Tuesday, February 28, 2012

Software Company Stocks Moving to Cloud Computing

Intuit, Sage and Cloud Computing

Intuit $INTU is a stock that offers investors exposure to the shift towards SaaS (Software as a Service) amongst software providers. This makes Intuit a stock set to benefit from cloud computing growth. It is also attractive as a way to play an economic recovery in the US via its tax offering.

So with Intuit, you have a structural growth story with the shift to cloud, combined with the cyclical growth story of increasing US employment leading to increased tax filing.  I thought it would be interesting to do some equity research analysis on Intuit and compare it with a UK stock called Sage, which competes in some of its end markets.

Intuit Earnings Analysis

Firstly, these set of results beat estimates but what is really important is the outlook for the April quarter, which usually makes up around 85% of earnings for the year.  Intuit confirmed previous guidance and forecast $2.47-2.51 in non-GAAP EPS for April, which is in line with analyst estimates of $2.49.

Similarly, the conference call made some positive noises on the next quarter, although cautioned that there was a lack of data from the IRS this year on tax returns. No matter, payroll data has been strong recently and most of the economic data- as well as commentary from the likes of Robert Half $RHI – has been indicative of decent employment gains.

Moreover, INTU noted in the conference call that (despite it being early in the season) tax returns are up on last year even though the evidence is that there is a trend towards tax returns being filed later and later each year.

Cloud Computing Stocks

However, Intuit isn’t just about a cyclical growth story, there is a real secular shift occurring in their digital business. Intuit was an early investor in the cloud computing and selling SaaS, and a company like Sage needs to take notice. The shift to online is progressing across the whole company and it is leading to increased ROI (return on investment) and lower churn rates. Indeed, as Intuit pointed out with QuickBooks Online, it has a 20% increase in life time value (LTV) as compared with QuickBooks Desktop.

A company like Sage should take note because the possibility to leverage its leading position in the UK (accountancy software) into the cloud is significant. Sage is talking about doing this but is far too slow in adoption and, runs the risks of having its market share eroded and ultimately facing a disruptive shift when it does finally make the move aggressively.

According to Intuit, the company is already generating 62% of its annual revenue from connected services.  I doubt Sage is anywhere near that, but the company should be thinking aiming for it. Let’s look at what Intuit said in the conference call and see how it demonstrates the power of the cloud to steal market share. In this case with QuickBooks…

“3 years ago, we used to get 40% of our new customers outside of QuickBooks Desktop. We're now getting 70% of new customers beyond QuickBooks Desktop. So as we shift to more Connected Services and mobile apps, it's helping us get new customers into the franchise and it's easier for us to identify additional problems that we can introduce them to a product through a simple link and so that drives cross sell and up sell and attach.”

Indeed, Intuit’s Turbotax is the highest grossing iPad app in the Apple store. It is initiatives such as this that have lead to online tax returns growing to 75% of the market versus 25% for retail. Intuit is trouncing the likes of H & R block $HRB.

Sage Future Challenges and How Intuit Shows the Way

Intuit competes with Sage with its QuickBooks accountancy software and, it is worth looking at what Intuit said about growth rates of QuickBooks online and Desktop…

“Well, what we're seeing right now in QuickBooks is year-to-date, the desktop customers, the units are down about 2% in terms of the units sold. With that being said, the online version's up 35%, but you've got to keep that in perspective. We've got 4 million installed QuickBooks customers and we have 326,000 odd or 230,000 odd QuickBooks Online customers. So it's growing off of a smaller base. If we had to take a look at what we think the future will be, you're going to continue to see a faster growth rate in online than desktop. But a lot of customers really want to have their accounting information on the desktop. “
In other words, unless Sage wants to continue along the conservative low single digit revenue growth path, it had better get into the cloud and quickly. There will always be a core demand for desktop but the growth is online.

Not only is the growth online, but the ROI is higher. The LTV is higher and the marketing is more targeted, which results in lower churn rates. Sage has the chance-given its market dominance in the UK- to aggressively make an ‘Intuit’ style shift, but does it have the commitment and are the management being slow to adapt?

Sage is launching several versions of their mid-market offerings in the cloud this year and, if successful, Sage has the potential to generate some upside surprise. Although, potential investors will have to consider that nearly 60% of revenue comes from Europe and notably the SME market. These headwinds create a fair amount of uncertainty for Sage.

Intuit Equity Research

Turning back to Intuit, INTU currently trades at $57.57 which gives it an enterprise value of $17.23bn.  Over the last five years, revenue growth has had a CAGR of 9.6% and EPS growth is forecast to grow this year at 17.9% and then 13.2% for July 2011-12.  These are excellent numbers and, furthermore INTU is very good at converting income growth into free cash flow..

