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Our Disputers column will sometimes cover those companies that are doing the disrupting, sometimes those that are being disrupted and should therefore be avoided – and sometimes those that are managing to avoid being disrupted even when investors fear that their business model is about to be rendered obsolete by more innovative rivals.
Today we cover one that we think belongs in the last category: Sage, the business software company.
We have a particular interest in Sage because it was the very first stock tipped by this column after its relaunch in the autumn of 2016, and because we recommended it partly on the strength of its inclusion in the popular Fundsmith Equity portfolio run by Terry Smith, the renowned investor.
Smith sold his fund’s stake in Sage last month, but we think the shares have a bright future. What have we spotted that he has missed?
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If Smith sold out of fear that Sage was on the wrong end of disruption, he was not alone. As a long-established provider of software to small businesses, it is having to switch from selling its software as a one-time purchase in the form of a CD or download to providing it as a service hosted online in the “cloud”.
Many younger rivals have only ever offered their software in the cloud, a model also known as “software as a service” or Saas, which involves charging customers a regular subscription for as long as they use the software. Some investors doubted that Sage could compete as a Saas provider against newer competitors that have specialised in it from the start.
But the British company is making progress: more than half of its business has now been migrated to the cloud. However, even when the transition proceeds smoothly from an operational point of view, financially it can look bad: revenues tend to fall in the short term if instead of selling a piece of software for say £1,000 in one go you start to receive £30 a month instead. And the transition requires investment.
After a year or two, however, you will have recouped much of the shortfall and have a smoother, more reliable long-term revenue stream.
“You see the same pattern again and again when long-established firms are forced to change the way they work as the world goes digital,” said Nick Clay of RWC, whose Global Equity Income fund recently invested in Sage.
“Look at Reed Elsevier [now RelX], the academic publisher: its transition from selling printed books and journals to online publishing was very messy and some investors thought it would destroy the firm.” But after a sticky period about a decade ago the shares recovered strongly.
He added: “Now people think new disrupters will take Sage’s business, but it has loyal customers and now that 50pc of those customers have transitioned to the cloud it will start to see the benefits. You have to have patience, but the flags are going from amber to green, and the stock yields a forecast 2.7pc so we are being paid to wait.”
That yield is an expression of the market’s scepticism: it’s a very high figure for a software firm and values the business, in Clay’s words, “as if it were in permanent decline”.Instead, he ruled out “any possibility” of a dividend cut, saying the firm had “plenty of cash flow”.
“We expect the dividend to be flat until 70pc-75pc of the business has moved to the cloud,” he said.“Then you’ll start to see free cash flow grow, followed by the dividend. I’d expect that to happen within a couple of years.”
A dividend rise from a share that already yields close to 3pc would do wonders for the share price, although in practice it is likely to have started to rise long before then as investors gradually realise that their pessimism was misguided.
Terry Smith’s investment strategy is to invest in companies that have “already won” as opposed to those that are transforming themselves, so we can see why he might have decided to drop Sage. But his way, while hugely successful and admired by this column, is not the only way.
Sage is well on the road to success in this tricky process of reinvention and the yield shows the scope for share price recovery once it’s through to the other side.
Questor says: buy
Ticker: SGE
Share price at close: 677p
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