Software stock hard-wired for growth

There has been a lot of commentary in recent months about Australia’s deteriorating competitive position, and it’s fair to say that I have provided some fuel for the debate.

For the past 12 months I have warned of the transience of the mining boom, and that the economy has been enjoying the benefits at the expense of more enduring value-creation.

Sadly, I still feel that miners and mining servicing companies will experience further pain as management try to rein in costs while commodity prices, particularly iron ore, fall. However, in other parts of the economy there are companies that are in control of their destiny and prices. As a consequence, they are able to increase the value of their services and products – and the difference this makes to their long-run profitability is striking.

Technology One is an example of an innovation-focused business that fits this description. The company was established in Brisbane in 1987 to develop accounting and financial software, and it met with some early success. Management could have decided to enjoy the ride on this early success, but were cognisant that their advantage would not be easily sustained in such a dynamic industry.

So management focused on building Technology One into a complete enterprise solutions provider – the more features the software provides, the more value that is created for the customer, and the greater potential for customer retention. To achieve this, they directed 20% of revenues to research and development, while conducting rolling five-year reviews of each division to ensure the business strategy was being executed efficiently.

The value that has been created from this approach is reflected in Technology One’s financial statements. Over the past decade, the company has maintained a return on equity of 30%, earnings per share has grown by 11% annually, and the company currently has net cash of more than $40 million. If that’s not impressive enough, note that Technology One has been profitable for 20 years. This is a Brisbane-based IT company that has flourished during the tech bubble and GFC while competing against juggernauts like Microsoft, Oracle and SAP.

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Source: ASX

The focus on innovation is setting the company up very well for the future. In recent years, research and development expenditure has been directed towards migrating the software packages to cloud technology. Technology One is partnering with cloud infrastructure providers to supply IaaS (Infrastructure-as-a-Service) and SaaS (Software-as-a-Service) as complete solutions to their clients.

The company will be charging an additional fee for this service that is double what they currently charge for Annual Support & Maintenance. This may seem significant, but management believes it is a small price for clients to pay. After all, the service allows clients to outsource a significant portion of their internal IT departments. For Technology One, the revenue that will be generated from this service will flow largely through to the bottom line, since the infrastructure is highly scalable.  

Management is confident the company can maintain a competitive advantage over SAP and Oracle because of the quality of their product. Technology One develops its software templates to ensure they can be tailored to any client’s needs, which provides for easy upload to the cloud servers. Technology One management live by the mantra that the customer should never have a terrible experience with their product – this is an important principle in an industry that in many examples has been built upon patchy software.

The transition to the cloud is a work in progress, and it will still be a number of years until the majority of Technology One’s clients adopt the new technology. But management is very excited by the opportunities that the cloud presents, and have likened the potential of their earnings to that of a dam wall breaking once critical mass is achieved – when you’re looking for bright prospects, this is an encouraging metaphor.

With all being said, I consider that the share price is already reflecting a large amount of this potential upside, and investment is hard to justify at these levels.  However, I will be watching closely for any opportunities. Technology One is a company that has not just survived, but flourished, in a difficult market that is dominated by global players.

It just goes to show that at every stage of the economic cycle, there are Aussie companies innovating and winning for their owners.

Roger Montgomery is the founder of The Montgomery Fund. To invest, visit www.montinvest.com