Sage proves its doubters wrong

It is hard to find much to dislike about accounting software company Sage (SGE) currently. It is growing consistently, adding new customers and expanding its underlying profit margin.

There used to be question marks about whether it could pivot the legacy business to the cloud. Research and development costs were significant and it was taking a while for it to get its existing customers to switch over, but now this process is complete, the investors that stuck with it are seeing the benefit.

In the year to September, underlying annualised recurring revenue (ARR) increased 11 per cent, or £224mn, to £2.19bn. Of this extra ARR, £190mn came from new customer acquisitions while the rest came from selling more to its existing customers. Price rises were just 4.5 per cent for the year which was below wider inflation. This helped to retain customers and correspondingly customer churn was at record lows.

Chief financial officer Jonathan Howell told the Investors’ Chronicle that Sage didn’t want to drive prices up too much as it wanted to keep providing good value. The upside of this strategy is it will leave room to keep increasing prices over the coming year, when we can expect another 4.5 per cent rise, which this time will be ahead of inflation.

This will help expansion of the operating margin. Software companies always talk about how scalable their businesses are in theory. As the number of users rise, they can spread the fixed cost of marketing and development over a larger customer base. Sage’s operating margin grew 1.4 percentage points to 20.9 per cent. Correspondingly, underlying operating profit rose 18 per cent. 

The only concern for Sage investors now is the valuation. It is trading on a forward price to earning ratio of 29, which is on the expensive side. The 116 per cent cash flow conversion rate means it looks a little cheaper relative to cash but investors will be expecting growth and margin expansion to continue.

An issue could be presented by a worsening macroeconomic environment. Sage’s customers are mostly small and medium-sized businesses which could come under pressure due to higher borrowing costs and this would worsen if a recession arrives. However, Howell pushed back at this by saying that Sage's accounting software actually saved costs, so this would be seen as a way to reduce overheads.

In terms of growth, the North American market is an area of promise, where revenue increased 16 per cent, which was ahead of the wider group. America now makes up almost half of total sales and given the strength of the US economy it’s likely it will keep driving growth moving forward. Overall, a good year all round. We stick to buy.

Last IC View: Buy, 850p, 17 May 2023