INTRODUCTION

     Graham Wylie, a computing and statistics graduate started Sage in 1981 when he developed the original Sage accounts package. (He is still with the company as Managing Director of Sage UK).

     Through the 1980sf Sage increasingly came to dominate the UK market for accounting software for SMEs. (Small and medium enterprises)

     In the late 80s management attempted to adapt the original UK product to the US SME sector. This strategy failed and was abandoned in 1990. Management then started a strategy of growth by acquisition recognizing that accounting packages needed to reflect the unique characteristics of the accounting and tax regulations in each target geography. The first acquisition was made in France in 1991. They moved in to Germany in 1997 and finally moved back in to USA with a number of acquisitions starting in 1998.

     In 2001 management decided to expand their product range by offering a CRM software package for SMEs. (Customer relationship management). This was achieved through the acquisition of a company called Interact. This was seen as a logical expansion as CRM uses a lot of the information that accounting packages create. For example a sales manager might find it useful to know whether a customer regularly pays on time.

    One of the features that Sage believes makes them unique is their after sales support service. They offer all purchasers of their software a period of free call centre based support and then when the customer sees the benefit of this support they offer them a contract. This support is not just about the technicalities of the software because Sage also provide advice on accounting issues. This is particularly attractive to SMEs because they generally do not have IT or accounting specialists. This strategy has not been adopted by Sagefs competitors who have attempted to provide software based support. (click on gHelph). Accountancy firms certainly do not want to have to provide this type of ad hoc support and therefore accountants have tended to recommend the Sage product.

OVERVIEW

Breakdown of Sales:

        Division

         $m

       %

             Product

        265

       47

             Support

        299

       53

        Total

        564

     100

Sage do not give a breakdown of profit by division because they claim that they need to keep it secret for competition reasons. Deutsche Bank have made the following estimates of how profits have progressed over time by division.

If these Deutsche Bank estimates are correct it makes sense for Sage to sell the software cheap and lock in the customer to a high margin support contract.

Sales and Profits by Geography:

                                      AREA

                       Sales

                  EBITDA

       $m (02e)

         %

    $m (02e)

        %

     UK

      158

         28

       59

        40

Europe

      120

         21

       32

        22

     USA

      230

         41

       50

        34

Interact CRM

        55

         10

         5

          4

  Total

      563

       100

      146

       100

  Sage is most profitable in the UK where it is most entrenched. The USA is currently less profitable. This is due to the fact that fewer customers take up the support contract. Sage argue that this will change over time. They have only owned their US operations since the late 90s so it is still very early to tell whether they will be successful. So far there is evidence of increased support contract sales but not to the extent that one could believe it will get to the level of penetration seen in the UK.

18% of US customers take support contracts which is a long way behind the 70% figure for the UK.

France is in between both of these supporting the idea that it is just a matter of time before US customers see the benefit of support.

Sage in total now has 2.9m customers and in addition to selling them support contracts they also hope to increasingly provide accounting software tailored to the needs of specialist industries. For example 10% of customers are small accountancy practices. Sage have software particularly designed to suit the accounting needs of accountants. They also believe that this results in accountants recommending Sage to their clients.

I have attached in Appendix 1 some statistics from Intuit showing the size and growth potential of the small business market in the US.

COMPETITIVE POSITION

   Appendix 2 represents the competitive landscape. At first sight names like Microsoft, Oracle, SAP and Intuit scare me to death. My initial reaction was to believe that Sage will be eaten alive by these gorillas. Sage made a reasonable case as to why it will be difficult to penetrate their customer base and why they will be in a position to grow further. Sage make the following points about their existing 2.9m customers:

-             95% of customers employ less than 100 people

-                          95% of customers have turnover of less than $10m

-                          97% of customers have less than 20 PCs in their company

-                          Less than 1% of customers are multinationals.

-                          Average license price <$1000.

As far as I can ascertain Microsoft, Oracle and SAP do not really service this very small customer market and they certainly do not provide the same type of support.

Sage themselves admit that this makes Intuit their biggest competitor but so far Intuit have not attempted to become a serious player in Europe. This makes the US the main battleground. So far it appears that there is room for 2 players generating decent returns. Support is the way that Sage is trying to stand out relative to Intuit. As stated in the overview section the evidence is not there yet to state categorically that this is working.

Sage also point out that their route to market is different to most of their competitors. They use VARS (Value added resellers) who are more likely to be used by SMEs. These VARS tend to be local PC and technology shops.

COST STRUCTURE

     Sage is similar to most software companies in the way they have a tiny cost of goods sold giving them 90% gross margins. Their biggest single costs are labour costs that are split between R&D and SGA. In the case of Sage a major part of this is the cost of support staff in the call centers. Sage spend 10% of revenue on R&D which is at the lower end of software companies. (Maybe software engineers are cheap in Gateshead?)

