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Valuation An Issue For Technology One

Australia | May 25 2016

This story features TECHNOLOGY ONE LIMITED. For more info SHARE ANALYSIS: TNE

-10-15% profit growth reiterated
-Strong competitive advantage
-Is the stock too expensive?


By Eva Brocklehurst

A fall in first half profit for Technology One ((TNE)) does not worry brokers unduly, given the company enjoys strong momentum and a host of contracts in the pipeline. The issue for the stock is more one of valuation, given a substantial premium to peers.

The company reported a first half profit that was 17% below the prior corresponding half. Brokers account for the weaker than expected result in the combination of strong revenue growth that was offset by growth in total expenses. Operating cash flow was affected by working capital investment.

There is always a timing issue, and Morgans is inclined to look past first half results to the momentum that is occurring. As the company has guided to FY16 profit growth of 10-15% and is already at 14.7%, and 11% cost growth was pre-empted, the broker makes no changes to estimates.

The company expects 11% in expenses growth across the full year, versus 16% in the first half and has declared a 2.36c per share dividend, up 10%, which Morgans believes is indicative of its confidence in the outlook.

On analysis, UBS also believes FY16 guidance is achievable, driven by first half revenue growth of 12%, growth in cloud services and the second half revenue pipeline. Still, the broker tinkers with forecasts, lowering revenue estimates for FY17-18 by 2-3% on slightly slower initial licence fee expectations.

Incorporating a marginally higher cost base to reflect continued investment, UBS reduces its profit margin estimates by 96-180 basis points which results in a reduction of 6-10% in FY17-18 net profit forecasts.

All that aside, the broker believes the company has an enviable track record of earnings growth and a strong competitive advantage. Moreover, in the transition to the cloud, UBS believes Technology One is well positioned to take market share as its product is modular and can be configured, compared with alternative product suites that have been highly customised.

UBS observes there are two main benefits from the shift to the cloud. Firstly, revenues become stickier and, secondly, margins improve through increased operating leverage. The benign organic growth environment faced by many industrial stocks under coverage means the company's growth rate and history of delivering warrants a premium valuation in the broker's view. Still, this is already reflected in the share price. Hence,UBS retains a Neutral rating.

Morgans agrees the business is high quality but expects momentum to weaken eventually, which will be the catalyst to exit the stock. For now, as the market is buoyant and supportive, there is little reason to change the share price dynamics and a Hold rating is maintained. While acknowledging cheaper capital has pushed equity risk premiums lower, even on relative valuation grounds the stock appears expensive to Morgans, given its profit growth is not as substantial as its peers.

The main risk for the stock relates to market sentiment, the broker contends. A large part of the re-rating of the share price has been an investment market being willing to pay a substantially higher multiple for the same dollar of earnings. To emphasise this point, Morgans notes Technology One has traded historically on a 15 times price/earnings multiple and nowadays it is more like 39 times.

The results were highly likely to favour the second half but the scale of this seasonality was a minor surprise for Macquarie. Revenue growth was marginally stronger than expected, while expenses were the main drag as the company invested ahead of a number of large contracts which are to be finalised in the second half.

The broker observes the balance sheet remains in a strong net cash position. Cloud customers have more than quadrupled since September 2014 and Macquarie expects the cloud service fee will be a medium-term driver of growth, providing significant operating efficiencies as products scale up.

There is the potential for delays in uncertain markets, but Macquarie observes the company's customer base of government and education entities tends to be more resilient. The broker considers a premium valuation is warranted and retains an Outperform rating.

Bell Potter downgrades earnings forecasts by 1-2% for the next three years, driven by higher depreciation, lower interest revenue and higher number of fully diluted shares. The broker forecasts pre-tax profit growth of 16% for FY16, and subsequently expects an uplift in FY17 and FY18 to 20% and 18% respectively, driven by continued growth as well as a move into profitability for both the cloud services and UK business.

Bell Potter, not one of the eight stockbrokers monitored daily on FNArena's database, retains a Sell rating and $4.75 target. The recommendation is solely based on valuation and the broker emphasises it continues to have high regard for the stock and its outlook.

The database contains one Buy and two Hold ratings for Technology One. The consensus target is $5.22, suggesting 3.6% in downside to the last share price. This compares with $4.25 ahead of the results.

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