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Morningstar | Technology One Remains Undervalued Despite Planned Accounting Changes. See Updated Analyst Note from 17 Jul 2018

We have maintained our earnings forecasts and fair value estimate for narrow-moat-rated Technology One at AUD 5.70 per share following management's presentation regarding planned changes to their accounting policies. At the current market price of AUD 4.94, we continue to believe the shares are undervalued. Technology One shares have trended lower since late 2016 as EPS growth has slowed and the price/earnings multiple has contracted from relatively high levels. A combination of the problematic Brisbane City Council contract, the resignation of founder Adrian Di Marco as CEO, and investor concerns the business is ex-growth have all contributed to a gradual build-up in short interest in the stock this year. The impending change in accounting policy has also been a red flag for some investors.

However, we expect the 8% share price jump following the presentation reflected investor relief that things aren't as bad as the market had perceived. Importantly, fiscal 2018 NPAT growth guidance was maintained at 10% to 15% and the change in accounting policy does not impact the earnings growth outlook or free cash flow generation. Our fiscal 2018 NPAT growth forecast of 16% remains slightly above guidance and we suspect management may try to further restore investor confidence by beating their guidance this year.

The key reason for the change in accounting policy is the change in the AASB 15 accounting standard which relates to the revenue recognition of customer contracts. The change in accounting standard began on Jan. 1, 2018 but will not be implemented by Technology One until fiscal 2019, which is the company’s first full fiscal year following the change. To avoid confusion, we will continue to base our forecasts on the current accounting policy until the beginning of fiscal 2019.

We expect Technology One's reported revenue will fall by around 10% on a like-for-like basis in fiscal 2019 as the new standard will prevent the full recognition of a contract's revenue at the inception of the contract. Instead, Technology One will recognise revenue on a continuous basis as it is earned during the life of the contract. Aside from being required, this approach is more suitable for the company considering its transition towards a software-as-a-service business. Importantly, free cash flows to the firm and our fair value are unaffected by the revised accounting method.

Although Technology One will be required to change the way it accounts for revenue, the company has also decided to change the way it accounts for research and development costs. Historically, the company has taken the relatively conservative approach of expensing all of its research and development costs. In theory, R&D costs could be capitalised, depending on their nature, but the process has a degree of subjectivity and can be used to manipulate reported NPAT. We believe the company has decided to adopt the new accounting policy to offset the profit impact from the revenue recognition change, but as neither impacts the underlying free cash flow of the business, we are comfortable the change is not an attempt to hide underlying issues with the business and also that the new policy conforms to industry standards.