Staff costs are 39% of revenue and the company claim that a substantial proportion of these staff have 3rd level qualifications. This suggests that there will be constant upward pressure on costs.

     As in all software companies I believe that this is not the most important issue. The key question is the quality of the software and the strategy adopted by management.

PROFITABILITY AND RETURNS

Sep. year end.

 

            00

           01

            02e

Operating Margin (%)

            27

           27

            26

ROE (%)

            28

           17

            16

CFROI

            35

           40

            34

Transaction CFROI

            12

           12

            10

On the face of it Sage is very profitable and has generated great returns. The more important question is whether the acquisitions that they have made will be able to generate similar levels of profits and returns. This is why I have included a figure for transaction CFROI.

Peer group comparison

(02 estimates)

COMPANY OP. MARGIN %

         ROE

     CFROI

Intuit

            22

           10

           8

Microsoft

            42

           16

          17

Oracle

            37

           36

          12

SAP

            20

           19

          14

Exact

            20

           21

          21

The two pure competitors for Sage are Intuit and Exact. Exact has a market capitalization of Eu300m so is too small for us. Intuit is a good company but is currently not as profitable as Sage.

VALUATION

COMPANY

      P/E   (IBES CONSENSUS)

MARKET IMPLIED CFROI (t+5) HOLT PRICE TO BEST %

           02e

       03e

Sage

           20

        17

            15

          67

Intuit

           42

        34

            13

        -39 

Microsoft

           28

        27

            11

           2

Oracle

           27

        26

            12

         30

SAP

           46

        45

            11

           8  

Exact

           10

        10

            12

         30

       EV/ Revenue = 3.4x                           Dividend Yield = 0.3%

Sage looks good value relative to its peer group on a P/E basis (apart from Exact which is too small). Holt believes that Sage is the best value in the group but there may be questions over the assumptions that they use. I have attached the Holt model in Appendix 3.

BALANCE SHEET

   Net Debt/ Equity = 35%.      Total borrowings = 228m.    Bank debt =198m            Senior notes= 30m.  Bank debt facility in place to 2006. Senior notes payable in equal installments from 2001 to 2005. Coupon on notes=6.77%.

Interest cover = 16x.    

Free cash flow for 02 (assuming no more acquisitions) should be at least 50m.

As long as Sage do not borrow to make a big acquisition I think their balance sheet is fine.

MANAGEMENT

    As I mentioned in the introduction the original founder is still head of Sage UK. I get the impression that he prefers the role of techie rather than head of the overall company.

CEO of the group is Paul Walker who joined in 1984 as company accountant .

The CFO presented in Dublin a couple of weeks ago. He has been with Sage since 1997.

Overall it appears like a reasonably stable team.

There may be a small issue over management funding gpeth projects because the company has just announced a $10m sponsorship of a new centre for music based in Gateshead. Management claim this is an investment in the brand !!

 LIQUIDITY/ MOMENTUM / SENTIMENT

Market Cap.                            $2.5bn

Average daily volume             8.1m  shares (value $15m)

FTSE 100 weight                     0.17%

Beta v FTSE                            1.6

HVT                                         62

Not the biggest company in our universe but I believe that it is liquid enough for our requirements.

There is a small possibility that it could fall out of the FTSE100. A couple of weeks ago at the low of the share price it fell to 97th. This would obviously hurt the share price. The review date is Sep. 11th so we should be careful if markets and technology stocks are weak around that date.

CONCLUSION

     I would like to add Sage to the portfolio with a target price of 212p which is taken directly from Holt.

SAGE      (K. Power 22/8/02)

SUMMARY

  Sage is the biggest supplier of accounting software packages to small enterprises in the UK and is second biggest in the US. It also has operations in France and Germany. It has recently expanded its product range beyond the original accounting packages.

The Deutsche Bank analyst, Kevin Ashton does a good job of describing what makes Sage special :

I believe that because most small companies cannot afford to hire their own accountants and technology specialists, they really need the Sage support service. This model of telephone support is Sagefs key strength.

Here are the key numbers:

I think the investment case for Sage is strong because :

-                          It is a market leader

-                          It has created a barrier to entry through its support service

-                          It is not capital intensive

-                          It generates good cash flow

-                          Growth prospects look reasonable

-                          It is on a reasonable valuation both absolute and relative.

I therefore recommend that we buy with a target price of 212p. (Current price 141p)

GRAPH 1      SAGE 1 YEAR RELATIVE   ( V FTSE & Nasdaq)

GRAPH 2      SAGE 3 YEAR RELATIVE   ( V FTSE & Nasdaq)

GRAPH 3      SAGE EARNINGS ESTIMATES

GRAPH 4      SAGE MAJOR HOLDERS

Killeevan Investment Consultants Ltd, trading as KIC, is regulated by the Central Bank as an Investment Intermediary.
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Directors: Kenneth Power (Managing) B.Comm, MBS, ASIP, Regular Member of the CFA Institute.
Siobhan Power