Cashing In On Small Business Solutions

Published in Company Comment on 13 December 2010

This FTSE 100 company has put in a stellar performance throughout the recession

A quick scout around its website and a look at the financial track record of FTSE 100 constituent, Sage Group (LSE: SGE), paints a picture of a well performing business. 

In fact, its cash flow has powered through the recession like a freight train with brake failure!

The company specialises in providing business management software and services to small and medium sized enterprises, and such is its grip on the market that many will have seen office staff recruitment adds asking for 'experience with Sage.'

Investor enthusiasm

On the other hand, as an investment the company hasn't performed as well, with the share price today practically at the same position as five years ago. And it's still way below the £9 level it peaked at during the dot com boom. It's clear that the share price had previously been bid up to levels that over-priced the real growth prospects of the business. 

Although the share price has been waggling around, the business has been set on a steady trajectory throughout the whole period -- up.

Cash generative

Sage has a great business model in my view: it sells its kit to its customers, gets them to depend on it to run their own businesses, with excellent training and support, and then locks them into a support contract with an annual fee.

Such has been the success of this strategy that the recurring 'subscription' fees constituted over 66% of the revenue in the 2010 financial year.

But you won't be buying tangible assets if you invest in Sage, for the net tangible asset figure is a negative £561m or so. But what you will be buying into is a steadily rising flow of cash as shown in the company's past financial performance:

 200520062007200820092010
Revenue (£m)7609361,1581,2951,4391,435
Net Profit (£m)133153154166189227
Diluted Earnings Per Share10.3p11.7p11.8p12.7p14.4p17.2p
Dividend2.88p3.59p7p7.21p7.43p7.8p
Net Cash From Operations (£m)178193220254286342
Gearing20%68%54%47%32%16%

At the current 282p share price, the historical dividend yield is roughly 2.7% and covered around 2.2 times by earnings. Meanwhile, the return on equity is running at a comfortable 14%, or so.

It's reassuring to see how the torrent of cash is being used to support the progressive dividend policy and to pay down debt accumulated during previous acquisition activity.

Valuation

But it's all very well identifying a good business, that's the easy part; the hard part is buying it at a price that makes your investment sensible.

Historically, Sage has a price to earnings ratio of about 16, with enterprise value to net cash from operations of around 11.

These ratios compare to annualised growth rates of around 14% for revenue and net cash from operations, and 11% for net profit. Ideally, we'd be looking for the valuation ratios to be less than the growth rates, as an indication of good value.

However, these are past figures and what really matters is whether the growth rate can continue.

Outlook

A new CEO has taken charge recently and this has been accompanied with a bit of a director reshuffle. Often such changes can signal renewed management vigour, so this could be a good sign.

In the final results statement released on 1 December, the directors said:

"Our focus is on improving organic revenue growth, particularly in North America, in driving our web strategy, and in growing our margin in the medium term whilst continuing to invest in higher growth initiatives such as payment processing and Sage ERP X3."

With North America already forming around 40% of revenues, growth there could be significant to the overall results of the group.

Meanwhile, there is great potential in the web strategy, which aims to bring the advantages of the internet to both existing and new customers through Sage applications.

Sage reckons that it is the third largest business management solutions provider in the world with an 8% market share. Also, 80% of its customers are businesses with less than 25 employees, which all rather suggests that there may be plenty of room for Sage to gain market share, going forward.

Margin of safety

There is potential, but the shares look to be priced as if growth is a done deal; I'd be more cautious, particularly as the dividend was only raised by 5% this year.

Although the dividend looks solid enough, I'd prefer the margin of safety that comes with a bigger payout and a lower share price before taking the plunge, particularly in the light of the big run up that holders of the shares have enjoyed over the last couple of years.

Having said that, this is a good business and one to buy on any significant share price weakness, I reckon. Of course, there is no guarantee that such a buying opportunity will arrive.

To me, this is one for the watch list.

More from Kevin Godbold:

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Comments

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jackdaww 13 Dec 2010 , 9:58am

i wonder about the impact of cloud computing - sme business's may be able to get their needs off the internet .

maybe sage will get their software up there anyway.

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