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Morningstar | Technology One Overvalued Following Broader Technology Stock Rally

The Nasdaq Composite Index fell 23% in the fourth quarter of 2018 but has since rallied 23%, lifting local Australian listed technology stocks with it. Technology One’s share price has risen by 93% since mid-last year, however, we believe the rally has more to do with the improvement in market sentiment than an improvement in Technology One’s outlook. Little has been announced by the company in recent months and management’s vague earnings guidance, of strong profit growth skewed to the second half, is unchanged. We expect little to be announced before the interim fiscal 2019 result on May 29, 2019 as the company is already in its investor blackout period. We maintain our fair value estimate at AUD 6.20 per share and, at the current market price of AUD 7.94, believe the shares are now overvalued.

Technology One was blighted in mid-2018 by investor concerns about its ability to grow its customer base, issues with client contracts and ex-employees, and the resignation of founder and CEO Adrian Di Marco. However, investors have gained comfort from Edward Cheung since his appointment as CEO last year and it’s now clear Di Marco’s resignation was not a precursor to a downturn for the company. Indeed, Di Marco has remained on the board of directors and continues to be involved with projects in an executive capacity. Issues with the Brisbane City Council contract and ex-employees have also blown over and now appear to be isolated events rather than a cultural issue.

We forecast an EPS CAGR of 14% over the next decade, versus 11% over the past decade. However, this growth is insufficient to justify the current share price, which implies a fiscal 2020 price/earnings ratio of 35, versus 28 at our fair value. The market price implies a dividend yield of 1.6%, or 2.3% including franking credits, which we consider to be sustainable.

We continue to expect the company to benefit from the transition of its customers from perpetual licences to software-as-a-service, or SaaS, contracts, which should drive revenue growth and profit margin expansion. To some degree, recent share price growth may reflect a change in investor perceptions of the company and application of the lofty valuations multiples of many other relatively young SaaS stocks. Investor confidence has also been boosted by management’s handling of the introduction of IFRS 15/AASB 15, which will change the way revenue is recognised, and the fiscal 2018 result last November also gave the market confidence the company remains in good shape.

From a balance sheet perspective, Technology One remains in great shape thanks to the capital-light nature of the business model and high proportion of recurring revenue from defensive industries. We expect this situation to continue and consider the fully franked dividend payout ratio of around 60% to be sustainable. Management remains reluctant to undertake acquisitions but is warming to the idea of small strategic acquisitions if achievable at an attractive price. Share buybacks are also an increasing possibility but we don’t incorporate potential merger and acquisition activity or share buybacks in our forecasts.