Sage: does every cloud have a silver lining?

The business

Sage designs and makes accounting and business software, which it mainly sells to small and medium-sized companies. Its products and services aim to make its customers’ companies more productive and efficient while helping them to learn more about their businesses so that they are well placed to grow their future profits.

Sage’s portfolio of software helps companies and accountants perform a range of tasks such as accounting, invoicing, VAT calculations, corporation tax, stock control, payments and payroll. More sophisticated products help in areas such as business and financial management to provide detailed business intelligence reports. 

For years Sage software products used to be bought in physical form (such as a disk) and installed on desktop computers. They became deeply entrenched within businesses and with lots of accounting firms.

However, Sage was slow to realise the changes in the way companies work and how they used technology. The need for constant access and the ability to use data on the move has meant that more businesses have switched to using browser-based software over the internet with their data stored remotely in a cloud. Having desktop software products is no longer enough for many businesses today.

In recent years Sage has been playing a game of catch-up to put its business on the right track to prosper in the changing world. It has pursued a twin strategy of moving its customers from desktop to cloud-based products and services and getting them to switch from buying software licences to buying monthly or yearly subscriptions.

Spending on cloud computing by companies continues to grow rapidly, with accounting and finance software making up a sizable chunk of a market estimated by Sage to be worth more than $36bn in 2020.

Moving to cloud-based services makes a lot of sense for businesses and many software companies such as Sage. For businesses it means they can use the product anywhere as long as they have an internet connection and on devices such as tablet computers and smartphones. Upgrades to software are instantaneous and done remotely, while companies don’t have to spend money on special IT software or their in-house networks to run the software.

From Sage’s perspective, the cloud makes a lot of sense as well. It provides it with a lot of customer intelligence which makes it easier to cross-sell and upsell bespoke products to customers. This, in time, will hopefully lower retention costs and the cost of winning new business. The hope for Sage is that it will help it to become more profitable in the future.

The key to Sage’s strategy is to move existing customers and get new ones onto its Business Cloud, which is based around the following core set of products:

• Sage Accounting. This allows companies to manage invoices and expenses and their tax compliance. They can share their data with an accountant or bookkeeper with the benefit that all the required data is in one place.
• Sage Payroll. An online payroll system that helps businesses to pay their workers.
• Sage Intacct. This is a comprehensive financial management system aimed at larger companies that have more complex financial and business management performance issues. It automates many processes, which saves lots of time while providing value-added business and financial analysis.
• Sage People. Human resources and people management.
• Sage X3. Business management aimed at saving companies money by improving areas such as supply chains and staff costs.

These products are complemented by many third-party applications (apps) which allow Sage to offer better and more bespoke products. For example, Microsoft 365 is integrated into some of its products, while payment enablers such as PayPal and Gocardless can be attached to invoices so that companies can get paid faster.

Sage offers bespoke products for businesses. Sage 50 is its entry-level product sold to small companies with up to 50 employees. It allows the customer to do all its necessary accounting tasks as well as things such as digital tax returns and stock control. Sage 200 is sold to bigger, growing companies and offers more analysis and management tools on top.

Sage’s move to a subscription and cloud-based business has not always been a smooth and happy one. It has had to spend a lot of money to get itself into a position to compete and grow. 

By its own admission, it spent too much time on retaining its traditional desktop licence customers instead of moving them over to subscription and cloud-based products. It has also come up short with its product development and has not spent enough time tailoring its work towards solving problems its customers have.

Spending on research and development and wages has increased significantly in recent years to try to fix these problems and as we shall see shortly, profits have taken a hit. To Sage’s credit it has expensed these costs against its revenues and has resisted the temptation to flatter its profits by capitalising them and writing them off over a number of years.

The company has also had to spend significant sums of money buying businesses. It bought Intacct to help it grow in the cloud-based financial management market but paid £627m in 2017 for a business that was making annualised losses of £17m at the time. However, there are signs that this deal is starting to pay off.

Sage is a global business, but currently makes most of its money from three main markets: the US, the UK & Ireland, and France.

