Description

Vista’s Robert Smith said, “Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit?”

That is particularly true for mission critical accounting systems, like Sage.  Sage is THE system of record for operations and accounting with 90% gross retention and net retention of 100+% among their small and mid-mkt business customers.  They were founded in 1981 and have subsequently transitioned to cloud, representing nearly 70% of our forecast Fiscal 2023 revenue.

You can own Sage for 3.7x forward revenue, and 16x forward EBITDA on today’s trough 23% EBITDA margins.  At a 35% margin, which is how I think PE would assess the business, they are trading at more like 11x EV/EBITDA.  Other SMB and mid-mkt accounting deals have been done at 5-6x sales (MYOB, Visma).

Several vectors have inflected positively: 1) margins have bottomed and are guided higher from here, 2) organic growth has accelerated from +MSD to +HSD.  For which EV/S sits at a local low relative to Sage’s own history, and cheap vs peers and historical PE bids for similar assets.

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Background

Sage was founded in 1981 to manage back-office accounting and IPO’d in 1989.  Sage provides horizontal accounting software across both service and product industries, geared towards SMB and mid-mkt companies.  Originally serving the UK, where they are still the market leader, they are global today (20% UK, other major markets include US, Continental Europe).

Sage was run by CEO Walker from 1994-2010, during which time they grew from GBP 50m of revenue and ~100m market-cap to GBP >1B in revenue and 3.7B market-cap, largely through M&A.  They operated with ~90% gross margins and 25-30% EBITDA margins.  From 2010-2014, under CEO Berruyer, Sage suffered a period of mediocrity, hardly growing organically. 

In 2014, Steve Kelly became CEO, coming from Micro Focus. He brought in new management and arranged a credible turnaround plan to move from license to a recurring SaaS subscription model. In Nov 2018, the prior CFO Stephen Hare, became CEO. Hare accelerated the push to SaaS, while reinvesting margin to get there.

Product

The core product is the General Ledger, or the record of every transaction that takes place across the organization.  This includes, for example, the inventory account, as product progresses through the order and manufacturing cycle, or the AR account, as product is shipped and payment received.

Within the business software stack, accounting is among the stickiest layers.  Sage has ~90% gross retention, a high level for a SMB/mid-mkt customer base.  People talk about replacing an accounting system as changing the engine on a car while it is moving.  An important piece of this moat is integrations between Sage software and customer bank accounts, which eliminate manual data entries.

Further, from their position deep in the enterprise software stack, and as the holder of mission critical operational and financial data, Sage has the privileged opportunity to cross-sell additional module adjacencies, such as Core HR & Payroll, AR/AP automation, and payments.  The Core HR product is called Sage People.  This is a cloud native product with modules for recruiting, talent management, time-off management, and performance management.  Sage People is a down-market version of SAP Successfactors, Oracle Taleo, or Workday.  This product sits alongside Sage Payroll, an organically developed cloud native product for actual payroll calculation.  Core HR and Payroll are often sold together, as the core system of record for employee data.  They also make sense as adjacent solutions to the ERP accounting system, as this streamlines data flows between the payroll system and general ledger.

A separate adjacency is Payments, which includes a rev share of processing revenue tied to payments made on invoices sent out through the Sage AR module or payments made through the Sage AP module. 

The average customer pays Sage ~$800, which includes $150 for small customers and ~$5k for mid-mkt (they also have an enterprise accounting system that costs $75k license).

They sell the product primarily direct (~60-70%), but also through accountant referrals (i.e. accounting firms will recommend that their business customers adopt Sage).

Here is a break-down of revenue in Fiscal 2022.  You will see that 94% of revenue is now recurring, as Sage has stopped selling perpetual licenses.  Among the recurring revenue, they are mostly in the cloud, which is a mix of cloud-transitioned revenue and native cloud revenue:

Intaact

In July17, Sage acquired Intacct ($850m; 7.5x EV/revs), a cloud-native accounting software for the US mid-mkt. This is the crown jewel of the Sage portfolio.  The Intaact suite includes Core GL, AR/AP, fixed asset accounting, and financial planning.

