The Sage Group PLC is the UK’s leading accounts software company for small and medium businesses and is quite possibly the only accounts software company you’ve ever heard of (if you’ve heard of any).
It’s been quite a success story too. In 1981, what became the company’s first product started out as a computer program written by a student as part of his summer job. Soon afterwards, the company was formed and in 1989 it was listed on the stock exchange. Just 10 years later it entered the FTSE 100.
Today Sage is a very different company, with more than 250 products on all manner of hardware and software platforms. These products are sold to and used by more than 6 million small and medium-sized businesses across the world, with just 18% of revenue now generated in the UK.
Its business model is to provide small and medium businesses with accounting and related software as well as 24/7 telephone support and to offer companies a migration path onto both additional and more sophisticated (and expensive) software as small businesses and their accounting needs grow.
In recent years the software side of the business has gradually moved to a subscription model like much of the software industry. Rolling subscriptions rather than one-off payments means constant upgrades for customers via the Internet and reliable, recurring revenues for software providers.
Recurring revenues from subscriptions and support services now account for some 71% of the company’s total revenues.
Here’s a snapshot of how Sage has performed over the last decade:
As you can see it’s been a story of steady growth and a progressive dividend. Here are some key numbers (which you can calculate for any company using this investment spreadsheet):
- Growth rate – Overall growth has been 10% a year, although that’s skewed upwards by the near 15% a year growth in the dividend, which is highly unlikely to be repeated. Earnings have grown at about 9% a year while revenues and book value have grown at closer to 5% a year
- Growth quality – Revenues, earnings and/or dividends have increased 88% of the time over the last decade
- Return on equity (ROE)– The median return on equity has been about 15%
In comparison the FTSE 100 has grown revenues at about 2% a year over the last decade, increasing its earnings and dividends (I don’t have data for revenues) 58% of the time. As for ROE, the 10-year median ROE for the 74 dividend-paying FTSE 100 stocks that I track on my stock screen is 17%.
On a numbers-only basis, it looks as if Sage has grown well while retained earnings have probably produced a reasonable if unspectacular return on investment.
So much for the past; what about the future?
A strong competitive position but a sprawling company and many competitors
Sage has set itself the goal of growing organic revenue at 6% a year in the medium term, with increasing profit margins and hence even faster growth in profits.
To help it do this the company has a number of competitive strengths, including:
- A brand name strong enough to make Sage the almost de facto choice for many small businesses
- Market-leading positions in the UK, Spain, France, Canada, Brazil and South Africa
- A deeply embedded network of around 40,000 accountants who use and recommend Sage for their clients
- 20,000 business partners who provide installation, support and training to customers, so that customers know there will always be someone who can help with almost anything they might need
- 24/7 business support for customers, which means that the company has more than 30,000 conversations with customers every day. This embeds customers further into the Sage system and also provides the company with huge amounts of real-time information on what its customers are thinking and doing
- Significant scale which allows research and development, marketing and other costs to be centralised and driven down on a per-customer basis
But the most powerful advantage comes from the fact that once a company has been using an accounts package for a while it will be very reluctant to switch to another provider. That’s because switching from one accounting solution to another is almost always a huge pain.
Once a company has been using a particular system for a while it will have thousands of bookkeeping entries, dozens or hundreds of accounts set up in a particular way, year-end balances, error accounts, quirks and other peculiarities. The software may also be integrated with various other systems and processes in all manner of ad-hoc ways.
The company’s staff will also have gotten very used to using Sage and the particular way that that software approaches various accounting activities.
Switching to another provider would mean switching all of that over to another system, which may or may not be better, not to mention re-training all the company’s accounts staff and the drop-off in productivity and increase in errors as they get used to the new system.
This switching cost means that new customers are likely to stick around for a long time, and a subscription renewal rate of 80% suggests that for the most part, they do.
But Sage also has challenges ahead.
Its international expansion came mostly through acquisitions. This was seen as a good thing because its software in international markets had been developed by locals for locals, providing a better fit with local business, accounting and software norms.
However, I’m always a bit wary of large or numerous acquisitions as they can prove difficult to manage and integrate.
Sage has swallowed around 50 companies in the last 25 years and, perhaps somewhat tellingly, the company is now looking to centralise more decision-making and unify the numerous brands under a single Sage brand globally.
Another problem is competition. Thanks to the internet it now has many more competitors with cooler brands that seem to have a better fit with today’s young startup companies, which are of course the mid-size companies of tomorrow.
The internet makes it easy for a company with a strong brand to sell web-based software across the world, and low barriers to entry often go hand in hand with low returns on equity; that is, unless you can become the default choice like Amazon, Google or perhaps Xero.
Overall Sage appears to be a solid market leader with a good ability to generate and grow reliable revenues, profits and cash over many years, but like any company, its future will involve some risk and a lot of hard work.
I think I would be happy to own it at the right price.
A low yield means market-beating dividend payments may be several years away
With the shares at 380p, the dividend yield is 3%, the PE ratio is 19 and the PE10 ratio (price to 10-year average earnings) is 24.
In comparison the FTSE 100, a reasonable benchmark for a FTSE 100 company like Sage, at 6,800 points has a yield of 3.4%, a PE ratio of 13.7 and a PE10 ratio of 14.4.
This means that Sage shares have a lower dividend yield and higher PE and PE10 ratios, so relative to current earnings and dividends it is more expensive than ‘average’.
The question is whether or not the company will be able to grow dividends fast enough in the future to make up for a lack of dividends today.
It certainly isn’t a clear-cut thing.
If Sage can grow its dividend at 6% a year, as it’s hoping to, while the FTSE 100 grows its dividend at its recent overall growth rate of 2% a year, then it will take four years before the dividend from £1,000 invested in Sage is larger than the dividend from £1,000 invested in the FTSE 100.
But of course, there is a huge amount of uncertainty in all this. If the FTSE 100 grows its dividend at a more historically normal 4% then it will take seven years before the Sage investment paid the larger dividend.
So for me, it looks like Sage is reasonably priced, but doesn’t seem to offer either the prospects for outstanding longer-term growth or the chance of a nearer-term share price re-rating due to an extremely low current valuation.
If I owned it I might hold onto it, but I don’t own it and won’t be buying it at 380p.
To calculate a ‘buy’ price I can change the share price in my stock screen to the point where the shares rank near the top of the 250 dividend-paying stocks that I track (they currently come in at number 70). If I reduce the price to 320p then the shares reach number 35 on the list, at which point I might be interested.
At that 320p price, the shares would have a dividend yield of 3.5%; which is the same as the FTSE 100. With reasonable prospects for above-average dividend growth, I think that Sage shares at 320p probably would be an acceptable investment for both myself and my defensive value model portfolio.