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Morningstar | MYOB Remains Undervalued as First-Half Result Meets Expectations

Narrow-moat-rated MYOB’s first-half result was in line with our expectations, and we have maintained our earnings forecasts and AUD 3.82 fair value estimate. At the current market price of AUD 3.05, we still believe the shares are undervalued. The market price implies a fiscal 2018 price/earnings ratio of 18, versus 23 at our fair value estimate, and an unfranked dividend yield of 3.0%. We still forecast an EPS CAGR of 8% over the next decade, underpinned by steady subscriber and average revenue per user, or ARPU, growth.

We were astonished that the MYOB share price initially dropped 8% following the result, considering it was in line with our forecasts and management guidance, and we weren’t surprised by the subsequent rally. However, the market seems preoccupied with technology stocks, which demonstrate particularly strong revenue growth, and profits are almost considered a negative attribute these days. MYOB’s first-half revenue growth rate of 7% looks weak relative to hot stocks like Wistech Global and Xero, which are growing at around 40% per year, as well as compared with its own historical average growth rate of 12% over the past three years. However, MYOB’s growth was broadly in line with our full-year forecast of 9% and management’s guidance of between 8% and 10%.

Perhaps in an attempt to satisfy the market’s appetite for revenue growth and disdain for profits, MYOB is increasing its reinvestment over the next two years. Following the failure of the Reckon acquisition earlier this year, management outlined a plan to increase sales and marketing costs by AUD 30 million per year, or around 37%, and make a one-off AUD 50 million incremental investment into software development, versus research and development spending of AUD 68 million in fiscal 2017. We are perfectly comfortable with this strategy and forecast a drop in EBITDA margin to 41% in 2018 before it rebounds gradually to 45% in fiscal 2021.

MYOB’s small and midsize enterprise, or SME, division, which comprises 62% of group revenue and increased revenue by 7% in the first half, remains the growth engine of the group. Total fee-paying customers grew by 5% in the first half, in line with our full-year growth forecast; the growth comprises two offsetting trends of growing cloud customers, which rose 32% to 340,000 during the half, and declining desktop customers, which fell by 15% to 291,000. We expect both rates gradually moderate over the next decade as the company matures, but the existing fee-paying and non-fee-paying desktop customers should provide plenty of leads to help build a strong cloud customer base. Management maintained guidance for 1,000,000 subscribers by 2020, which looks optimistic, but we suspect may be achieved with the inclusion of low-priced practice subscribers, which reached 152,000 in the first half. We forecast 707,000 by the end of 2020, but this figure excludes practice subscribers, meaning our forecast is roughly in line with guidance once adjusted.

The 2% growth in SME ARPU was below our full-year forecast of 4% but was due to discounting in the first half to drive conversions of non-fee-paying customers. We are comfortable with this strategy, considering customers are usually very sticky, which enables ARPU to revert to normal levels later in the client’s life. We expect a stronger second-half SME ARPU result, as management doesn’t intend to discount to the extent it did in the first half and has guided to full-year growth of over 3%. In the long term, we expect this kind of ARPU growth rate to be maintained as MYOB continually improves its software.

Although the practice management division, which comprises around 20% of group revenue, delivered only 1% revenue growth, this was broadly in line with our expectations. We’re also comfortable with this division treading water for now, as it’s an important strategic asset that supports the SME business. MYOB’s increased software development investment should enable revenue to grow by our forecast 3% annual growth rate in the longer term. The enterprise solutions division, which comprises 15% of group revenue, provides a key differentiator to Xero in that it serves midsize companies that MYOB can retain as they grow. However, the 10% revenue growth was broadly in line with our high-single-digit full-year and longer-term forecasts, which are unchanged.

MYOB’s capital-light business model enables strong cash flows and sustainable dividends, with franked dividends likely to begin in fiscal 2019. It also enables relatively low financial leverage, and MYOB had comfortable debt metrics of a net debt/EBITDA ratio of 2.1 and EBITA/interest expense of around 12 as at June 30, 2018. The company was prepared to increase the net debt/EBITDA ratio to 3 times to fund the Reckon acquisition, and management continues to seek further acquisitions. However, with the company maintaining focus on the Australia and New Zealand region, we doubt anything other than small bolt-on acquisitions are likely anytime soon. We expect metrics to remain reasonably stable during the period of elevated reinvestment before declining from fiscal 2021.