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Pay Attention to this Software Company
08/16/2013 11:30 am EST
I'm not exactly known for my enthusiasm when it comes to investing in software businesses.
Don't get me wrong—economically, the software industry has a number of attractive advantages. Returns on shareholder capital can be enormous—the company's earning power comes from its proprietary code, rather than heavy, depreciating machinery or demanding shareholder investments.
But like any fast-moving industry, staying on top of a market position in high technology can be like trying to capture lightning in a bottle. And as we know, lightning rarely strikes in the same place twice.
So it might be a surprise that I'm looking at Sage (LSS:SGE) today, which primarily develops business and accounting software for small-to-medium sized companies. There are three things I particularly like about Sage.
Firstly, unlike many other software companies, I think Sage could enjoy a long-lasting durability in its market. I get the impression that Sage is particularly well embedded within the firms who use their software. Generally, once companies start using Sage's software, I suspect they become reluctant to switch to another system they're less familiar with. This kind of stickiness provides an attractive recurring source of revenue from subscribers, and keeps the cash rolling in.
Secondly, the company's record of growing its earnings, dividends and cash flow over time is remarkable. Sage's performance has slipped in the last few years, but I think this can be forgiven, considering how small European businesses have struggled in recent years. Sage's customer base has grown from four million to six million since 2003, and in my view, we could see further growth in the next decade too. This track record, perhaps, suggests that other firms have struggled to muscle in on Sage's market position to date.
Finally, I think the current valuation is a fair—if not spectacularly cheap. Sage's shares trade at roughly 16 times normalized earnings, or 15 times last year's free cash flow. I feel that a 6-7% earnings yield is acceptable, assuming Sage can grow its profits modestly in the coming years.
Of course, no potential investment is without risks—the valuation isn't exceptionally cheap, and as ever in the software industry, there's a constant threat of competition and upheaval. But on a balance of the facts, I think Sage is a company worth taking a closer look at.
Mark does not own any share mentioned in this article.
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