Are IT stocks worth stocking?

IT stocks such as UXC have outperformed … but technology adopters need to be careful.

PORTFOLIO POINT: There is a technology boom underway on the market, but investors should build in a safety margin with some stocks clearly overvalued.

Revitalised technology consultant, UXC, is leading a pack of stand-out small-cap IT stocks.

UXC has rocketed from a 52-week low of 38 cents to $1, amid booming earnings growth, clever acquisitions and signs its transformation under new management is paying off.

This strong performance has led to several positive newspaper stories and broking reports about UXC this year. Although some praise is deserved, UXC badly lags its closest listed peers on return on equity (ROE), and before rushing out to buy shares you should know that I reckon its shares are overvalued after the recent price spike.

Nevertheless, it’s worth providing an appraisal should the share price decline and the circumstances for the company remain otherwise unchanged.

Another reason to put UXC on your watch list is anticipation of improving value once the gap between its intrinsic value and share price narrows. It may have more long-term upside than other small-cap tech stocks, which, like UXC, have outperformed the sharemarket and captured attention.

The ASX software and services sector has been a treasure trove this year for investors who are comfortable with micro-cap and small-cap stocks. There are technically 62 ASX-listed software providers and 24 hardware and equipment stocks.

The majority are too speculative and low quality for portfolio value investors. The highest-quality software companies are DWS (the only one with the top A1 Skaffold rating), SMS Management and Technology (A2), Reckon (A2), Technology One (A2), and UXC (A2).

These stocks have mostly delivered strong returns over one year. UXC has a 97% total shareholder turn (including dividends) over one year. Technology One has returned 36%, DWS 33% and SMS 24%. Reckon is down 10%, but lost a major partner when Intuit in the US pulled its agreement with Reckon to sell its Quicken accounting product suite in Australia.

There is a lot to like about the business model and performance characteristics of SMS, DWS, Technology One and UXC. Technology consulting is typically less capital intensive than other industries, and leading software service companies can produce strong free cash flow. In theory, this means more scope to self-fund expansion and less need for debt or new share issuance that dilutes shareholders.

SMS and DWS have no debt, UXC has negligible debt (after paying down high debt levels in recent years), and Technology One has modest debt – a 14.1% debt-to-equity ratio. Each company has had solid growth in cash flow over the past three years and rates well on cash flow scores.

Good growth in cash flow gives scope for higher, or special, dividends from these tech stocks in the next few years. At current prices, DWS is forecast to yield 8.04% fully franked in 2013; and Technology One, SMS and UXC should yield about 5% fully franked. Decent, sustainable yield is an attraction in fast-growing small-cap industrial companies.

The main downside for these stocks is seemingly low barriers to entry. Low capital intensity opens the door for software providers that can attract and keep good staff, and challenge for contracts. Technology consulting is a people business; wages can account for as much as 70% of total costs in some companies, and maintaining high staff utilisation rates is the key to higher profit margins.

The fragmented competitive landscape is shown by the market leader, IBM, having a 9.8% share of the business and technology consulting market in 2011, according to research firm Gartner. UXC was second with 6.7%.

The industry’s main sustainable competitive advantage comes through high client-switching costs. Big technology projects often run for years, making it hard for clients to change providers. And developing new technology in one part of a business often has a ripple effect in others, in turn creating more work and recurring annual income for the consultancy through technology licence fees. It’s a beautiful business model when it works.

UXC’s business model, however, has not always worked. Its five-year average annual total shareholder return is minus 10%. An over-reliance on utility contracts, a low earnings before interest, tax, depreciation and amortisation (EBITDA) margin, and an inefficient structure, hampered growth.

There was too much focus on revenue growth and not enough on achieving a decent return on shareholders’ funds, which is central to my valuation methodology, where a high and rising ROE leads to a rising intrinsic value and inevitably a higher share price.

UXC’s ROE needs work: 9.4% in FY12 is too low for a company of its calibre, and the market is betting, perhaps prematurely, that UXC can quickly achieve a similar return on shareholders’ funds as its peers of circa 30%. On that score there has been much good work following a strategic review and the appointment of a new managing director, Cris Nicolli, in October 2010.

Nicolli simplified UXC’s business structure and strategy, divested non-core businesses (notably its struggling environment service and utility operations) and acquired other businesses. Under Nicolli’s watch, UXC has become a pure information technology provider of consulting and professional solutions, enterprise applications such as Oracle, and technology infrastructure.

A process of board renewal, which culminated in the appointment in September of a new chairman, Geoff Cosgriff, and two new non-executive directors, gives me more confidence in UXC’s governance and its strategic oversight. It is easy to overlook the value that good boards can bring to fast-growing small-cap companies, especially with a discipline of maximising the return on shareholders’ funds.

UXC’s impressive 2012 results reported revenue rose 7.4% to $560.1 million, thanks to a string of contract wins. EBITDA rose 11.7% to $34.1 million and the EBITDA margin – the key to continued profitability growth for UXC – lifted from 5.9% to 6.1%. Earnings per share rose from 1.48 cents to 5.94 cents, and the dividend per share jumped from 2 cents to 3.5 cents.

But the most important question when examining high-quality businesses, or those with brighter prospects, as always, is valuation. My intrinsic value for UXC, 59 cents a share, rises to 71 cents in 2013 and 82 cents in 2014. UXC’s share price was tracking the intrinsic value calculation for much of this year, but a rally from about 60 cents in early August to almost $1, on my view, has put UXC temporarily into overvalued territory.

Technology One and, to a lesser extent, SMS and DWS, are also trading above their intrinsic values. It seems the market has got too far ahead of itself with valuations for small-cap tech stocks, and chasing them higher offers no margin of safety. But I think patience, as always, will be rewarded.

Part of the reason for the strength in the sector is talk that giant Indian technology companies could acquire Australian providers, sparking more price action. Value investors aren’t speculators and never buy companies on the basis of unfounded takeover rumours.

I own UXC shares, which were purchased at lower prices, and my hope for a margin of safety to return will continue to cause me to watch the company closely. Perhaps you should too.

Roger Montgomery is an analyst at Montgomery Investment Management and author of, available exclusively at

InvestSMART FORUM: Come and meet the team

We're loading up the van and going on tour from April to June, with events on the NSW central & north coast, the QLD mid-north coast and in Perth, Adelaide, Melbourne, Sydney and Canberra. Come and meet the team and take home simple strategies that you can use to build an investment portfolio to weather any storm. Book your spot here.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Related Articles