Sage: A ray of British sunshine

A difficult mix of winter, illness and lousy market conditions have left me with a bit of a gloomy disposition of late.

Jeremy Hunt’s ‘budget’ this week did very little to rouse any optimism. Great, we get an extra £5,000 tax free allowance to invest in British stocks, but what are we going to do with that? The London Stock Exchange isn’t teeming with exciting opportunities right now. In fact, the announcement prompted some subscribers in our discussion forum to ponder how they could use their additional allowance to invest more in international stocks. ‘Use it to buy London-listed ETFs or Investment Trusts which specialise in the US or Europe’ was one suggestion.

Two more downbeat British companies were snapped up by larger rivals this week. The takeover offers look like massive premiums to the current price, but in fact only value the companies at the levels they were at about a year ago. It’s a bad situation which isn’t going to be rectified by an additional ISA allowance or the floatation of some more shares in Natwest (the bank that the government had to rescue from insolvency during the last financial crisis). Thanks for nothing Mr Hunt.

Meanwhile, at Stockopedia, we’re seeing a rising demand for coverage of stocks listed across the pond. Companies like Super Micro Computers which has seen its share price rise 65% in the last month alone, adding more than $25bn to its market capitalisation.

Next week we’ll get first quarter numbers from software group Adobe and writing a preview of these figures for The Week Ahead (look out for the article on Monday) has helped stir some optimism - not just because Adobe is my favourite company in the world, but because looking at the numbers has helped remind me of the power of a software as a subscription business. And in that field, the UK actually has an interesting opportunity - Sage.

How subscription revenues can revolutionise margins

Adobe has a classic Silicon Valley origin story. In 1982, computer scientists John Warnock and Charles Geschke left their previous jobs to set up a tech business out of the former's garage. Their product, PostScript, is a programming language which found itself in such immediate high demand that Apple attempted to buy the company before it had even matured from said garage. The two founders refused and instead signed a licensing deal with Apple which helped Adobe became the first company in the history of Silicon Valley to turn a profit in its first year.

Licensing revenues have historically been commonplace among software companies. By selling long-term licences, software companies retain very sticky customers and revenue visibility. But, for Adobe, licensing had its limitations. Most notably its ability to roll-out feature upgrades at regular intervals, and in 2013, the company decided to switch to a subscription model.

In 2024 it is funny to think that, a little over a decade ago, subscriptions were a relatively novel concept. Today we all see subscription expenditure roll out of our bank accounts for everything from entertainment (Netflix) and exercise (Peleton) to office supplies (Microsoft) and groceries (Hello Fresh). But Adobe was one of the first companies to offer subscriptions for its software.

The shift initially disrupted sales, but within a year of rolling out the new model, Adobe was generating more than two thirds of its sales from recurring subscriptions.

The recurring nature of subscriptions has made Adobe’s software extremely cheap to sell, meaning the company’s gross margins now sit at almost 100%. Operating margins have also averaged 33% in the last five years and net cash inflows regularly exceed net profits. With the excess cash, Adobe has been able to invest heavily in upgrading its software solutions (including a recent foray into the high growth world of artificial intelligence) meaning sales growth has averaged 17% in the last five years.

Sage - playing catch up

British tech group Sage might not offer the same spark as Adobe (accounting software is less exciting that PhotoShop), but it’s a similar investment case.

Founded in 1981 in Newcastle to develop software for small and medium sized business accounting, Sage spent most of its life selling its products via licences and it wasn’t until 2018 that management decided to switch to a subscription model. But the switch proved far more challenging than investors might have hoped. Revenues hopped around the £1.9bn mark between 2018 and 2022 and the costs associated with the switch have seen operating margins fall to 14% (from 23% in 2018). Between 2016 and 2023, the share price wallowed around 700p, with any optimistic lurch being stymied by disappointing financial results.

But in the last year, Sage seems to have finally turned a corner. Subscriptions now contribute 80% of the total top line (£2.1bn), meaning almost all of the ongoing revenues are recurring in nature. This should have a positive knock-on impact on margins. In 2023, sales costs were just £156m meaning gross margins were nearly 100%. And if you strip out the one-off costs associated with various business divestments as the company becomes more subscription-focused, operating margins rose to 20%. Underlying profits therefore rose ahead of revenues and underlying earnings were up 27%.

And investors who have patiently waited for this turnaround have finally been rewarded. Sage’s share price now sits at over 1200p after a 68% increase in the last year. A welcome ray of sunshine in the UK market.