EUR 850.00 For Business Accounts Only

Morningstar | TNE Updated Star Rating from 22 May 2019

We weren’t particularly surprised that narrow-moat Technology One’s share price plunged by 13% following its first-half results. The share price has had an incredible run over the last few months, rising by about 130% since last July. However, despite moving beyond the challenges experienced in 2018, such as the Brisbane City Council contract dispute, disgruntled former employees, and the transition to a new chief executive officer, we don’t believe these minor events justified such a rally.

The result itself was broadly in line with our expectations although we’ve reduced our fiscal 2019 underlying net profit after tax forecast to AUD 58 million from AUD 61 million, which puts us at the top of management’s fiscal 2019 net profit before tax guidance of AUD 72 to AUD 76 million. We expect guidance will be reasonably accurate considering the recurring nature of earnings and that we’re already two thirds of the way through the financial year.

We maintain our fair value estimate at AUD 6.20 per share as the earnings cut has been offset by the time value of money effect on our financial model. At the current market price of AUD 7.83, we continue to believe the stock is overvalued. Our fair value implies a fiscal 2020 P/E ratio, of 29, versus 37 at the market price. The fair value implied dividend yield is 2.2%, or 2.7% with franking, versus 1.8%, or 2.1% with franking, at the market price. Our forecasts include a continuation of the AUD 0.02 annual special dividend, which has been paid for the last five years, and we consider the dividend to be highly sustainable.

The first-half result was messy for a few reasons. First, the first half usually comprises about 15% of the full-year result meaning it provides relatively little indication of how the company is performing. Secondly, the adoption of new accounting standards and policies also caused confusion.

The adoption of accounting standard AASB 15 means revenue is now deferred over the life of customer contracts, rather than being recognised at inception, which has caused revenue to fall. For example, fiscal 2018 full-year revenue would have been 15% lower under the new standard, and net profit before tax would have been 42% lower.

However, management took this opportunity to also relax their previously conservative research and development accounting policy, and begin capitalising research and development costs. This change offsets the revenue effect to some degree. For example, the effect of the revenue recognition change on fiscal 2018 net profit before tax was reduced to a 16% decline from a 42% decline.

We’re not too concerned about the new, more aggressive, research and development accounting policy, which was not required by accounting standards. This approach brings Technology One into line with its technology company peers and, importantly, cashflows are unaffected by the income statement changes. Technology One remains a high-quality company and one with an enviable track record of growing profits and dividends, and we maintain our Exemplary Stewardship rating.

Importantly, Technology One’s customer retention rate remains at about 99% and the transition toward a software-as-a service, or SaaS, business model continues to progress to plan. This should not be underestimated because recurring revenue is worth far more than revenue, which must be won from scratch each year.

If Technology has a weakness it is its ability to attract new customers. However, this is unlikely to be an issue in the short- to medium term because the transition of existing customers to SaaS contracts should create savings for customers and increase the opportunity to upsell additional software modules. The company also has potential to add customers in the relatively large U.K. market.

The Digital Experience Apps, or DXP, project could also be a material new source of revenue for the company as DXP aims to tap into the large customer base of Technology One’s customers. For example, Technology One currently sells enterprise software to Universities but the software isn’t sold directly to students. The potential to sell apps to students and council ratepayers is an exciting prospect which opens up the potential to develop network effects and increase switching costs. However, this is still at the early stages and is excluded from our forecasts.

From a balance sheet perspective, Technology One is in great shape because of the capital-light nature of the business model and high proportion of recurring revenue from defensive industries. The company had a net cash position of AUD 68 million by 30 March 2019 and we don’t expect the balance sheet to be leveraged. 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.