Valuation A Chief Concern For TechnologyOne

Australia | May 22 2019

Large accounting clients continue to migrate to TechnologyOne's cloud offering but brokers remain concerned about the stock's valuation.

-Increased interim dividend, special dividend at final being considered
-Sentiment and lower cost of capital are affecting valuations
-Free cash flow likely to trail net profit, reflecting migration to SaaS

 

By Eva Brocklehurst

While accounting changes will have material impact on comparisons in the company's FY19 earnings statement, TechnologyOne ((TNE)) is still expected to increase its product per client as it transitions to software-as-a-service (SaaS). Large clients are expected to continue migrating to the company's cloud offering. TechnologyOne has less than 15% market share in Asia Pacific and 99% customer retention.

Accounting changes made cross-comparisons difficult in the first half results. Morgans notes, as recurring revenue expands, seasonality will dwindle but for now a large skew to the second half remains. The company has guided to pre-tax profit in FY19 of $71.6-76.3m. On-premises and consulting revenue declined -7% and -2% respectively. However, consulting profit of $3.4m reflects a turnaround from a loss in the prior corresponding half.

While free cash flow does not change materially, the accounting standard changes had a significant impact on the balance sheet and shareholder equity took a large hit. Total liabilities went up by $105m, reflecting cash received in advance but not yet booked as revenue in the profit and loss.

Setting aside the messy accounting, which is of little concern, Morgans believes the most appropriate measure to view is the 3.2c interim dividend. This was up 10% year-on-year and 75% franked, with a first half pay-out ratio of 56%. The board is also considering a special dividend at the end of the year.

The company also believes it is turning the corner in the UK business and remains positive about the opportunity, expecting significant upside in the UK in coming years. Macquarie agrees upside exists if the UK segment gains momentum but considers the stock's valuation stretched. The share price is expected to suffer from volatility as it becomes increasingly compared to higher-growth global peers.

Wilsons, not one of the eight stockbrokers monitored daily on the FNArena database, assesses the company has made the journey to cloud from on-premises business smoothly and expects this to continue.

Valuation

The central issue for most brokers is the valuation of the stock. TechnologyOne is trading as though it were a pure play global SaaS operator, Wilsons notes, yet does not fit this category, currently, given the legacy exposure. The broker envisages some near-term weakness but the upside in the medium term negates the need to downgrade and a Hold rating and $6.70 target are maintained.

While changes to forecasts have not improved substantially, the share price has rallied to near $9 from $5 in the last six months and Morgans asserts that sentiment and assumed lower cost of capital are impacting valuations. In conjunction with increasing passive/ETF and momentum funds, this is driving the share price higher. Hence, investors need to watch momentum closely for any material changes.

The main drawback for Ord Minnett was guidance around cash flow, suggesting that free cash flow in FY19 will trail net profit. This does not reflect collections but rather lower upfront cash payments from customers as they migrate to SaaS. While largely related to timing, it still affects forecasts, in the broker's view. As the valuation is now considered stretched, Ord Minnett downgrades to Lighten from Hold.

SaaS

Macquarie agrees the ongoing transition to SaaS is dragging on top-line growth, albeit generating significant long-term value. SaaS grew 45% in annual contracted value which offset weakness elsewhere. The broker expects, given the typical second half skew and the many growth levers TechnologyOne enjoys, the company will hit its typical 10-15% growth in pre-tax profit.

While some investors expect growth will accelerate materially with the transition to SaaS, Morgans does not expect this to happen. The company is expected to grow at at a steady rate around 15% per annum, consistent with CEO Edward Chung's comment that the business should double in size in the next five years.

FNArena's database shows three Hold and one Sell (Ord Minnett) rating. The consensus target is $6.86, signalling -13.0% downside to the last share price. This compares with $5.61 ahead of the first half results. Targets range from $5.60 (UBS) to $7.80 (Macquarie).

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