Business Performance: Improved revenue quality but patchy growth

Sage makes its revenue from three sources:

1. Recurring revenue - from subscription contracts and maintenance and support contracts.
2. Software and software-related services (SSRS) - income from software licences, professional services, training and hardware.
3. Processing - income from processing customers’ payments or processing a customer's payroll.

In recent years, Sage has been very successful at shifting the mix of its revenue towards products and services with recurring revenues.

It has also moved more of its revenues onto subscription. In 2017, 37 per cent of its revenues were on subscription, in 2019 it was 55 per cent. We can also see that it has made good progress in migrating a decent chunk of its revenues to the cloud.

4. Sage: Subscription and Business Cloud as % of revenues

Source: Annual Report

In 2019, 48 per cent of Sage’s £1,559m of recurring organic revenue was on its Business Cloud, compared with 29 per cent in 2018. The company reckons that a further £713m of annual revenue has the potential to move across to the cloud.

There can be no doubt that Sage has significantly improved the quality of its revenues. The shift to subscriptions away from licences should help with customer retention and make its revenues more predictable, which is something that investors tend to like and regularly pay rich valuations for.

Where things get a little bit more hazy is when you start to look at Sage’s track record of growth and its ability to win new customers.

The company talks a lot about recurring revenue growth when it communicates with investors, but this is not the same as underlying revenue growth and it therefore has the potential to confuse. 

A lot of the company’s recurring revenue growth is just a reflection of changes in sales mix - a shift away from licensing to subscription. The increase in recurring revenues is coming from declines elsewhere in the business. Yet, the company’s future guidance for the financial performance of its business tends to be based around recurring revenue growth.

The point I want to make here is that it is possible to have decent rates of recurring revenue growth while the business continues to shift to subscription, but at the same time have very modest and patchy levels of real underlying or organic revenue growth.

As we can see, Sage’s recurring revenue growth has been a lot more impressive than its organic sales growth, which given the growth in cloud computing spending by businesses in general might be seen as a little bit disappointing. Investors need to keep a close eye on organic or underlying revenues as this is going to be the main driver of any increased future value in Sage as a business. That said, the improvement in revenue mix should be helpful to profitability in the future.

If we look at organic sales growth by region it has been patchy. North America has done well in the past couple of years, but growth in Europe and the rest of the world has been modest and lagged way behind what some of its key competitors have been achieving.

Drilling down further and looking at the organic sales growth performance in 2019 again shows the patchy nature of Sage’s performance. The UK and Ireland had a good year - helped by the move to digital taxation for companies in the UK - but France and Europe was very weak. The US performance can also be described as disappointing relative to the growth in the market and growth seen by competitors. The one real bright spot was Sage Intacct in the US - more on this shortly.

One of the reasons why software companies can make great investments is that the businesses are very easy to scale up. Once some software has been made it costs very little to sell an additional copy of it. This makes the business very capable of leveraging its fixed overheads and delivering strong profit growth with high profit margins.

This has been true of Sage, which continues to produce very attractive financial returns from its business. Its task now is to accelerate revenue growth and get profit margins going up again.

Sage: Key financial performance measures

Source: Annual Reports/Investors Chronicle

If you consider some of the key financial hallmarks of a high-quality business - high operating margins, high return on capital employed (ROCE), high free cash flow (FCF) margin and the ability to convert its profits into cash - then Sage has these in large measures.

The one vital missing ingredient is profit growth. Profits and profit margins came crashing down in 2019 as the company significantly increased its investment in innovation and pay for its staff in order to improve its competitive position. FCF margins actually improved, but this was due to a big improvement in the collection of trade receivables, which was long overdue but is likely to be a one-off. FCF margins are likely to fall back significantly in 2020.

Without meaningful profit growth, Sage takes on the characteristics of what I call a ‘quality trap” - a very good business in many respects, but possibly not a great investment if it cannot grow.

Competitive edge and future growth prospects

Sage does have some significant competitive strengths. It has been around a long time (since 1982) and has become a trusted brand that is deeply entrenched within businesses and with firms of accountants. Financial software products also often have significant switching costs. Once a user has become familiar with a software package they are unlikely to want to take the time and effort involved in switching to another provider. This seems to be borne out in Sage’s high customer retention rates.

