Who is right on Sage, Terry Smith or Nick Train?

For UK tech investors, Sage (SGE) has been a reliable bet for decades. The accounting software company, which was founded in 1981 and listed in London eight years later, has been a stalwart of the UK’s diminutive listed tech sector. But compared with the new generation of tech businesses flocking to the market, it is starting to look rather sluggish. Views on the stock are starting to diverge, most strikingly among two of the UK’s most revered investors. 

Famed fund manager Terry Smith sold out of the stock at the end of last year, as disclosed by the Fundsmith Equity (GB00b41YBW71) fund in May. Sage was one of its biggest detractors in 2020, second only to Amadeus (SP:AMS), a software company for the travel industry. No prizes for guessing why that business had a difficult year. 

But Smith said in his annual letter to shareholders at the beginning of 2021 that the fund was waiting to see “whether the new management team can make the product fit for purpose in the age of the cloud and subscription software and compete effectively with those who can”. 

One of “those who can'' already features in Smith’s portfolio. Industry giant Intuit (US:INT) sits among the fund’s top 10 holdings and last month was among the top five contributors alongside Paypal (US:PPL), Idexx (US:IDXX), Microsoft (US:MSFT) and Facebook (US:FB.) So, while Smith has been put off Sage, it looks as though he plans on sticking with its closest competitor. At the very least then, we can assume that he has faith in the long-term market opportunity. 

But Nick Train, another of the UK’s leading fund managers, holds a different view on Sage. His Finsbury Growth & Income Trust (FGT) holds the stock among its top 10. So which star fund manager has got it right?

Ultimately, it depends on whether the company can pull off its big transition to a software-as-a-service (SaaS) company. The SaaS model generates sales by charging its clients for access to its product on an ongoing basis, and is highly sought-after by investors for its high revenue visibility and typically chunky margins. It is also much more elegant – and profitable – than the lumpy licensing model that Sage had used up until a few years ago. 

But the group is admittedly has been slow off the mark in implementing this strategy. It only began its focused push to migration to cloud-based, recurring revenues in 2018, while SaaS pioneer Adobe (US:ADBE) introduced the structure into the mainstream back in 2013.  

How successful has the transition been so far?

Even Sage sceptics will not claim that the quality of the group’s product itself has been in question. The software is highly rated, with a 4.6-star rating on online review platform Trustpilot.

That has meant that the group’s relatively new management team (chief executive Steve Hare has only been in the role since 2018) has been able to leverage an attractive portfolio of products. By the end of its latest financial year, 90 per cent of Sage’s revenue was recurring, up from 86 per cent in the 2019 period. Meanwhile, software subscription penetration reached 65 per cent, up from 56 per cent, and Sage Business Cloud penetration was at 61 per cent, up from 51 per cent. 

But not all key performance indicators are pointing in the right direction. Renewal by value – which tracks the growth of existing contracts through upselling and renewals – ticked down to 99 per cent in 2020 from 101 per cent in 2019. Management blamed that fall on the impact of Covid-19, with cautious clients less willing to spend on add-ons. 

But Sage does have other important quality markers of a software business. For one, it is highly cash-generative, with a free cash conversion rate that has averaged 129 per cent over the past five years. Meanwhile, return on capital employed, which measures how effectively money is turned into profit, sits at a respectable 15 per cent. 

Its portfolio is starting to look smarter too, as it exits non-core geographies. Towards the end of last year, Sage announced an agreement to sell its Asia and Australia business (excluding global products) to Access Group for around £95m. That followed the sale of its Polish unit for £66m. A sharper geographic focus should help Sage build its SaaS scale, with fewer complications of varying price strategies. 

These disposals offered some welcome cash boosts, but spending elsewhere on the SaaS transition has weighed on Sage’s profit margins. Organic operating profit missed consensus expectations by 3 per cent in the first half of its financial year, as margins slipped from 23.2 per cent to 20.2 per cent. 

And spending needs to increase further. Building up a dominant position in its largest geography, North America, will not be easy – especially as US-listed Intuit operates almost solely in its domestic market, according to data compiled by FactSet. While Sage’s products currently are highly rated, a historic lag in research and development (R&D) expenditure should cause concern over its long-term competitiveness. 

The industry norm in software is to spend around 20 per cent of your revenues on R&D. Sage, however, has typically spent closer to half of that amount. It is true that management is taking some steps to address that imbalance, with the proportion ticking up to 13 per cent in 2020, compared with 11 per cent in the year prior. But Intuit dedicated 18 per cent of its revenues to R&D last year, or $1.4bn (£1bn). That dwarfs Sage’s £252m. 

The price is right!

Sage’s ongoing SaaS project, and its impact on profit margins, has caused the shares to lag – even dropping as low as 564p towards the end of last year. But as slow progress continues, we think the valuation gap could present a compelling – if risky – entry point.  

The company has a robust enough balance sheet to stomach a temporary decline in its profit margin, with £693m of cash on hand as of the end of its 2020 financial year. At the time, its net debt to cash profit ratio of 0.2 was below its medium-term target multiple of 1 to 2. 

As a wider economic recovery coaxes small and medium-sized companies (who make up most of Sage’s client base) back into spending, Hare should feel more comfortable in splashing out for Sage, too. Management has reinstated the share buyback programme that was put on the back-burner over pandemic-related uncertainty – although not before it had already repurchased £7m-worth of stock. 

It is also worth noting that Sage could well become an acquisition target for larger peers, including Intuit; especially if it chooses to pursue international growth. After all, it may be easier to absorb Sage’s 40-year-old position in the European market rather than compete with it. 

One of Smith’s investment principles is ‘do nothing’. However, in the case of Sage he's found himself having to do something. But this could still be a good company that is pushing (slowly) to become a much better one. True, Sage’s transformation has been slow and may have come too late. But we think there is still significant upside for growth, as the wider macro outlook lifts and the company makes steady progress on its SaaS project.  

The shares are not overly expensive for the software sector, trading at 30 times forward earnings. The shares also offer a free cash flow (FCF) yield of 4.5 per cent based on forecasts for the next 12 months. If Sage can pull off its transformation,  we think this looks reasonable for an industry leader. Growth initiatives do not always come hand-in-hand with increased profitability in the short term, but we are inclined to take Train’s view that Sage is worth holding in the long run.