Computer services sector - recurring income attractions

In the middle of a recession, looking at tech stocks as a safe haven might seem strange. Software stocks in particular are highly geared to capital investment – and companies can cut expenditure on new software extremely savagely, and surprisingly quickly.

But the computer software and services sector is highly diverse, and it's worth looking hard to see what kind of a beast you have in front of you. Some software stocks, it's true, are highly dependent on licence fee income from new sales, and these are the companies that are suffering the worst from the recession. Some services providers, too, are dependent on big projects – just the kind of high profile investments that tend to get cut when the knives are out.

 But there is also an increasing number of companies which have high quality recurring income streams – some from maintenance and subscription income, others from the provision of network or IT management services. In particular, 'software as a service' is a concept whose time has come – companies as diverse as Fidessa Group Plc in financial trading, Statpro Group in asset management, and Aveva Group in industrial design software, have all moved into charging for usage rather than upfront payments.

 It's also worth comparing earnings declines in computer services with other sectors. Most of the larger companies are seeing brokers forecast a fall in EPS of around 15% - some are still expected to grow. Compared to, say, retail or real estate, that looks good.

 Some of the services companies are trading on quite nifty yields. Headline historic yield for the sector is 3.9%, good though not great, but a number of stocks are trading on more.

 For instance Tikit Group, a company which focuses on business in the legal sector, has a 4.7% yield and held its interim dividend despite a rather weak set of interims, with profits down a third. Over 50% of its revenues come from contracted managed services; while clients obviously can exit such contracts, it would cost them to do so. Tikit has also done well increasing support revenues for its own software products, which increased from £1.37m to £2.09m revenue in H1 2009 [ref] Tikit interim results, http://www.stockopedia.com/news/announcement/TIK/090909tik000794.htm [/ref] .

 It's worth noting that the dividend is well covered – while some of the more obvious sectors for income investors offer high yields at the price of patchy dividend cover, that's not the case with tech stocks.

 Fidessa Group Plc only offers 2.1% yield, on what seems at first sight an overextended PE multiple of 22 - but this stock is more attractive than it looks on the bare numbers. Unlike many other stocks in the sector it's been forecast to increase its earnings this year – by as much as 11% - and it increased its interim dividend by 33%. You couldn't ask for a much clearer indication of confidence in the future.

 Fidessa Group Plc supplies trading platforms to financial services houses; while some of its clients might go bust, and it might not be able to sign up too many new ones in the short term, those still trading can't afford to stop paying for the service. Recurring revenue now accounts for 81% of total revenues [ref] Fidessa, interim results to June 2009: http://www.stockopedia.com/news/announcement/FDSA/090803fdsa000430.htm [/ref] , so the company has a strong revenue base – add the prospects of economic recovery as a kicker, and maybe the high PE is justified.

 Software testing services provider Sqs Software Quality Systems Ag trades on a 5% historic yield (though a cut in dividend looks likely: Edison forecasts 3.4% this year [ref] Edison investment research, 10 March 2009: http://www.sqs-group.com/investors/edison_10_march.pdf [/ref] ). Having seen some projects suspended earlier this year, it's more recently seen them reactivated – and it's won more contracts, too. A confident interim management statement, despite profits falling nearly two-thirds in the first half, makes the 9x historic rating look stingy.

 Just looking through the high yield stocks, as in any sector, is a dangerous way to go. Sanderson Group for instance has a 9% historic yield, but I bet it's not going to pay a dividend this year – with profits on the slide, it halved the dividend last year, and its recently announced interims showed a pretax loss.

 But there are still plenty of good recurring income plays. Statpro Group for instance provides performance measurement and valuation software for asset managers – and with recurring revenues at 92% of the total intake, and a 95% renewal rate, it looks well set to continue it record of growth. First half results came in above expectations, and at 14x earnings, with a 1.8% historic yield and the likelihood of increasing its dividend by 10% or more, it seems modestly valued.

