Technology One Limited (ASX: TNE) develops and sells enterprise software to government and government related businesses such as education, health and utilities. The company has been profitable since 1992 and paid dividends since 1996. Over the past five years, operating cash flows have nearly doubled, return on equity has been consistently over 30% and consequently the share price has risen by 360%.
Unfortunately, the market is well aware of Technology One's strengths and the stock is priced for perfection. Through trying to understanding the drivers of its stellar performance, I hope to be able to recognise similar companies before the market wakes up to their potential.
Management
I seem to find that a disproportionate number of elite companies have founder CEOs and Technology One is no exception. Executive Chairman, Adrian Di Marco, founded the company in 1987 and holds 14% of shares on issue. Fellow director and founding shareholder, John Mactaggart, owns a further 18%.
Typically, founder CEOs are instrumental in moulding the culture within their company and this may be part of the reason why such companies are often successful. They also tend to put the business before themselves, and their ongoing presence provides stability.
Customer focus
Through focus on customer service, Technology One has been able to win business from its multinational competitors, Oracle, SAP and Microsoft. The company owns its supply chain and does not use implementation partners or resellers. This enables it to be more receptive and responsive to customer needs.
The company focuses on seven specific industries related to government. This niche strategy not only ensures that Technology One can carefully tailor its products, but allows it to handpick the most profitable sectors. Each of the seven industries are highly defensive ensuring profitability through the economic cycle.
Technology One recognises that existing customers largely determine its future financial performance via recurring revenues or additional product sales. It enjoys a high level of customer retention and derives 60% of annual revenues from present customers.
Business model
Technology One charges both upfront as well as recurring license fees for its products. Software is scalable in that, once developed, it can be duplicated at little cost. These two factors combined have led to incremental revenue growth and margin expansion over many years.
The software that Technology One sells is highly integrated into its customers' systems and so is costly and troublesome to replace. It is also modular allowing customers to add additional functionality post implementation. As more modules are added, the platform becomes more entrenched, increasing the stickiness of revenues.
Research and development
Technology One spent $38 million on research and development in 2014, or 19.5% of its total revenues. The industry average is just 10%-12% and the company's unusually high commitment to improving its products also sets it apart from the competition.
Over the next six years, the plan is to reduce research and development to 15% of revenues whilst increasing spend in absolute terms. This makes further margin expansion and growth in earnings per share seem likely in coming years.
Such high research and development expenditure ensures that Technology One has a forever growing pipeline of products to sell to existing and new customers. In 2014, it released the TechnologyOne Cloud and Ci Anywhere platforms which make it possible to access enterprise software from anywhere, at any time with any device.
Foolish takeaway
The story of Technology One demonstrates what is possible when an excellent management team operates in a highly favourable industry. Such companies are rare and finding shares of companies with these characteristics that are also trading at a discount to fair value is the Holy Grail of investing.
