‘One’ technology company for the watchlist

Continuing growth prospects, a healthy balance sheet, a relatively reasonable valuation, and a modest dividend make this a promising investment.

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Those of us who used computers in the ’90s may still sometimes think of software as a one-off purchase — something that comes in a box, on a CD-ROM (or even a floppy disk). But the reality is far different today, with many leading software companies having what are essentially subscription-based business models that offer predictable, recurring revenue and earnings.

When the latter comes replete with continuing growth prospects, a healthy balance sheet, a relatively reasonable valuation, and a modest dividend, you’ve got the makings of a promising investment. All of this is why you’ll want to take note of TechnologyOne (ASX: TNE).

Licenses, plus the joy (and pain) of switching costs

TechnologyOne, which is among Australia’s largest listed software companies, supplies ‘enterprise software solutions’ to businesses and government bodies in Australia, New Zealand, and increasingly the UK.

Its products allow clients — some 800 in total today — to manage crucial functions such as finance, human resources, payroll and supply chains, among others. Using preconfigured templates, TechnologyOne customises its various platforms to suit these clients’ individual needs. For the privilege, clients pay the company license fees on an ongoing basis, hence the recurring revenues and earnings.

While competition in this IT space can be fierce, it’s important to bear in mind how customers’ reluctance to move these crucial functions to new, unproven systems can lead them to favour the incumbent instead of switching to a new provider. What is a tedious prospect for customers is a source of delight — and stable sales — for TechnologyOne.

Growth translating to dollars

The ‘stickiness’ of TechnologyOne’s offerings is shown in its increasing annual license fees, climbing by a compound annual growth rate of 20% since 2003. TechnologyOne has also been adding new customers year by year, with its initial license fees climbing by a compound annual growth rate of 18% over the same period, according to company presentations. It also has a quickly growing consulting business, with sales in this segment growing 9% in 2012.

The growth becomes all the more alluring when you put a dollar sign to it. Just in the last five years, the company’s overall revenues have more than doubled, rising from $74.5 million in 2007 to $169.1 million by 2012, while net income grew from $11.6 million to $23.6 million and earnings per share doubled.

Aussie tech companies abroad — and valuation

TechnologyOne has in the last five years expanded into the UK, where its operations are currently unprofitable. Management has said it expects this market to become a profitable one and a source of growth, but its prospects for such are somewhat uncertain in the near term, given the continuing economic uncertainty, and more generally, how Australian tech companies sometimes struggle to compete overseas. In short, some make the leap. Others don’t.

While in 2010, TechnologyOne announced a series of initiatives to move its business — and its clients — into the cloud, overall, cloud-computing technology poses a risk in that it lowers the bar to entry for new competitors and increases the chances for disruption significantly.

It’s a mark in its favour that, with these risks in mind, TechnologyOne maintains low debt levels and a large cash position, including nearly $44 million in net cash. And the shares appear relatively reasonably valued, with the company’s total enterprise value (market capitalization plus debt) at about 12.6 times operating earnings. TNE shares also offer a trailing dividend yield of about 3%; in 2012, the dividend was franked at 85%.

Foolish takeaway

Tech companies come and go, but TechnologyOne appears to have considerable staying — and growing — power. It’s my view that this company is likely to outperform the market over the next several years, and the shares deserve a spot on your watch list.

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Motley Fool contributor Catherine Baab-Muguira has no financial interest in any of the companies mentioned in this article. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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