Another competitive strength is customer service. Sage has introduced internet chat apps, but also has extensive telephone support for its customers and provides lots of training as well. This allows it to form a strong bond with the customer, which is difficult for a new entrant to copy.

Having said that, barriers to entry - particularly at the simpler end of the market - are not particularly high and there is a growing intensity of competition and consumer choice.

Where Sage seems to have lost out is in the market for new small business customers. In this space, US company Intuit (US:INTU) with its Quickbooks product and New Zealand company Xero (Aus:XRO) has been snapping up a lot of customers.

Xero has been growing rapidly and added 478,000 new subscribers to take its customer base to over 2m in the year to September 2019. Sixty per cent of its subscriber base is in Australia and New Zealand, but It has been growing rapidly in the UK where its subscribers have risen from under 200,000 three years ago to 536,000 in 2019. Sage does not currently disclose how many subscribers it has.

Xero’s aggressive stance is shown in the fact that it is barely profitable, but it did turn free cash flow positive last year after years of burning cash. According to S&P Capital IQ forecasts, its revenues are expected to keep on growing rapidly from NZ$728m (£364m) in 2020 to NZ$1378 (£689m) in 2023. 

Quickbooks has been a big success for Intuit. Its small business and self-employed division - where Quickbooks sits - has been growing its revenues at a very healthy rate. They increased by 15 per cent last year and delivered an outstanding profit margin of 44 per cent - nearly double Sage’s current margin.

It has continued its stunning performance into its 2020 financial year. Its first-quarter results released in October saw another 15 per cent revenue growth, but with its online and cloud business performing very well. Online accounting revenues increased by 41 per, with service revenues (payroll and payments) up 27 per cent. International sales increased by 60 per cent. The bad news for Sage was that Intuit announced that it had grown its UK subscribers and that it had become the market leader for cloud accounting services in the country.

By contrast, Sage’s first quarter of its 2020 financial year saw more modest underlying growth of 6.7 per cent, but that does represent an improvement on 2019’s growth rate. Profit margins are expected to stay unchanged on last year. Given the loss of profits from its former payments business, profits are unlikely to grow at all  in 2020.

Sage forecasts

Source:SharePad

The current bright spot for Sage is the performance of its Intacct product aimed at medium to larger-sized business. The business was generating annualised revenues of £78m when it was bought in 2017, which Sage increased to £119m last year. This business continues to grow strongly and will benefit from a phased rollout in English-speaking countries. The product was launched in Australia in 2019 and will be offered in South Africa in 2020.

The bottom line is that Sage is underperforming its peers in terms of revenue growth and in profitability when compared with Intuit’s Quickbooks business. If current forecasts are any guide, modest revenue growth of 6-7 per cent over the next few years and a continued shift to subscription revenues is not going to transform the company’s profit margins.

It seems that the company is still paying the price for being late to the cloud computing game and the mistakes it made once it got there. At 763p, the shares are quite highly valued on a one-year forecast rolling price/earnings (PE) ratio of 25.2 times.

A possible takeover target?

Despite its share of troubles and relatively lacklustre growth rate, there is no doubt in my mind that Sage remains a very good business with attractive characteristics. It just needs to raise its game.

If it does not then it is a possible takeover target in my view. Getting growth going again could see the operational gearing of the business kick in and see profits grow meaningfully, which could incentivise a determined buyer and convince it that it could make an acceptable return from buying Sage,

In the early 2000s Sage was linked with a possible takeover by Microsoft (US:MSFT). I can still see why it could happen, given that Sage uses Microsoft’s Azure cloud platform and has integrated Microsoft 365 into its product offerings. Microsoft also has a related business in Microsoft Dynamics, which offers client relationship management software.

Microsoft tried to buy Intuit in the 1990s, but was blocked from doing so. Would it want to buy Sage? It’s possible, but adding £450m of Sage’s annual operating profits to its business isn’t going to change Microsoft too much. That said, Sage’s current market capitalisation of £8.3bn would be small change to a company such as Microsoft.