Sage still looking a wise bet

The quality of Sage’s business model has also been improving for some time, as the group transitions away from a lumpy licence model to a mainly subscription-based service, as well as pushing cloud-based products. It generates its income from three key sources: software and software-related services (SSRS), processing, and recurring revenue from subscription and maintenance-and-support contracts. The proportion of recurring revenue within the group total has been growing over the past five years - 83 per cent in 2019 compared with 67 per cent five years earlier.

As a software business, it is also not particularly expensive to operate: capital expenditure took up just 1.6  per cent of its revenues in the first half of 2019-20. The group is therefore highly cash generative – underlying cash conversion stood at 129 per cent in 2019. Return on capital employed, which measures how effectively a company converts investments into profit, stood at a healthy 20.5 per cent in the first six months of this year. 

Sceptics are less worried about the quality of Sage’s business, which in any case would be difficult to undermine. Instead, they are concerned about the group’s capacity to grow, especially outside the UK. While the company has progressed well in marking up the quality of its revenues since its transition to cloud-based products, it has struggled to keep up profit growth. Underlying profit margins nudged down 0.5 per cent in the first half this year and profits suffered particularly in 2019, after the company pumped large amounts of money into innovation as well as staff pay to strengthen its competitive edge.

But this is a necessary long-term move for Sage, especially as competition heats up in the sector. US company Intuit (US:INTU), which sells rival software ‘Quickbooks’, and New Zealand company Xero (Aus: XRO), have both been muscling in on the market. So Sage's aim to become a "great SaaS [software-as-a-service] company" is perhaps delayed, but, if achieved, can only serve to strengthen what is an already dominant player in the industry.

Take, for example, its Sage Accounting for Professional Users product, which is a small business solution for so-called 'cloud-native' accounts, which are run solely from remote servers. This is designed to attract new customers, both directly and through accountant referrals. Over time, the group will be able to funnel customers to a cloud-native solution. Investors should be encouraged that Sage's bosses have not shied away from prioritising products such as this as part of their strategy. While this process may weigh on profit margins in the short-term, it should bolster value for clients longer term, as well as the rate at which Sage can add new customers. 

Sage’s performance in the first half of 2019-20 was decent enough. True, growth in headline revenue was less than 2 per cent, but revenue growth unaffected by acquisitions was almost 6 per cent and recurring revenue was up 10 per cent. Profits growth was restrained by pushing through development spending. Also, the group saw a slowdown in new customer acquisition due to coronavirus, with around half the level management had expected in April. But its existing customers are remarkably reliable: renewal by value stood at 101 per cent in the first six months of this year.