen Technologies ((HSN)) and Pexa Group ((PXA)) had superior growth prospects built on sustainable competitive advantages, scalable business models, and defensive characteristics, backed by strong balance sheets.

Morgan Stanley found TechOne's business model based on customer relationships would by nature limit its growth prospects and prevent it from ever expanding successfully in other geographies where much larger, much more sophisticated global competitors are in charge.

Interesting, more recent research updates from other analysts are suggesting TechOne's everything-in-house approach, without external consultants, makes it a positive stand-out in the industry which is greatly appreciated by customers and contributing to its quality image.

Equally interesting, out of the three nominated superior choices, only Megaport has outperformed TechOne's performance since November 2022 and it can be argued the starting point was always in Megaport's favour as it followed a significant sell-down in the shares. Both Hansen Technologies and Pexa Group shares are sitting on a negative performance since.

TechOne shares are up 44% in surely what must be the ultimate proof that the tortoise tends to win the race, as long as the contest is spread out over many years?

This has not stopped those Morgan Stanley analysts from sticking to their view. Last week's research update came with an Equal-Weight rating and $13 price target.

The Ever-Recurring Investor Dilemma

Even if we adopt a less skeptical view than Morningstar/Ord Minnett and Morgan Stanley, there's no arguing with the fact TechOne shares are not cheaply priced, even if FY24 and FY25 results were to beat current market forecasts. This is also reflected in RBC Capital initiating coverage with a Sector Perform rating and a price target of $18.

For investors still waiting to get on board, it is equally worth pointing out TechOne shares are highly unlikely to genuinely trade on low PE multiples, unless something seriously goes wrong, or the macro outlook changes dramatically, like it did in 2022 when global bond yields rose sharply as central banks started tightening on the back of the post-covid outbreak in inflation.

It can even be argued the prospect of economic recession should not have a major impact on the business, which is backed up by its track record from the past two decades.

Which is why I tend to advise investors to have a wish list for the great quality compounders the local bourse offers, and wait for opportunity to present itself. Another strategy might be to build a long-term portfolio exposure through smaller increments.

The FNArena-Vested Equities All-Weather Model Portfolio, in which TechOne shares are considered a cornerstone exposure, has in the past used share price weakness to buy or add to today's success stories in Goodman Group ((GMG)), Car Group ((CAR)), Hub24 ((HUB)), WiseTech Global ((WTC)), and REA Group ((REA)), to name a few.

The share market being what it is, a public forum where all kinds of opposing narratives converge, the next reason for a share price to weaken is seldom out of reach for too long. But one has to know in advance which stocks are on the personal wish list, and be ready to execute when the opportunity presents itself.

Corporate Signals In May

Another observation is that while high multiple, quality growth stocks seem to be performing well, judging from recent market updates by the likes of Xero ((XRO)), Webjet ((WEB)), Aristocrat Leisure ((ALL)), and, yes, TechnologyOne too, the opposite has been happening for the more vulnerable, cyclical alternatives that are trading on much cheaper valuations, but whose market updates are increasingly exposing operational disappointment and weakness.

Think, for example, Nufarm ((NUF)), recently, but also Elders ((ELD)), GrainCorp ((GNC)), Michael Hill ((MHJ)), Telstra ((TLS)), and including Dicker Data ((DDR)). While for some of these companies a valid argument can be made that things will look better in twelve months' time, there's equally a good chance economic momentum is set for more weakness first, before the next recovery announces itself.

In a share market that remains as polarised as ever, I see two different types of risk and, given the deteriorating trend this month, the bias may remain towards more profit warnings than weakness in sturdy, reliable 'champion' stocks.

The local confession season starts in June (next month). I stick to my self-manufactured habit of looking at the share market in terms of the 'vulnerable' (cheap) and the 'strong' (not cheap), which might be the more appropriate way of looking at companies in the run-up to the August results season.

Correct or not, the proof will be there for all to see.

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(This story was written on Monday, 27th May, 2024. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

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