Sage expecting profit to start rising

Sage (SGE) is going through the arduous process of converting itself into a software-as-a-service (SaaS) business. It was slow off the mark, only starting its focused push in 2018, but it is now closing in on the finish line. The company said its 'business cloud' subscription products saw a seven percentage point increase as a proportion of overall recurring revenue, taking it to 67 per cent of possible take-up. Management’s aim is for this to eventually reach 90 per cent of recurring revenue. 

The transition hasn’t come cheap, though. Increased investment in sales, marketing and R&D meant that organic operating profit decreased 10 per cent to £343m. This represents an organic operating margin of 19 per cent, down from 22 per cent last year.

This investment is starting to bear fruit, however. Annualised recurring revenue (ARR) was up 8 per cent to £1.68bn, with growth accelerating in the second half of the year, and £140m of ARR was added through new customer acquisitions. The SaaS business has notoriously sticky customers, which makes gaining new customers extremely valuable. Once on board, it is quite easy to raise subscription fees by adding new features to the software. 

Management said 2021 would be a low point in terms of profitability and it is now expecting organic operating margin to “trend upwards in FY2022 and beyond”. Sage needed to invest to accelerate the transformation but now it is on the way, the hope is that it will now be able to efficiently scale up the business.

The promising thing for investors during this scale-up phase is that because it is a subscription business, Sage is also highly cash generative. Underlying cash conversion was 126 per cent this year (up from 123 per cent) and as more customers are moved to the cloud this should continue to improve.

FactSet consensus is for EPS to rise to 28.6p in 2023 from 22.9p this year. Correspondingly, free cash flow is expected to rise to £397m by then, which gives the shares an impressive two-year forward free cash flow yield of around 5 per cent.

Sage is currently trading on a forward PE ratio of 28.3 which looks very affordable, given the strong free cash flow yield. For comparison, US peer Intuit is currently trading at 55.2. Even if Sage doesn’t reach this lofty valuation, it has a strong position given the difficulty of gaining new customers in this industry. Buy.

Last IC View: Buy, 698p, 22 July 2021