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Why I think ELMO Software Ltd (ASX:ELO) could be one of the biggest bargains on the ASX

The share price of payroll and human resources software developer ELMO Software Ltd (ASX: ELO) has been on a more or less steady downward trajectory since the company released its FY18 financial results in late August. After storming to a record high of $8.54 on the August 24, the company’s shares have shed more than 35% of their value, and as of Friday trade at just $5.48.

The cause of the selloff is a little hard to determine, considering the company’s results were mostly positive. Revenues were up over 36% against the prior year to a little over $23 million, which even exceeded the company’s own upgraded guidance issued back in March. EBITDA was up over 122% to $2.7 million, as ELMO’s revenue growth outstripped growth in operating expenses.

The only downside came in the company’s FY19 outlook. Despite forecasting revenues to grow by upwards of 70% to $39.5 million, the company’s guidance for FY19 EBITDA was just $1.1 million, implying heavy investment in marketing and R&D. Low to negative growth in the company’s bottom line may have been enough to turn some short-term investors away.

Even some promising first quarter results couldn’t do enough to win them back. ELMO recorded cash receipts of $10.3 million in the first quarter FY19, which represented growth of 91% versus 1Q FY18. This was also up 4% against 4Q FY18, which is a particularly strong result given that historically first quarter performance has always been muted.

Management did not upgrade its earnings guidance in either this report nor in the CEO’s address to shareholders at the company’s November AGM. This might still be sending negative signals to the broader market about the company’s ability to convert its revenues into actual profits.

But I still rate ELMO’s long-term growth potential, and I think the company’s investment in marketing and R&D will only set it up to deliver even stronger results in years to come. ELMO delivered excellent results across almost all customer-related metrics in FY18. Customer retention was 92%, recurring revenues accounted for 93.2% of total revenues, and its customer base nearly doubled to 1,031.

The company is pursuing an organic growth strategy, with plans to broaden its suite of software product offerings to grow its customer base and increase the number of products sold to its existing clientele. Additionally, the company has a pipeline of strategic acquisitions in place for companies with complementary technology.

In my mind, this makes ELMO similar to logistics software developer WiseTech Global Ltd (ASX: WTC), which is also expanding its business through a clever combination of organic growth and strategic acquisitions. WiseTech also has extremely high customer retention rates. And like ELMO, close to 90% of WiseTech’s FY18 revenues were recurring.

Foolish takeaway:

I rate both of these software companies as excellent long-term growth prospects. And I’m happy to take some short-term pain in their bottom lines while they invest in growing their customer base. Both companies have proven that once they win over a customer it generally means they are able to lock in those revenues for years to come, which is great news for shareholders.

Rhys Brock owns shares ofELMOSFTWRE FPO and WiseTech Global. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of ELMOSFTWRE FPO. The Motley Fool Australia owns shares of WiseTech Global. The Motley Fool Australia has recommended ELMOSFTWRE FPO. 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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