This week is one of the last chances to decide which shares to buy before earnings season starts. There are a few unique dynamics going on this year. As investors we have been speculating since the start of the coronavirus pandemic about how companies are going, yet we haven’t seen any earnings reports yet. In August, we finally get to look behind the curtain to see what is really going on.
Having said that, there are a few companies that have been diligently working away in the background that I believe are likely to deliver an earnings surprise. These companies all use an online, or software-as-a-service (SaaS) business model. Companies like this, that provide corporate functionality, have a few characteristics in common that gives them a distinct competitive advantage.
First, as an online product there are no update cycles – it just happens. Second, as a subscription-based business model, most revenues are recurring. Third, and most importantly, retention rates are high. This means that the first movers are often the companies that dominate the sector. It is almost a winner-take-all business.
Payroll system shares to buy
ELMO Software Ltd (ASX: ELO) provides SaaS human resources management systems. This includes HR systems, payroll, as well as rostering and timesheet functions within Australia and New Zealand.
On 9 June, Elmo reinstated its previous guidance. The company expects to generate annual recurring revenues (ARR) of $55–$57 million. In its H1FY20 report, Elmo announced a 30.9% growth in the customer base. In addition, the company’s customer retention rate sits at approximately 92.9%.
However, one of the most important figures is the customer concentration. For example, less than 1% of the company’s ARR comes from its largest customer and less than 6% from the top 10 customers. This is a measure of the resilience of the company’s revenue streams – Elmo could lose a big client without a large material impact.
At present, Elmo has a market valuation of approximately $599.61 million and is showing strong signs of forward momentum. It is not profitable at present and spends more than it earns to fund growth. However, the company has a cash balance of $140.3 million, and operations continued uninterrupted through the lockdown.
Although the company may surprise on the upside during earnings reports, I think it is a good share to buy for growth over the next 3–5 years, regardless.
Insurance claims management
FINEOS Corporation Holdings PLC (ASX: FCL) sells core enterprise software solutions for insurance management. It calls itself a life, accident and health (LA&H) company. The software is an SaaS module based platform. Its strength is in claims and payments management, as well as a string of additional modules to provide increased customer engagement and business intelligence.
Based in the IT hub that is Dublin, the company is active across 8 countries. Fineos is used by 6 of the top 10 Australian life and health insurance providers, 7 out of the top 10 life and health providers in the US, and is used to process 100% of accident claims in New Zealand. Fineos is also working on expanding the footprint within each client, and adding additional functionality through artificial intelligence.
The company has recently listed in Australia and has yet to post a profit. However, it has signalled that it is on track to beat prospectus forecasts. In my opinion, this is a good share to buy for relatively high growth in the medium term. I also believe that this company is going to surprise investors on the upside and is likely to spark a lot of interest.
Enterprise resource planning
TechnologyOne Ltd (ASX: TNE) is a company I have been following for a while now. Enterprise resource planning systems are enterprise level systems designed to manage all aspects of large organisations. In the case of TechnologyOne, this includes sectors like local, state and federal governments, utilities and infrastructure, health and community service providers, and financial companies.
TechnologyOne has been in this space for a while, although the move to a 100% SaaS model is fairly recent. It follows a different financial year, so H1 FY20 finished in March, and FY20 finishes in September. In its half yearly report, the company revealed a 6% increase in net profit after tax and an increase in ARR of 33%. In addition, the SaaS model also meant the recent lockdowns had a relatively low impact.
I think this is a good share to buy for solid growth over the next 2–5 years at least. It should also surprise during its earnings report, in my view, although that will be later in the year.
This collection of SaaS companies cover a range of areas. I think all of them will do well during earnings season, particularly Fineos and TechnologyOne as their figures are still relatively unknown. Each company has the benefit of high retention rates and increasing ARRs. In addition, they have all established a first mover advantage over their competitors.
Last, and most importantly, the business models of companies like this are totally different from the IT companies of the late 20th century. Here installation and implementation is low cost, just as the ongoing subscription costs are manageable. As such, the cost of a client switching out, given the integration with enterprise business processes, is often not worth it.
All of these reasons make these companies good shares to buy in today’s market, in my view.
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Daryl Mather has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Elmo Software. The Motley Fool Australia's parent company Motley Fool Holdings Inc. recommends FINEOS Holdings plc. The Motley Fool Australia has recommended Elmo Software and FINEOS Holdings plc. 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.