There’s almost universal love among my Motley Fool colleagues for FTSE 100 software giant Sage (LSE: SGE). The company, which released its annual results today, is also a favourite of luminary fund managers Terry Smith and Nick Train.
As such, my caution over the past year about the valuation and prospects of the business has put me out on something of a limb. Have today’s results, and share price fall of as much as 5%, persuaded me the valuation and prospects are now more attractive for investors?
Merited premium rating
To put today’s results (for its financial year ended 30 September) into context, let’s go back two years to the company’s near-term expectations, medium-term guidance, and long-term aims for the business.
For its financial year ending 30 September 2018, it said it expected organic revenue growth of around 8% and an organic operating margin of around 27.5%.
At a subsequent Capital Markets Day, it issued “mid-term guidance that over the next three years, organic revenue growth will reach 10% on a sustainable basis and organic operating margins will be at least 27%.”
It also said: “Over the long term, Sage has an aim of achieving organic operating margins of at least 30%.”
At the time, its shares were trading at around 750p. This valued it at 22.7 times trailing earnings per share (EPS) of 33.1p. Certainly a premium rating, but arguably well-merited on its projections for impressive, double-digit revenue growth and high profit margins.
Well short of expectations
Sage’s performance in fiscal 2018 fell well short of expectations. The chief executive walked the plank before the year was out, and was replaced by the finance director. The company reported organic revenue growth of just 6.8% for the year.
The new boss gave no concrete guidance on organic revenue growth for fiscal 2019, beyond telling us the “rate may decrease in the short-term.” However, he said that due to “£60m of specifically targeted investment to accelerate the transition to SaaS … organic operating margin will be in the range of 23%-25%.”
Valuation
Today, Sage reported organic revenue growth of 5.6%, and an organic operating margin of 23.7%, having previously alerted the market in a Q3 update it would be at the lower end of the 23%-25% range. For fiscal 2020, management told us “organic operating margin is expected to be around 23%, as Sage continues to invest in the transition to SaaS.”
Two years ago, when the company was guiding on organic revenue growth reaching 10% within three years and organic operating margins of at least 27% (with a longer-term aim of at least 30%), the stock was trading at 750p and at 22.7 times earnings.
How’s the valuation looking today, with organic revenue growth running at 5.6% and margin guidance of 23% for fiscal 2020? The shares are dealing at 707p, which represents 24.9 times today’s reported underlying EPS of 28.4p.
As you can see, the stock’s earnings valuation is more elevated now than it was two years ago, when the market was pricing it for significantly stronger top-line growth and higher profit margins.
I believe the valuation is too high for the level of growth and margins it’s likely to offer going forward in an increasingly competitive market. At a sub-20 earnings multiple I might be interested, but at around 25 I’ll continue to avoid it.