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Software bargains

Created:
4 August 2008
Written by:
David Stevenson

Let's be honest. By and large, the UK's technology sector is pretty dreadful. True, we have the odd world-class operator, like Sage, Autonomy or ARM, and we have some great science and academic research, but we don't have Silicon Valley and we don't have Nasdaq. The sector lacks scale.

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That's mirrored in the investment performance. The techMark index has serially underperformed the equivalent US indices. But there is an exception. We have some great software companies. The UK has a big pool of well-trained IT specialists, many of whom cut their teeth developing software for FTSE 100 companies, or who have helped keep the City of London at the forefront of financial innovation.

We also possess a strong venture capital sector that values software companies highly, attracted by their royalty revenue models and high gross margins. Once software is established, it also generates healthy cash flow.

Many UK software groups have developed long term service and product contracts in really specialised niches that generate extra revenues (or cut costs) for their much bigger global customers. Crucially, software that generates almost immediate payback tends not to cut back by bigger customers looking for cost savings.

What's more, valuations are at rock bottom. Take a look at the table below, which shows average metrics for 14 software companies.

Mkt val Fwd PE Roce EPS growth F'cast EPS growth PCR Gearing  Price/net cash Rolling  PEG
Average  34.2 7 50.7 27 33.9 10.3 -132 9.8 0.4

Some of the companies from the list have already showed up in other screens. But with valuations having sunk so low, I want to look at the entire sector - because I think that for the patient investor, there are some really great opportunities. Forward price-earnings ratios of between five and eight just ain't right for sound companies growing earnings by 30 per cent or more a year.

• Several factors in particular make companies in this sector attractive:

• Earnings visibility through long-term contracts.

• Captive customers through maintenance revenues

• Niche positioning, with relative lack of competition high value-added.

For more on why these attributes are so important, see the IC's recent feature Is IT back in favour?

And there are two other key factors:

Strong cash flow. Many software companies have reliable cash inflows which shouldn't vary greatly over time. Fundamentally, once the hard bit of the software development has been accomplished, you're into a recurring revenue stream. But it gets better – that recurring revenue stream also means that the cash slowly builds up on the balance sheet – the average share price to net cash for my shortlisted set of companies is a staggering 9.2 – that means that for every £1 you'll invest in these companies, you're also buying more than 10p in cash on the balance sheet. It also goes without saying that most of these companies have no debt.

Rapid growth. Strong free cash flow does not come at the expense of growth with these companies. The average EPS growth in the current year across my target list is just above 25 per cent and in the forthcoming year that growth rate increases to over 30 per cent.

One final thing - if the market doesn't start appreciating these companies, others will. Private equity companies and trade buyers have already been sniffing around. IBS, Flomerics, Detica, Northgate Information Solutions and Civica have all been taken over since the end of last year.

The UK's cheapest software shares

So, without further ado, here's how I screened and what I got.

First of all, I looked at the software sector and picked out shares with:

• a forward PE of below 12

• a return on capital employed above 10%

I then weeded out any companies where earnings in the coming year are expected to drop by more than 20 per cent, and looked for evidence of positive cash flow.

Next steps were to:

• Eliminate any company with a price to cash flow measure of more than 20.

• Exclude any company with net gearing above 20 per cent

• Exclude any firm with a PEG (price earnings growth) of more than 1

• Lastly, I looked for forecast earnings per share growth of 5 per cent or more.

This is what I got:

Name Price Mkt cap Fwd PE Roce Hist. EPS grwth F'cast EPS grwth PCF P/cash  Rolling  PEG
Velti  174 58.7 11.39 20.3 50.7 78 23.7 6.69 0.21
K3 Business Technology  115 27.3 5.23 46.5 60.6 8.44 8.84 0.17
Gladstone  19 9.1 4.67 27.9 4.4 56.5 7.45 1.94
Innovation Group 17.5 113.7 8.58 34.6 3.9 54.5 6.79 2.83 0.35
smartFOCUS  9.5 8.9 6.13 46.6 94.9 34.8 12.1 5.84 0.19
Vero Software  12.75 4.8 5.12 32.4 26.4 33.2 3.42 5.85 0.15
StatPro  77.5 42.3 9 20.1 26.6 6.56 43.3 0.44
Alterian  117 66.8 9.14 23.3 87.4 26.5 18.8 6.28 0.4
Bond International Software  102.5 33.8 7.07 115 -11.3 22.9 15.2 26.7 0.41
Average  0 38.3 6.9 46.6 34 39.5 9.8 12.7 0.3
Delcam  270 20.8 9.63 9.89 -35.1 16.4 8.34 2.7 0.76
Dillistone Group  157.5 8.5 9.63 145 20.8 16.3 6.99 5.54 0.64
Ascribe  20 23.5 7.75 44.5 8.9 6.52 5.46
Financial Objects  58.5 26 9.06 51.9 -1.6 5.9 10.2 5.07 0.81

Five shares in particular jump out as representing great value – Velti, K3 Business Technology, smartFOCUS, Vero Software and Alterian. All five are growing fast (the mean average forecast EPS growth rate is 47% for these five, and most-recent EPS growth averaged 61 per cent), yet their average PE ratio is 7.4 times forecast earnings.

Let's look at a few of these companies in more detail.

Velti is already an IC buy tip, so you can read more about its attractions here.

K3's shares are being savaged at the moment because of its perceived vulnerability to a downturn in spending on IT by retail companies (one of its core markets). But this pessimism is at odds with a trading statement back in April where it reported a 43 percent increase in full year pretax profit and a 25 percent increase revenues, and said it continues to view its prospects for 2008 “positively with its sales pipeline at record levels”.

Multi-channel marketing software expert smartFOCUS is also booming. The company is debt-free, operates in a large and growing market, and is making acquisitinos and growing organic revenue.

Cad-cam software specialist Vero Software is also growing fast, and most recent trading news indicated the company continues to trade in line with expectations. Also noteworthy is the presence of investor Per Gyllenhammar, with a 22 percent shareholding, on the share register.

Lastly, Alterian looks very compelling. Another marketing software specialist, it's currently trading very strongly despite the slowdown – growth in its fast growing North American markets is very strong and in recent months brokers have been increasing estimates of earnings growth, yet the share price has continued to slide!

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