TNE: Doubling in size every five years

I have written a number of articles about quality compounder stocks, analysing stocks that are consistent with the Quality Compounder screen as presented by Stockopedia contributor Roland Head in his article Building a screen to find Compounding Quality stocks. Another ASX listed stock that makes the grade for this screen is TechnologyOne (ASX:TNE).

TechnologyOne has been focussed on building a business that compounds since their inception 35 years ago. They have a stated ambition to double in size each five years. Whilst they do make some strategic acquisitions, most of their growth is organic.

They are an Enterprise Resource Planning (ERP) software company. They have transitioned the business such that they are primarily a Software as a Service (SaaS) business. A high portion of their revenue is recurring. Their annual recurring revenue (ARR) has reached $350 million, with a growth rate of 22% in the most recent period. They are aiming for ARR of $500 million by FY26. The business has very low churn rates which facilitates the ability to compound revenue growth.

Most of their revenue comes from the APAC region, but they recently acquired UK based Scientia Resource for $22 million as they look to expand their geographic coverage. Their customer base is well diversified across different sectors as shown in the chart below. Their clients are government bodies, educational institutions, hospitals, financial services institutions and large corporates. In other words, large organisations with complex operations and sizable IT budgets.

Source: TechnologyOne, 2023 Half Year Results, 23/5/23

Returning to the initial proposition, of Technology One being a quality compounder, the data for the Quality compounder screen is presented in the table below. As can be seen, they exceed all thresholds by large margins.

The first component of being a quality compounding stock is to have a high Quality score. With a score of 99, TNE is right at the top. A big contributor to that is the Health Trend, measured by the Piotroski score, which comes in at 8 out of 9. The one area it didn’t score was on improving gross margin, which declined from 87.6% to 86.6% but is still at a very high level.

Overall margins are very high and have been growing strongly. If we look at operating margins, the five year average is 25% and the most recent figure was 31%. Likewise, net profit margins have averaged 20% over the last five years with a most recent figure of 24%. As can be seen in the chart below, profit margins are not only high, but they have been growing at a strong rate for the last five years and the company is expecting them to continue growing in the coming years, reaching at least 35%.

Source: TechnologyOne, 2023 Half Year Results, 23/5/23

One factor assisting them with their margins is that most of their contracts include the provision for them to be able to pass on increases in CPI. In the current high inflationary environment this means that their margins are not eroded by increasing costs.

These high margins are translating into strong returns. The long term return on capital employed is 44% with a most recent figure of 43%. Return on equity is also 43% and has been consistently high in recent years. These are exceptionally strong numbers and suggest that the business has a solid economic moat in place.

One factor that would be contributing to that moat is their heavy investment in research and development. They invest about 24% of revenue back into R&D. For technology businesses to be successful long term, they need to be continually allocating capital to R&D to keep up with, and ahead of, the competition. Many technology companies find that whilst they can grow revenue strongly they still struggle to generate positive cash flow due to the heavy development investment required. TNE are on top of this, generating solid free cash flow after allowing for capital expenditure. In the most recent period, their operating cash flow exceeded EPS by 70%.

This growth has not been achieved by taking excessive risks. The balance sheet is conservatively managed, with negligible debt and cash of $139 million.

Growth in revenue and profits and good cash flow has enabled steadily growing dividends. In fact the first half dividend has increased by 10% every year for the last 10 years. The most recent payout ratio was 36%, meaning that there are plenty of funds retained for reinvestment, which is an essential characteristic of compounding businesses. The dividends have been 60% franked for the last few years.

As is the case with most of these quality compounding stocks, they are not cheap. TNE has a Value score of just 5, placing it in the top 5 most expensive stocks. The PE ratio is 44 and the Price to Book ratio is almost 20. Even the Price to sales ratio is 12.6. Thus to earn a good return as an investor you are relying on continued growth.

TNE is not a small business, with a market capitalization of $5 billion. This places it in the top 100 stocks on the ASX and it is included in the S&P/ASX 100 Index (although it is one of the smallest stocks in the index). It is the ninth largest stock in the S&P/ASX All technology index.

So the questions investors need to consider are, firstly can the business continue compounding their earnings at a strong rate, and secondly how much scope is there for the market capitalization to continue growing? Whilst revenue might double in 5 years to circa $800 million, can the market capitalization hit $10 billion in the same period. Ultimately it is the answer to the second question that will determine the return on investment for shareholders.

TechnologyOne operates on a financial year ending 30 September, so their full year results for FY23 will be released in November.

---

Important Information: Stockopedia Ltd ABN 39 757 874 670 UK business registration number 0637267 (“Stockopedia”) is an Authorised Representative of Daylight Financial Group Pty Ltd ABN 77 633 984 773 (“DFGPL”) which is the holder of an Australian Financial Services Licence (AFS Licence No. 521404).

Information in this commentary is current as at date prepared unless otherwise stated. However, please bear in mind that investments can go up or down in value, and that past performance is not a reliable indicator of future performance. For more Important Information please refer to the Disclaimer section of this website.

This communication may contain general financial product advice. It has been prepared without taking into account your personal circumstances, and you should therefore consider its appropriateness in light of your objectives, financial circumstances and needs before acting on it.

If our advice relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement (PDS) before making any decision.