Risk aversion among London’s investors has worked to Sage’s advantage, because a high degree of recurring revenue and market dominance make the software provider a classic defensive stock.
The shares are valued at close to a record high, equating to just over 31 times forward earnings, but there are potential catalysts ahead. A profit-sapping five years of heightened spending on research and development and marketing has ended and today revenue is growing ahead of those areas of cost. Last year the operating margin rose to 20.9 per cent, from 19.5 per cent, a trend that the accounting software specialist thinks it can replicate this year. Analysts have forecast a margin of 21.9 per cent.
Moreover, heavier spending is justified. The business has been shifting away from licence fees towards a subscription model by getting customers to sign up to cloud-based services rather than accessing software on their PCs. The recurring revenue generated by cloud-based software products rose by almost a quarter to £1.6 billion last year, accounting for more than three quarters of the group total.
Selling more software products that operate on the cloud, rather than by being downloaded on to a user’s computer, also helps to generate more revenue from existing customers. About 85 per cent of its customers use cloud-based products, up from 75 per cent last year.
Cross-selling and “upselling” are big features of the business. Strip out the impact of customer churn, somewhere just north of the 7 per cent mark in revenue terms, and existing customers contribute roughly the same amount to sales growth as new business.
The group’s ability to sell more to the same businesses is linked to the health and confidence of the companies that subscribe to its software. Businesses might start with a basic accounting software, but growth in staff headcount brings with it a greater need for HR and payroll packages. The risk is that businesses swerve or fail to renew more sophisticated products to save money, but a recovery in the British economy could have the opposite effect.
There is also the health of America’s economy to consider. Sage’s growing exposure to North America is no bad thing. The United States’ economy is expected to expand at a faster rate than most G7 countries, including Britain and Germany. Inflation has cooled more rapidly in the US and markets are betting that the Federal Reserve will start cutting interest rates soon, which could spur more rapid growth.
The move from servers to the cloud is already more advanced in North America, Sage’s largest market. Revenue grew by 16 per cent last year and by a compound annual rate of just over 12 per cent over the past five years.
Continental Europe is seen as a prime market for growth. The region is hardly flagging. Underlying sales were up 5 per cent last year.
Pushing sales organically remains the company’s preference. Sage is not one for big deals. Instead, it favours bolt-on acquisitions, such as the £11 million purchase of Spherics, a company that specialises in helping businesses to measure their carbon footprints. Leverage stood at a multiple of one at the end of September, at the bottom end of the target range and enough to prompt a £350 million share buyback programme.
It will become harder for Sage to maintain its lofty status if there is a flight to riskier assets next year. For that to happen, investors will need to become more comfortable that interest rates have peaked and that the prognosis for the economy is brighter.
There is also the long-term performance to consider. Sage’s shares have delivered a total return of more than 190 per cent over the past decade, outstripping the FTSE 100 more than 13 times over. The present rating is rich, but there is little reason to doubt that it will deviate from that record. Any weakness in the shares should be an opportunity.
Advice: Hold
Why: The shares offer solid compound growth potential
Howden Joinery
The stellar run in Howden Joinery’s shares since the start of this year appears incongruous against a backdrop of higher interest rates and inflation that has run hot. The building materials supplier is on track to end the year as one of the best performers in the FTSE 100.
Investors have focused more keenly on the group’s relative resilience and signs that the market could turn in its favour. Howden sells to small builders, rather than the general public, a customer set that tends to offer a more regular flow of repeat business than retail consumers.
Volumes are about 6 per cent lower since the start of this year, while price inflation is roughly the same level. Excluding sales of solid work surfaces, products that are the last to be fitted and where revenue often slips into the next period, sales so far this year are flat. Analysts have forecast a return to growth next year.
Howden generates a higher return on capital and beefier margins than building materials peers such as Travis Perkins, Wickes or Grafton. The group occupies sites on the edge of towns with cheaper rents, forgoes any flashy advertising campaigns and makes about 40 per cent of the products it sells.
The shares are not expensive, trading at just under 17 times forward earnings. That is in line with the long-running average and is half the peak reached in 2020. The odds look favourable for trading to improve next year. Price inflation is cooling to the low single digits and interest rates seem likely to have peaked, which could stimulate the housing market and DIY activity.
There are also potential gains from overseas expansion. An initial plan to open 25 new depots in France each year was too ambitious. Investors can now expect between 15 and 20 over the next couple of years, in addition to the 60 already open. Those sites are not profitable, a milestone that the company hopes to hit by the end of next year.
That is backed by a strong balance sheet, with leverage standing at a multiple of only 0.8 including lease liabilities.
The recovery in the shares could have further to run.
Advice: Buy
Why: Improving economic conditions could spur the shares higher
