We recently research Technology One (ASX:TNE) in The Dynamic Investor after the Company reported its results for the six months to 31 March 2023 (1H23). While the 1H23 result was in line with estimates, the key focus point for investors is that the Company retained its key medium-term targets. Market confidence in the Company achieving these targets led to the shares reaching it all-time high prior to the release of the results. The shares have since steadily retreated from its recent highs. With this in mind, we assess whether current levels present an entry opportunity.
Overview of Technology One
Technology One is Australia’s largest enterprise resource planning (ERP) Software as a Service (SaaS) provider. The Company is the only SaaS provider with a fully integrated ERP suite and its entire enterprise suite is delivered on mobile devices. There are currently 15 products onto the new cloud native Ci Anywhere (CiA) SaaS platform. Customers use TNE’s SaaS solution, as the benefits include cost savings, scalability, security, and anywhere-anytime access. It also allows agility and speed to market of new products. These customers have hundreds of thousands of users, making TNE’s the largest ERP SaaS offering in Australia.
The business model entails TNE developing, marketing, selling, implementing, supporting and running its preconfigured solutions for customers across eight verticals. These are: government, local government, financial services, education, health and community services, asset intensive, project intensive and corporate.
Around 85% of revenue is generated from the government, education and health sectors. These verticals are highly defensive and where the Company has a customer retention rate of +99% and very low customer churn rate.
Key Fundamental Drivers
FY26 ARR Target Likely to Be Achieved Earlier
Growth in total Annual Recurring Revenue (ARR) continues to be driven by growth across all verticals, with five of the six verticals reporting ARR growth ranging from 20-33%. Approximately 90% of the total ARR amount is generated from SaaS.
Based on the recent performance of key metrics (in particular Net Revenue Retention), we expect TNE to reach its +$500m ARR target in FY26 a year early in FY25. The path to this ARR target can be achieved via:
i. Organic growth via higher pricing,
ii. Increasing the wallet share opportunity within existing customers (from 6.2 products per customer in FY22 vs 15 available products).
iii. Additional cross selling opportunities for customers transitioning to the cloud and
iv. New business growth.
Higher Risk of Not Achieving Margin Target
The Company reported a Profit Before Tax (PBT) margin of 25.1% in 1H23. While this figure was higher than the 24.7% reported in 1H22, group PBT has been diluted by the acquisition of Scientia (September 2021), which generates a PBT margin of 5%.
TNE has retained its 35% PBT margin target “in the next few years”, after increasing this target from 30% in 2021. We assume this target refers to FY26. Excluding the Scientia acquisition, the PBT margin in FY22 was 32%. While we previously took the view that achieving a 35% PBT margin target by FY26 was achievable, we highlight that there is now a higher risk of this target not being achieved, given:
i. Inflationary pressures on operating and CAPEX costs.
ii. TNE is likely to continue its significant Research & Development (R&D) investment in platforms for growth. These include SaaS+, App Builder, Digital Experience Platform (DXP) and extending the functionality and capabilities of the Company’s global SaaS ERP solution.
Notwithstanding the increased risk of achieving the PBT margin in FY26, the expansion in PBT margin over the next few years is underpinned by two factors:
i. Continued run-down of legacy costs of running both on-premise and SaaS support systems and
ii. The Company is transitioning its cloud customers that are using original Ci products onto the new CiA platform. This is to ensure the best customer experience and enable TNE to cross-sell new cloud-native products.
Net Cash Position to Continue Expanding
TNE’s balance sheet remains in a net cash position. Further, the cash balance is expected to improve by the end of FY23. This is because free cashflow is materially weighted towards the 2nd half.
We expect the cash balance to will continue to expand to FY25, as the Company executes on its SaaS transition. The increasing cash balance provides TNE with capital management optionality. It also enables the Company to fund R&D expenditure. The latter is expected to double over the next five years, as TNE aims to expand its addressable market by rolling out new products.
Technology One shares are currently trading on a 1-year forward P/E multiple of ~44x. This multiple is above the upper end of the trading range over the last seven years (30-41x) and the average multiple of ~35x over the same period. This reflects TNE’s highly attractive fundamentals, underpinned by: i) A recurring revenue profile (>90%), ii) Low churn rates (typically <1%), iii) A highly cash generative business model, iv) A net cash balance sheet and v) Achievable medium-term targets.
While the market continues to factor in medium-term targets, we contend that the valuation remains stretched, with limited catalysts for a further re-rating. We are also cognisant of two factors. Firstly, commentary from global central banks indicate that the higher interest rate cycle is not coming to an end. In turn, this can impact sentiment on growth and technology stocks and lead to share price volatility. Secondly, the best time to trade TNE shares is typically ahead of results releases.
TNE remains in a uptrend. However, volumes on the way down these past few weeks has been fairly high, which is not a great sign. We need to see a decent bounce from this $15 area to be confident that the uptrend will remain in place. Otherwise, a break under $15 will have us targeting $14 as the next stop. Investors can therefore be patient here to see if we get cheaper levels in the short-term.
Michael Gable is managing director of Fairmont Equities.
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