Small Caps | Jul 10 2018
Software service provider, Class, posted a weak June quarter but brokers remain positive on migration to the cloud.
-FY19 expected to be less disruptive
-Year-on-year growth still in double digits
-90% of SMSF accounts expected on the cloud in 3-5 years
By Eva Brocklehurst
Changes to superannuation, implemented by the Australian government last year, have affected the portfolio of software service provider Class ((CL1)). The company reported a weak June quarter as changes to accounting requirements wrought disruption.
Additional work is required of accountants and administrators to implement capital gains tax relief for clients. This has meant end-of-year tax lodgements have been delayed which, in turn, affects the ability of prospective customers to evaluate software purchases.
Hence, account growth disappointed. While net new accounts totalled 4,526 during the quarter this appears to have been supported by slower migration of the AMP-based accounts. As FY19 is expected to be less disruptive for the industry, brokers suspect migrations will now accelerate.
UBS forecasts the remaining 8,300 AMP-based accounts will transition from Class over FY19. This could be offset by faster industry migration to the cloud as a result of regulatory changes at the Australian Taxation Office.
Moelis takes a conservative approach to growth expectations across FY19-21. FY19-20 estimates for earnings per share are reduced by -5-10%. The June quarter update was disappointing, although a more stable environment going forward should support the company's strong customer retention and cash conversion.
Meanwhile, the company's scalable platform provides an attractive investment opportunity over the medium term. Moelis, not one of the eight stockbrokers monitored on the FNArena database, maintains a Buy rating and a target of $2.70.
Morgans also downgrades forecasts to reflect a slightly lower starting base for paying subscribers at the end of the June quarter and a lower number of new account additions in the first half of FY19 because of logjams in the workload. The broker considers the shortfall in SMSF subscribers is not that dramatic as year-on-year growth is still in double digits.
While the growth rate in the second half of FY18 was below expectations, paying accounts grew by 16% Morgans points out, and in the financial year Class grew its share of SMSF accounts on platform to 26%.
Perceived earnings risks include a failure to grow customer accounts at the rate expected by the market, as well as regulatory changes that slow new SMSF formations.
Morgans maintains a positive view on the stock and believes sustained double-digit earnings and free cash flow growth should continue. As the stock trades at a discount to valuation an Add rating is maintained. Target is $2.73.
Headwinds
Extensive changes were made to superannuation regulations in the federal budget in 2017. There was little time provided for changing systems and administrators of SMSF platforms are struggling to cope with the workload. Class has noted that, as of June 21, 35% of the former financial year tax returns have not been filed.
Traditionally, the September and December quarters of each year are the best time for Class to sign up new customers, as the former year's tax and statutory accounts have been lodged and there is an opportunity for accountants to consider switching to a new platform.
Signing new clients was also made harder by main rival, BGL, offering 12 months of free use of its new cloud-based SMSF system. Morgans suggests this allowed accountants, who may have been tempted to switch to Class, to defer a decision for 12 months. The broker also points out that BGL is a private company and short-term earnings are less important than defending market share.
UBS factors in the "fee holidays" to its forecasts and acknowledges competition remains intense. Still, the possibility of a faster-than-expected transition to cloud-based software for SMSFs supports a Buy rating for Class, in the broker's view.
Morgans notes, of around 600,000 SMSFs, 57% are claimed by one of the two main cloud-based administration platforms. The remainder are up for grabs over the next three years. To support the broker's current valuation Class needs to win an additional 84,500 net new accounts between now and June 30, 2022.
UBS expects around 90% of accounts will be on the cloud over the next 3-5 years and this may accelerate should non-cloud accounts find it difficult to comply with the Australian Taxation Office reporting requirements that begin in the September 2018 quarter.
The database shows three Buy ratings (Ord Minnett is yet to update on the quarter). The consensus target is $3.06, signalling 39.1% upside to the last share price.
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