article 3 months old

Is TechnologyOne Too Heady?

Australia | Nov 23 2016

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

Enterprise software provider TechnologyOne continues to tick all the right boxes, although some brokers suspect the stock price is becoming a little heady.

-Stock considered high quality but valuation appears challenging
-Cloud expected to make up largest portion of revenue by 2020
-UK shifts to profitability, small acquisitions expected in FY17


By Eva Brocklehurst

Enterprise software provider TechnologyOne ((TNE)) continues to tick all the right boxes, although some brokers suspect the stock price is becoming a little heady.

The company produced a strong FY16 result, 1% above the top end of guidance, largely because of a lower tax rate. No guidance was provided but Morgans would not be surprised if the company guides to 10-15% profit growth at its AGM in February. The stock is considered high quality but the broker finds the valuation challenging.

Even a great business can be a poor investment if you pay too much, Morgans asserts. Price momentum is strong but this should eventually weaken and at that point the broker believes it will be time to exit the stock. The broker acknowledges that cheaper capital has pushed equity risk premiums lower but believes, even on relative grounds, the stock looks expensive.

The consulting division was the weak spot in the results but initial licence fees and annual licenses were up 20%, while cloud computing provides a robust long-term outlook for the company. Longer term, the company expects pre-tax profit margins will move back towards 30%, although commentary regarding potentially achieving 40% appears optimistic to Morgans. Operationally, the company appears in a strong position and the main risk relates to market sentiment, the broker suggests.

Asset manager Northern Trust differs, noting the company has some of the strongest operational dynamics in the region and a three-year average invested capital growth rate of 10%, as well zero debt. The company also has a long history of returning excess cash to shareholders and this should make for a compelling investment, particularly on weakness, in the firm's opinion.

Long-term dynamics are compelling, particularly in the licensing and cloud division. Cloud services have also exceeded Northern Trust's forecasts, with the original expectation of breaking even in 2017 now estimated as a $1m profit. The cloud division is expected to make up the largest portion of revenue for the company by 2020.

While the enterprise value to earnings valuation may appear higher on face value, the analysts believe recent broker upgrades in the last month have been on the basis of target valuation multiple upgrades, with very little earnings upgrades yet being incorporated into estimates. It goes without saying that Northern Trust, not one of the eight brokers monitored daily on the FNArena database, has a Buy rating.

The results provide further evidence of the company's strong track record and, given the benign organic growth environment facing many industrial stocks under coverage, UBS believes TechnologyOne warrants a premium valuation. Yet, with a view to the multiples on which the stock trades, UBS believes this is largely reflected in the current share price.

Macquarie is more upbeat and envisages considerable leverage will be realised once new products contribute to the bottom line over the next few years. The broker acknowledges the risks associated with migration to cloud services but believes a premium valuation is warranted, given the opportunity to up-sell clients to a higher value solution. Cloud services fees now total $16m in annual contracted value. Given the cloud revenue model Macquarie expects revenue to lag annual contract value by around 12 months.

The broker notes the UK business has also shifted towards profitability one year earlier than expected and has reached critical mass with 40 clients. With the company having secured preferred supplier status from the federal government the broker expects smaller agencies will now follow suit in FY17. Macquarie also expects the company to make small strategic acquisitions to add functionality to its cloud development in FY17.

The result was more mixed than Bell Potter expected, with revenue 2% higher and earnings 2% lower. The main reason for this at the earnings level was a higher-than-expected loss in the cloud segment, although this was mostly made up for by lower-than-expected amortisation and tax. The final dividend of 5.09c was in line, while the special dividend of 2.00c was below the broker's forecast.

Bell Potter downgrades forecasts for earnings per share in FY17 and FY18 by 2-3%, driven by reductions in margin forecasts because of increased marketing and corporate costs and lower profit forecasts from the cloud. The broker still expects growth in pre-tax profit of 17% in FY17 and 20% in FY18. Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, retains a Hold rating and a $5.75 target.

The database shows one Buy rating and two Hold. The consensus target is $5.92, suggesting 3.5% upside to the last share price. Targets range from $5.71 (Morgans) to $6.30 (Macquarie).

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