Analysts are raising their fair value estimate to £6.15 from £5.82 for Sage (SGE) Group, the global supplier of accounting and business management software.
However, with guiding for organic revenue growth around 8% and an organic operating margin around 27.5% in fiscal 2018, analysts aren’t notably changing our midterm financial expectations.
Sage caters primarily to the needs of small to medium businesses; about 80% of its clients have fewer than 25 employees. Sage has more than six million customers worldwide, employs over 13,000 people, and generates more than £1.7 billion in revenue.
As the firm focuses on shifting its users to a subscription model, away from a perpetual license and maintenance model, we have seen encouraging growth in recurring revenue. In addition, Sage’s partnership with Salesforce.com has led to a rapid acceleration in cloud native application development and initial interest from clients is promising.
Sage has a large footprint in the global small and medium business software industry. However, a changing competitive and technological environment has seen the company struggle to keep up with peers because of a muddled cloud strategy, decentralised organizational structure, and inability to leverage common technology across geographies. Still, new management has focused on addressing these issues.
Sage at Risk from Tech Shift
The industry shift to cloud-based products creates risks for Sage. The company's traditional strength has been its presence in many underserved international markets. However, with cloud-based products, the old barriers to international expansion such as distribution and localisation have diminished.
We think Sage is likely to face greater competition in international markets going forward. For example, close competitor Intuit has launched QuickBooks Online and is expanding aggressively outside the U.S. without the need for a local salesforce, unlike Sage.
The company generates over 55% of its revenue in Europe, which exposes Sage to significant economic uncertainty as the EU continues to face near-term growth concerns and issues surrounding Brexit.
In our bear-case scenario, we assume that Sage fails to execute on double-digit organic recurring revenue growth over the midterm. We predict that management will fail to refocus the business and that the company will be burdened by increasingly low-margin, cutthroat competition from online companies. Furthermore, we think Sage's online endeavours such as Sage One will be unable to win over customers who are spoiled for choice.
Lastly, we expect Sage's reseller network to be marginalized by cloud-based specialists that can provide better products for those resellers and their customers. Under such a scenario, we forecast revenue growth to hover in the mid-single digits and earnings before tax margins to contract to the low-20s. As a result, our fair value estimate for Sage would fall to £4.32 per share.
Best Case Scenario?
Our bull-case scenario assumes that Sage executes on its reorganisation efforts, while small tuck-in acquisitions will support the top line. Moreover, we think Sage will adopt a coherent cloud strategy and leverage its global resources to produce more compelling online products, which in turn, will lead to greater renewal rates and additional product attach rates. In this scenario, we forecast revenue to grow in the low-double digits over the next five years and earnings before tax margins to rise into the low-30s by 2020, resulting in a fair value estimate of £8.25.
The shares currently trade at £6.03, making the company fairly valued.
