Technology One: the one that got away

'We continue to double in size every 4 to 5 years,' said Technology One chief executive Edward Chung at the company's annual meeting last month (as is his habit) and it's hard to argue.

Over the past ten years the company's earnings per share have doubled almost twice, with every year but one falling in a range of 13-17%. The stellar performance has meant that the forward price-earnings ratio (PER) has more than doubled - from 17 to 40 - pushing the share price up roughly eight-fold. 

The only year that wasn't in the 13-17% band was 2017, when earnings grew a mere 8% (due in part to a contract dispute with Brisbane City Council). The result was a contraction in the PER from 41 to 26 in the year to June 2018 and a 30% fall in the share price.

All of which demonstrates the risks and rewards of investing in growth stocks: when things are going well it can be highly lucrative but setbacks can be painful.

It works best if you can pick out a few of the long-term winners, buy them on a temporary setback and then head down to the beach.

Oh so close

We came oh so close to doing that with Technology One last July, when Alex Hughes reviewed the stock almost at its nadir, but hung out for it to get another 10% cheaper.

It didn't - but no matter. You'll get into trouble worrying too much about the ones that got away.

And Technology One has certainly got away - leaping 80% since that review.

With the Brisbane City Council dispute resolved, earnings per share growth was back on track in the year to September, with an increase of 14% to 16.1 cents.

Revenue increased by 9%, but there was a notable shift towards recurring revenues reflecting the company's move to a software-as-a-service business model: initial licence and consulting fees fell 3% to $130m, while annual licence and platform fees rose 22% to $169m.

Expenses only rose 8%, so the operating margin expanded from 21% to 22%. As revenues shift further to the higher margin recurring revenues, the company expects the margin to 'improve to 25% in the next few years and then continue to 30%'.

If all goes well, that seems like a reasonable aspiration. The trouble is that the bigger the company gets the more it will need to move beyond its comfort zone - into overseas markets and away from its traditional, less price-conscious, customers in sectors like government, education and health. This will bring it increasingly into competition with enterprise software giants like Microsoft, Oracle and SAP.

Fighting a high price

Forecasts are for Technology One to earn close to 19 cents per share in the year to September 2019, putting it on a PER of about 41. Whether it turns out to be worth that will depend on how long it can carry on doubling every 5 years. That's anyone's guess, but we can put the valuation into some context by considering some possible scenarios.

If we say it will end in 20 years' time - at which point the company will revert to market growth and a PER of 20 (roughly suitable for a mature but cash-generative software business) - then you can expect a capital return over that period of about 11% a year, plus a couple of per cent a year for dividends.

If it ends in 10 years, then those figures come down to 7% and 9%; if five years, then the earnings double once and the PER halves, so you're all square, plus the dividends.

Most likely the actual outcome will be somewhere in the middle of all that, which goes to show how paying a high price can bring an exceptional business performance down to a merely average investment performance.

Sitting it out

As we noted earlier, the numbers work out much better if you buy in when the PER is closer to its final value. So we'll be sitting this one out for now in the hope that something might happen to bring the PER back into the low twenties - at which point we'll try not to be so greedy.

In the meantime, we'll aim to review the stock from time to time - perhaps once every year or two - but, given it's such a moving target (generally fast and away from us) and is unlikely to provide an opportunity, we're going to cease formal coverage.

For those that already hold the stock, we'd have to say that if we did maintain coverage we'd be very close to downgrading to Sell. There are arguments for holding on - along the lines of 'good things happen to good companies'. But they'd have to be very good to justify the current price and we think there are better opportunities on our Buy List.

If you do hang on, we'd recommend taking profits along the way and keeping your portfolio weighting below a maximum of 5% - or less when the valuation is looking stretched, as it is at the moment. CEASING COVERAGE.