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Urbem's 'Wonderful Business' Series: Technology One

Technology One (ASX:TNE) is an Australian enterprise software supplier of comprehensive, deeply integrated solutions mainly to government, financial services, health and community services, education and utility sectors. The business generates most of its revenue through software-as-a-service (SaaS) subscriptions (28% of FY2019 sales), on-premise license sales (14% new and 35% renewal of FY2019 sales) and consulting services (22% of FY2019 sales). The company mainly serves customers in Australia and New Zealand, with a small presence in the UK.

In 1987, after extensive experience in the software industry, Adrian Di Marco saw an opportunity to build financial software for businesses and governments. He then founded Technology One in a demountable office in the car park of a hidden factory in the industrial suburbs of Brisbane and grew the business to Australia's largest enterprise software provider. Mr. Di Marco is the current Chairman and Chief Innovation Officer of the company with over 7% ownership.

Technology One started as a traditional 'on-premise' software business but later pivoted to become a SaaS provider with a cloud-first, mobile-first focus. The transition is still ongoing, with the legacy license business estimated to account for only 2% of total software revenue by FY2014. As of FY2019, 435 enterprise customers were on TechnologyOne SaaS, up from 347 enterprises year-over-year (a 25% increase). The company expects to serve more than 1,000 SaaS customers by 2022 - quite an ambitious goal!

At Urbem, we have been especially interested in investment opportunities riding the SaaS trend. According to IDC, $1 out of every $3 spent on software will be in the form of SaaS subscriptions by 2021. Radically transforming the relationship between the customer and the software, the SaaS business model offers a few advantages, including higher efficiency of hosting and distribution, reliable recurring cash flow, and, hopefully, a high switching cost that widens the economic moat.

The management estimates the annual recurring portion to represent over 70% of total revenue, with a roughly half-half split between SaaS and license, but we notice that the SaaS portion is growing at over 40% at the moment, and it is reasonable to expect customers to continue moving away from on-premise solutions. We think that through the continuous transition to SaaS, the company would not only benefit from the industry tailwind but also improve the quality of its revenue and profit.

The top-notch 99% customer retention rate achieved by Technology One is a good indicator of the existence of an economic moat. Customers like the government and universities are reluctant to change their systems, which hold mission-critical data for day-to-day operations. Technology One has pioneered digital transformation for Australia since the very start, possessing a first-entry advantage and local reputation earned through decades.

Under the philosophy "one vendor, one experience," the company aims to be a comprehensive one-stop-shop covering all digital needs for enterprises. As a result, customer loyalty has increased, as it would be a headache for customers to deal with multiple vendors and platforms. As one of the largest Australian tech companies, Technology One leverages its local expertise and insights through the product life cycle and accumulates know-how, hence protecting itself from threats of global tech giants.

Lastly, while the barrier of entry in the information technology space is not high in general, the competitive landscape in Australia and New Zealand does not look so fierce as it does in some other parts of the world (e.g., China, the U.S. and India). Entrepreneurship is not such a "pop culture" among young people, which is good news for already dominant players in the market (and their owners).

As demonstrated below, Technology One delivered superior ROICs consistently over the past few years when compared to other major SaaS players, including SAP (SAP), Oracle (ORCL) and Infosys (INFY).

The management targets a 148% total increase in annual recurring revenue by FY2024. With this goal on the roadmap, the company is heavily investing in R&D (21% of revenue in FY2019) to further extend its SaaS offerings and enhance its technologies/products in the areas of AI, machine learning and digital experience.

The overseas expansion could be another growth driver. The management sees significant upside in the UK market, estimating its total addressable market is three times as large as APAC. In the meantime, we should note that the competitive landscape could be different there and would like to keep monitoring how the turnaround story of the company's UK business plays out over time.

Finally, the megatrend of increasing business automation and digitization may fuel further product penetration among existing customers. The company achieved 3.8 products per customer in FY2008 (out of 11 available products). That number grew to 5.1 products per customer in FY2017 (out of 14 available products), and is expected to reach over eight products per customer in FY2027 (out of 16 available products).

Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market; we own shares of Technology One.

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This article first appeared on GuruFocus.