The avg ACV is ~$50k and rev growth is 30%+. The closest competitor is Netsuite, which Oracle (ORCL) acquired in July 2016 for 8x EV/rev, similarly growing 25-30%.  The cloud native portfolio at Sage, of which Intaact is the largest piece, is growing 40%+ organically.

In summary, 20% of the business is an A+ cloud native mid-mkt accounting asset; 40% is Sage accounting software that has transitioned to cloud, 25% is on-premise Sage software, sold on a subscription basis, that will transition to cloud, 10% is maintenance and other processing revenues and 5% is licenses/pro services.  Over time, the A+ cloud native component will become larger, while the on-premise piece becomes smaller.

Growth

Recurring organic was HSD/LDD% from 2016-2020, falling to +MSD during covid.  Total org was pressured by declines in the perpetual license/services business, which is now down to just 5% of revs.  F22 recurring org is expected to re-accelerate back to HSD%.  By F23, as the legacy non-recurring business becomes insignificant, I expect total org to more closely resemble the HSD% growth of the recurring business.

Margins

The in-place EBITDA margin is 23%, which management says is the bottom, and margins will expand from here. It is natural that a subscription model transition will pressure margin on a temporary basis.  Over time, the stacking of recurring subscription revenue overcompensates for the short-term transition dynamics (see: ADBE, ADSK, DATA et. all).  Beyond that, Sage has stepped up R&D investment in their cloud portfolio.  Over time, we also expect R&D related to maintaining legacy solutions and architectures (i.e. tech debt) goes away.

Sage realized a peak margin of 30%, in 2013, and was in the high-20s in 2015-2018.  We see no reason they will not return to those levels, either on their own, or under different ownership:

Competition

Sage primarily competes in the mid-mkt.  These are companies graduating from INTU Quickbooks as well as companies that are still using manual methods of accounting (i.e. excel).

Sage primarily competes with INTU Quickbooks and Xero (XRO AU) on the LE and Microsoft Dynamics and ORCL Netsuite in the mid-mkt.  INTU and XRO are both further along in the cloud transition, with XRO being cloud native from day 1.

Their balance sheet has 1x leverage, and historical use of cash has been M&A and dividends.  The latest acquisition was Brightpearl in December 2021 for GBP 225m, which added cloud-native inventory and order management capabilities to the ERP.  More specifically, Brightpearl helps customers manage omni-channel commerce, including a portal to view orders, inventory, warehouse location across digital (i.e. 1P e-commerce, 3P marketplace) and physical channels.

Valuation

Sage trades for 3.7x EV/revenue and <4x recurring revenue.  This represents 16x EV/EBITDA on today’s trough 23% margin.  At a 35% EBITDA margin, which is how I think PE would assess the business, they are trading at 11x EV/EBITDA.

Private equity has a bid for sticky back-office enterprise software assets like Sage.  MYOB and Visma, Australian and European accounting softwares, respectively, were acquired for 5-6x EV/revenue.

Beyond that, Netsuite, their largest competitor, was acquired by ORCL for 8x EV/revenue.

Punchline: Sage is a leader in mid-market horizontal back-office accounting.  This is a mission critical product, at the bottom of their customers’ technology stacks.  Sage’s offering is increasingly cloud-based as they shift existing customers and sign up new customers for their subscription offering.  Looking forward a year, we think nearly 70% of revenues will be in the cloud.  Growth is accelerating to HSD% while margins have troughed and will expand from here.

At <4x subscription revenue, for a sticky mission critical piece of software, Sage is on sale.

Disclaimer:

This presentation is intended for informational purposes only and you, the reader, should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. Before investing in a security, readers should carefully consider their financial positions and risk tolerances to determine if such a stock selection is appropriate. At any time, the author of this report may trade in or out of any securities that are mentioned in the report as long or short positions in his own personal portfolio or in client portfolios that he manages without disclosing this information. 

This report’s estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

Continued value creation from +HSD organic recurring revenue growth and margin expansion.

Valuation convergence to history and peers.

PE interest in the asset.