July 2009
July 2010
July 2011
Non-GAAP Net Income
Operating Cash Flow
Ocf conversion
Capital Expenditures
Free Cash Flow
Fcf conversion

…so if we take a rough estimate of 120% FCF conversion, and the analyst of non-GAAP EPS of $2.96 we will get FCF of 2.96*1.2= $3.57 for 2012. For the next year, estimates are for $3.35 in earnings which would give around $4 in FCF for 2013.

This equates to FCF/EV of 3.57/57.57= 6.2% and 4/57.57= 7% for the next two years. This is cheap for a business that should be able to generate earnings growth with the shift to online services for many years to come. Compound this with the relatively defensive nature of the company (SME’s tend to have a high failure rate, but they all need tax and accounting software) and this evaluation of $57.57 looks cheap. 

Analysts mean price target is for $64 but I think that is too conservative. Intuit could trade closer to $70 if the economy continues on track. I bought some more after the results.

As for Sage, it has economic headwinds for the first half of 2012 but potential investors should watch events closely. If Sage is committed to the cloud then it could see a re-rating with a lighter than expected recession and he beginnings of traction in the move to the cloud. However, I would like to see hard evidence of the latter first, before piling in.

Tuesday, February 14, 2012

Telecity Set to Benefit From Cloud Computing Growth


A good set of results from Telecity $TCY which highlight how this stock benefits from the growth in internet traffic and cloud computing. Data centers are a very good ‘picks and shovels’ play and companies like Equinix $EQIX are seeing strong growth in end demand. Inevitably, this is causing increased capital expenditures as the data center providers expand capacity.

The potential downside here is that this ramping of capacity (the likes of Equinix and Telecity are expanding aggressively) will cause a supply glut which will lead to falling margins just as the data centers need cash flow in order to pay back the debt needed to expand capacity. No matter, right now, this doesn’t look like being a problem and investors will see the early signs when Telecity et al, start reporting slipping EBITDA margins. The growth in internet traffic is progressing at an exponential rate and increases in cloud computing will only strengthen the case.

Telecity is a Good Play on Cloud Computing

Turning to the expansion program, Telecity has nine simultaneous locations in development at the moment. Over the course of the last year, they expanded capacity to 68MW from 58MW last year. A further 10MW is expected to come online within the next six months and, longer term plans for a total of 124MW in three to four years are already in place. This is almost a doubling of current capacity, but Telecity has good reason for confidence over these plans.  

For example, 95% of last year’s revenues were recurring and 60% of organic growth came from existing customers, with only mid single digits churn. Clearly, Telecity’s end demand is very sticky and they are seeing strong growth from existing clients who need expansion to meet their mission critical demand.  Ultimately, this provides Telecity with a high visibility of earnings.

Telecity’s Growth Drivers

Moreover, the growth in internet traffic is broad based across sectors and, has proved to be recession resistant. This looks like a structural growth story and, will only increase as cloud computing and data traffic increases. Whilst, superficially, there is no moat in data center provision, it is in fact a mission critical application which requires substantial planning and trust on behalf of the clients.

An example of the broad base of Telecity’s clientele can be seen when looking at the breakdown of new customer wins by application type

  • 29% content
  • 24% financial
  • 16% connectivity
  • 16% systems integrator
  • 15% cloud computing

Financial simply refers to financial transactions through the centers. The diversification in usage belies the growth potential for Telecity.

Telecity Financials

At a current price of 650p the stock is valued at £1287m. Telecity currently has £164m in net debt, which put together gives an Enterprise Value of £1451m. This stock is obviously not bought for its dividend, even though Telecity is promising to pay 20-25% of its earnings in dividends. For those interested, this would make 6p or 1% yield based on analyst forecasts for 2012. The company expects to commence dividends at the half year in 2012.

The key to Telecity is to think if it as a cash generating ‘annuity’ type stock. It is in the expansion phase now so, superficially, cash generation looks weak but the underlying picture is much stronger. At the full year, Telecity generated £106.5m in operating cash flow from £109.9m in EBITDA and, cash flow conversion has been similarly strong over the years. Telecity spent £109.9m in expansion capex but maintenance capex was only £21.8m. This means that the operating free cash flow was £106.5-21.8m=84.7m or 5.8% of EV.

Telecity Stock Analysis

The underlying cash flow generation is strong and investors should consider that it will, roughly, take four years for a location to reach peak demand. Therefore, the expansion now will generate future revenue growth in the next  few years. Furthermore, the net debt situation of £164m is easily manageable given cash flow generation and a five year £300m debt facility hich was signed in May 2011. There is ample head room for more expansion.

The key thing here is that any investor will need to be confident in the long term growth rates of internet traffic and then try and ‘price’ in this confidence. The correct approach might be to watch gross margins across the industry and see that as a marker for over capacity. However, we are not there yet and Telecity’s stock price is probably at least capable of ‘doing its earnings’ for 2012. On this basis it is better priced at 750p then the current price of 650p.