The TAMIM Australian Equity All Cap Value IMA is significantly overweight tech stocks compared to the ASX as a whole. This week Guy Carson, manager of the strategy, takes a look at finding value and quality in the software space without having to go to Silicon Valley.
Through our portfolio we hold a number of software companies, and whilst they are relatively small on a market cap basis they are leaders both domestically and globally in what they do. The underlying business model is one that we are attracted to for a number of reasons. When software is embedded in a company’s operations it is typically very difficult to remove, as a result clients tend to be sticky (as long as the underlying software is of a high standard). Additionally, when new clients are added there is typically limited cost to adding them, meaning these companies can grow with very little cost. The nature of the business model means that these companies can potentially see:
Consequently companies with high quality software products can be relatively safe equity investments (not that any equity investment can ever been considered 100% safe). This is particularly true if they dominate or have a significant market position in a particular niche. Thankfully, several companies of this nature exist on the Australian Share Market and whilst they may appear small in market capitalisation terms in our opinion it would be a mistake to classify them as risky.
To illustrate the above points we will have a look through some of the major software companies listed on the ASX to see how we identify those high quality companies with the characteristics we have described above. The companies we have chosen are:
From this table we can divide in the universe into a number of groups. The first group to highlight are those companies trading at large multiples (Aconex, Freelancer, Xero, and Wisetech Global). These companies have large addressable universes and are spending in the hope of being the global leader; they have lower margins than the other companies and are all about growth. As a result we can expect their share prices to be volatile. They are what some commentators call “Long Duration” stocks (i.e. their valuation depends on earnings a long way into the future) and hence small changes to their expected growth rate can cause significant changes to their valuation. We have seen this in recent times with all of these companies below their highs from mid last year, most notably Aconex down 58% and Freelancer down 51%.
Another group though is of more interest to us. These are companies that trade at reasonable multiples although still have impressive growth rates (Altium, Gentrack, Hansen Technologies and Integrated Research). They tend to operate in smaller niche markets and are leading players in them globally. Due to their market leading position, the profitability of these companies far exceeds the first group seen by the higher margins above. They don’t need to spend or price aggressively in order to attract new customers.
The next thing we need to highlight is that with software companies not all growth is created equal. Accounting standards give companies the flexibility to capitalise development costs of software. Essentially this allows companies to take the development cost of the software onto their balance sheet and amortise it over the expected useful life of that particular product. The effect this can have is to boost short term earnings growth and potentially reduce free cashflow relative to profit. Thankfully it is usually fairly easy to spot. The below extract is from Xero’s financial statement, where we can see the impact of capitalised software through the cashflow statement.
The table below collates information from each company’s most recent annual report and looks at their capitalised development as a percentage of their revenue and Net Profit after Tax (NPAT):
Pleasingly, a number of these companies take the conservative approach to their accounts and expense all Research and Development. As a result these companies are more likely to have Free Cash Flow that matches their Net Profit. Two of the companies that caught our eye from the first table fall into this category: Altium and Gentrack. When we look at their recent history we are pleased to see this is the case (Altium is on the left and Gentrack is on the right). In most years, Free Cash Flow actually exceeds NPAT.
A number of companies though stand at the other end of the spectrum and are capitalising a significant amount of their software relative to their revenue and profit. As mentioned above, by capitalising software development a company can spread the impact of that spend over multiple years, hence boosting short term profit. A number of these companies that are doing this fall into the other group mentioned above, the ones with high valuations that need high earnings growth in order to justify their current share prices. The standouts in this regard are Xero, Wisetech Global and Aconex. In fact Wisetech Global and Aconex are current capitalising at rates more than their profits.
Of particular concern from this group is Xero, where the rate of capitalisation far exceeds the rate of amortisation on the Income Statement.
Due to this, the cash burn of the company actually exceeded the company’s reported Net Loss.
Overall, the capitalisation of software development isn’t necessarily a good or bad thing but we highlight it as a key aspect for investors to be aware of. Whilst we prefer the conservative approach of expensing all Research and Development, we won’t exclude companies that have a different approach. By focusing on the underlying Free Cash Flow of the business, you can ignore the noise around various accounting treatments and get a more complete picture of how these companies are performing.
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.