Sage, a U.K.-based accounting software specialist, has seen a significant increase in its stock performance recently. Previously regarded as an attractive investment due to its sticky customer base, strong product, and favorable business model, the company’s shares have now reached a point where the valuation is considered stretched. As a result, the rating has been downgraded to a “sell.”
In recent years, Sage has been transitioning to a cloud-based model to enhance recurring revenues. This strategy seems to be paying off, with the first half of the year showing a 12% increase in underlying annualized recurring revenue to £2.1 billion. The company attributes this growth to strong performance across all regions, as well as a balance between new and existing customers.
Furthermore, cloud native annualized recurring revenue has increased by 30% to £612 million, driven by new customer acquisition and migrations from cloud connected and desktop products. This indicates that Sage’s cloud focus is yielding positive results and has the potential to improve both revenues and profit margins in the long term.
However, there are some risks involved. While Sage’s business remains robust, particularly in North America, the broader economic slowdown experienced in many markets could impact businesses’ IT budgets. Although Sage has a strong position in the market due to switching costs and its core role in business operations, the company may face challenges in signing up new customers during a global economic downturn.
Despite these potential risks, Sage has managed to reduce its net debt by 6% between September and March, demonstrating ample liquidity. However, the current net debt of £691 million is still higher than desired. With the company generating £194 million of free cash flow in the first half of the year, it is suggested that Sage could bring down its net debt more quickly while the economic environment remains relatively favorable.
When examining Sage’s financial metrics, the company’s performance in the previous year compared to the last full pre-pandemic year does not appear impressive. Based on last year’s earnings and the current market capitalization of £10.4 billion, Sage is trading at a P/E ratio of 40. This increased valuation has resulted in a dividend yield of just 1.8%, significantly lower than many other FTSE 100 peers.
The question arises as to whether the valuation is based more on future earnings expectations rather than past performance. Sage’s outlook for the current financial year suggests organic recurring revenue growth of approximately 11%, driven by the strength of Sage Business Cloud. The company also anticipates a decline in other revenue (SSRS) in line with its strategy, with increasing operating margins expected in the future.
Although this outlook implies the potential for higher per-share earnings, the lack of specific expectations and the company’s inconsistent performance in recent years may warrant caution. With decent rather than exceptional growth opportunities ahead, a prospective P/E ratio in the thirties seems high. Consequently, the shares are viewed as overvalued, leading to a change in the rating from “buy” to “sell.”
More detail via SeekingAlpha here… ( Image via SeekingAlpha )