Parsing Our View

Software is an increasingly relevant sector for small-cap investors. Now representing about $15bn of market capitalisation and 7% of the Small Industrials Index, the sector is performing strongly and is being driven by several secular tailwinds, including:

 

  • cloud computing;
  • digital transformation, or a bigger slice of corporate operating expenditure; and
  • recurring revenue and incremental margin expansion.

 

In the US, the S&P 500 software sub-sector has outperformed the broader S&P 500 index by 2.7x since the global financial crisis, with that outperformance accelerating more recently. In the past two years, we calculate two-thirds of the sector performance has been driven by underlying earnings improvement and one third by multiple rerating. We have seen a similar performance and mix between underlying base improvement and multiple expansion play out on the ASX.

 

We acknowledge this multiple rerating warrants some caution, although software valuations appear to be tracking expectations for software spending (growth) and reflecting the business model shift towards subscription (quality of revenue). We initiate coverage of the following four software companies:

 

  • Technology One (TNE) offers investors both attractive growth and improving earnings quality. We see sufficient runway remaining in its core Australia and New Zealand markets, and we remain optimistic that the UK will ultimately prove a successful new market. We view the cloud services strategy as offering a relatively low-risk way to grow both its addressable market and recurring revenues. Based on our earnings forecasts, which are about 10% below those implied in long-term guidance, we initiate coverage with a Buy recommendation and a $5.45 target price.
  • WiseTech Global (WTC) offers investors leverage to a global software growth scenario that is still likely to be in its early stages. The company ticks almost every box for a software business, although every stock comes at a price and, following a substantial rerating over recent months, we would wait for a more attractive entry point. Based on our earnings forecasts, which are at the top end of guidance, we initiate coverage with a Hold recommendation and a $14.96 target price.
  • Altium’s (ALU) management has unquestionably executed well. However, we can’t reconcile the current valuation with the current level of recurring revenue, or a conservative view of the likely penetration implied in the company’s core addressable market. Altium remains heavily exposed to up-front licence sales, with recurring revenue the lowest among peers. We acknowledge recent corporate activity, although a potential bid seems unlikely at current prices. Based on our earnings forecasts, which are about 10% above those implied in long-term guidance, we initiate coverage with a Sell recommendation and a $16.45 target price.
  • IRESS (IRE) offers investors a relatively low-risk exposure to software, promising double digit growth, high recurring revenue, improving margins, predictable cash flow and some yield. However, its growth prospects are more complex with the wealth management business growing strongly and potentially starting to accelerate in the UK, but having to compensate for the lacklustre outlook in financial markets. We would like to see the UK deliver some outsized incremental organic growth in order to become more positive. Based on our earnings forecasts, which are towards the top end of guidance, we transfer coverage from our research partner to Ord Minnett with a Hold recommendation and an $11.24 target price.

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