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Is Class Ltd (ASX:CL1) a star growth stock at a fair price?

What is Class Ltd (ASX: CL1)?

Class Ltd is the Australian market-leading cloud-based SMSF administrative software company. It provides accounting practices with a software solution to make their job less time consuming and more efficient.

The Class software allows accounting practices to spend less time on tedious manual processes, and more time on servicing their clients. The efficiency gains also allows them to grow their business at a faster rate. In fact, practices that use Class’s solutions boast a 17% p.a growth rate. This is 3x the industry rate of 5.2% p.a. Clearly the product is adding value for its customers.

The company has benefitted from entering the sector at a crucial time, as software moves from the desktop to the cloud. This has has provided a ‘first-mover’ competitive advantage for Class Ltd, as it was the first provider to offer an entirely cloud-based solution. Because of this, they do not have the burden of having to maintain legacy desktop software, unlike the established providers who have been around for a long time.

By focusing on a purely cloud-based offering, Class Ltd is a nimble, capital light business, that is disrupting older SMSF software providers, and rapidly engulfing market share.

The business model reminds me of New Zealand tech stock, Xero Limited (ASX: XRO), which has been disrupting the SME accounting space over the past decade.

Are Class Ltd shares good value?

Class currently has a market share of 25% (FY18 half-year result), so there is a big growth runway ahead. Another growth lever for the company is the ‘Class Portfolio’ product, which has been gaining traction of late.

The product saw strong growth at the March quarterly update, with accounts up 30% on the previous quarter. This new product allows accountants to track and manage other investment portfolios outside of a client’s SMSF.

Class shares are currently trading for around $2.45, well below its 52-week high of $3.65.

Shares were sold off after the company’s latest Q3 update in March revealed slower-than-expected super account and total customer growth of 2.9% and 1.9% respectively. There are two reasons that could be causing the weaker Q3 numbers:

  1. The migration of AMP accounts that had previously been using Class software, onto their own in-house software. This has been well flagged to the market by management at the last few reporting periods, but the exact date of commencement was unknown. It seems this commencement is now well underway, and with 8,800 SMSF accounts remaining, this headwind will continue to blow into the near-future.
  2. A normal seasonal lull due to the rollover into a new calendar year. Something that stood out to me, when reading the Q3 update, was the consistent underperformance in Q3 of past years. This tells me this period of slower growth is only temporary.

All though these were slightly disappointing numbers, three months is hardly a suitable amount of time to draw any accurate conclusions. It may pay to note that Q2 was a very strong growth period with super account, and total customer growth of 5.2% and 7.2% respectively. This shows the company has still been growing strongly in recent times.

There have also been concerns about the company’s increased marketing spend in order to attract customers, and what this says about competition in the sector. This is a valid question with the 2018 interim report showing the Customer Acquisition Cost (CAC) jumping to $125 from $112 in the prior corresponding period.

Although this may hurt profit margins in the short-term, I believe this is a smart strategy if it continues to translate into increasing accounts and customers on the Class platform, like we saw in Q2. Especially with the company’s extremely high retention rate of 99.5%.

I will keep a keen eye on the next quarterly update to see if the company can bounce back to stronger growth in super accounts and customers. I will also keep an eye on retention rates, as a good measure of sector competition.

Until then, now could be a good time to buy while market sentiment is against the company. If the company matches its EPS growth from the first half of FY18 of 20%, then the company currently trades on a forward PE of 29 times. I think this is an attractive price for a fast growing, high-quality company, with sticky recurring revenues.

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Motley Fool contributor Jacob Ballard owns shares of Class Limited and Xero. The Motley Fool Australia owns shares of Class Limited and Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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