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Morningstar | Technology One’s Outlook Is Only Getting Stronger. FVE Increased to AUD 6.20.

Technology One’s fiscal 2018 result was in line with both our forecasts and management guidance, but we are regardless increasingly excited about the earnings growth potential of the company. The transition to selling software-as-a-service, or SaaS, contracts, from on-premise perpetual software licences, is now complete. However, most existing customers are yet to transition to the more lucrative SaaS contracts which creates a relatively low risk source of revenue growth in the medium term. Technology One also has a significant opportunity to increase the number of products it sells to existing customers, who currently only use 40% of available products on average. The potential for the next generation of products, known as Digital Experience Apps, or DXPs, is particularly interesting as they could expand the customer base beyond the large organisations currently serviced, such as universities and local councils, to individuals, such as students and council rate payers.

We have increased our fair value estimate by 9% to AUD 6.20 per share which reflects an increase in our revenue growth forecasts relating to the transition of existing customers to SaaS contracts. Over the next decade, we forecast an EPS CAGR of 14% and our fair value implies a fiscal 2019 P/E ratio 32. Although this multiple is relatively high, it’s worth bearing in mind Technology One has delivered average EPS growth of 14% over the past nine years, has never had net debt, and has consistently paid growing and fully franked dividends. At the current market price of AUD 5.53, we consider the shares to be undervalued.

We think CEO Edward Chung is doing a good job and gradually earning the market’s confidence. The transition from founder and previous CEO Adrian Di Marco was never going to be easy considering Mr Di Marco’s long tenure in the role and dominance over all aspects of the company. The transition was not helped by a drop in earnings growth last year and the issues with the Brisbane City Council contract. These things may have given some investors the impression that Mr Di Marco had resigned ahead of a downturn in the business, however, we were right to look beyond the short-term issues earlier in the year and continue to believe Technology One is a high-quality business with good long-term prospects.

The transition of the customer base to SaaS contracts appears to be going well, with existing clients charged an ongoing SaaS fee for the privilege of using cloud rather than on-premise software. However, despite the higher fees, clients often still benefit from the SaaS option because they save on a range of costs, such as hardware, I.T. employees, and software licences, and achieve productivity gains from being able to access the software on multiple devices. Although Technology One already has an incredibly strong customer retention rate of around 99%, the company is locking its SaaS customers into five-year contracts which only strengthens its switching costs.

The DXP project is noteworthy as it could be a material new revenue stream that strengthens the company’s economic moat. Technology One is the logical supplier of mobile apps to students and rate payers, considering it already provides software to universities and local councils. It’s feasible that Technology One will extend existing relationships with these organisations to provide services to their end clients. It’s also plausible that Universities and local councils could be prepared to pay for additional services on behalf of the end user on a ‘per user per month’ basis. This could create additional sustainable recurring revenue for Technology one, a significant increase in its user base, and has the potential to create a network effect. However, at this stage we haven’t included earnings from this initiative due to the early stage of development. We understand 14 apps have been created and presented to the sales team already, but we require evidence of monetisation before inclusion into our financial model.

We continue to view the transition to AASB 15 to be a non-event, although it may attract a disproportionate amount of investor interest. AASB 15 is the new accounting standard, which Technology One will adopt from October 2019, and which changes the way revenue is recognised. Although various aspects of the income statement will change under the new approach, cash flows will not be affected and statutory NPAT should also be similar.