 Ncc Group is another firm with increasing revenues and good visibility of earnings – two thirds of projected revenue is contracted. It's in a superbly recession resistant area – software escrow and assurance testing, which are key to large companies' IT security efforts. On 15x historic earnings, it's not bargain basement, but a 2.3% yield and the prospect of increasing dividends make it a reasonable investment for the income portfolio. The group is also highly cash generative, and is paying down debt fast – it could be debt free by the end of 2010.

 These companies all look very different from the more conventional 'IT services' firm, like Logicacmg or £CAE. The difference lies in the business model. A consultancy makes money by billing out its professionals – the margin is simply the difference between the billing rate and the rate the consultant actually gets paid. It's a non-scalable business model, so in the good times, companies add increasing numbers of staff, and in the bad times, they find they've got expensive full-timers who have to be paid one way or another, whether it's a salary cheque or a redundancy cheque.

 But most of these companies aren't charging consultants' time. They're charging for a service – managing the client's servers, providing a trading platform, or assuring a guaranteed level of network availability. Particularly with those companies that provide their own software, they're making good margins from providing a unique product. You might be able to get any one of ten consultancies to instal an SAP system – but only Tikit can provide its specialised management software for legal firms.

 Fancy a recovery punt instead? Then there are a few options for you. K3 Business Technology Group is trading on just five times earnings, and has just held a £1.5m placing, which was oversubscribed, to pay off debt. The company provides enterprise software, installing and maintaining Microsoft and Syspro products as well as its own 'piggyback' programs. Profits this year will probably come in flat – but the company should also generate cash, as the Syspro part of the business bills all its maintenance contracts in October. After a poor first half, the company says things have been improving. Warning though, it's a tiddler, with only just over £20m market cap and only one broker following the stock.

 Or there's Charteris – actually in the support services sector, though its stock in trade is mainly IT consulting. It expects to break even in the second half of this financial year, and is valued at only a tenth of its sales – giving the potential for fast price appreciation if it makes a profit next year. However, Charteris first hit trouble back in 2007 – before the credit crunch really hit – and recovering from recession while at the same time changing its business strategy might be too big an ask.

 Or you could just bet the big stocks in the sector for a play on recovery. Logicacmg for instance with its £2 bn market cap is a pretty big player by anyone's standards, with a diverse mix of businesses and strong international exposure – at 11x earnings, quite a way below the market's 15x. However, earnings are expected to fall 10-15% this year.

 Things may be looking up for the tech sector generally. Polar Capital, in its interim statement this year, said that earnings surprises have been frequent this results season – almost all on the upside. Analysts have clearly overstated the impact of the recession on companies' earnings. There's been an uptick in M&A activity, too, with some major deals going through in the US – for instance SPSS data mining software has been acquired by IBM [ref] Polar Capital, Interim Management Statement 2009: http://www.polarcapitaltechnologytrust.co.uk/Documents/Announcements/2009_Interim_Management_Statement_31.07.09.pdf [/ref] .

 Corroboration comes from an unusual source – Indian tech company Wipro. The head of European operations for this outsourcing firm says that business really picked up in the second quarter, particularly in Germany and France [ref] Wipro sees pick-up in European business in Q2, http://www.livemint.com/2009/09/15095240/Wipro-sees-pickup-in-European.html [/ref] . While overall IT spending might be flat, offshoring and outsourcing are likely to benefit from potential clients' cost cutting efforts – and I wouldn't mind betting that software as a service will benefit from finance directors trying to swap a big capital cost this year for a series of rental payments in future, particularly if the IT department can be shrunk a bit at the same time.

 It seems that there's an opportunity for tech investors right now such as we haven't seen since 2003, though the undervaluation isn't quite as extreme now as it was then. From the big consultancies all the way down to specialised small companies, and from the recovery stock to the continuing growth story, the software and computer services sector has got it all – and most of it looks cheap.

Further Reading:

For those interested in learning more about the sector, it's worth starting at Techmarketview - http://www.techmarketview.com/ - to get a good idea of what's hot, and what's not.