Recent industry analysis indicates that government entities are likely to continue to spend on IT software. With TNE having a clear competitive offering in the space, we see the company as ripe to continue to gain market share. We investigate TNE’s key target client groups (local councils and universities) which are showing positive trends and also forecast to show continued growth in spending.
Government software spending is forecast to rise ~13.5% in 2023 based on a recent industry report by Gartner. This is on top of a 10% increase in spending in 2022. TNE’s ‘power of one’ solution (a single integrated offering) continues to be a strong competitive advantage for the business and is likely to lead to taking a large portion of the market share.
Long-term margins could be higher with the majority of TNE’s expenses being on R&D (~25% of revenue), which can be pared back as revenue increases. TNE has stated it expects to reach ~35% profit before tax margin in ‘the next few years’. Given margins of ~32% in FY22 (ex-acquisition costs), we believe this target is more than achievable and may be reached earlier than expected, driven by significant economies of scale and operating leverage.
Valuation looks appealing on a growth-adjusted basis, despite near-term multiples looking above history. We believe that with the transition to the recurring revenue SaaS model, TNE can grow earnings at a faster rate than it has previously. With the migration of legacy customers essentially complete and a few years of transition teething behind it, TNE is free to start posting stronger growth metrics.
Investment View
TNE is in a strong position to comfortably deliver 15%+ EPS growth over the next 3-5 years. Whilst the near-term multiple seems elevated, when looking at the earnings stability and adjusting for growth and a net cash balance sheet, TNE’s share price should follow its EPS growth trajectory. With the recent share price weakness, we take the opportunity to upgrade our rating from Hold to Buy.
Industry Growth
A recent industry report from Gartner on global government spending forecasts overall IT spending to increase by ~8%, and specifically software spending to grow by ~13.5%. This is on top of a 10% software spending in 2022. TNE has 6 key target vertical markets, being Local Government (councils), Education, Federal Government, Health and Community Services, Asset and Project Intensive and Corporates and Financial Services. Of these 6, the two key and largest are Local Government and Education, contributing ~61% of 1H23 Annual Recurring Revenues (ARR). These are also high-growth segments, growing 23% and 20% respectively on the 1H22 period. The below charts show the contributions to TNE’s ARR.
Figure 1: Local Gov and Education largest contributor
Figure 2: Most verticals grew ~20%+ in 1H23
University spending on IT as a % of revenue continues to grow. Looking at some of the top universities in Australia, we can see the median spending has increased on 2021, from 2.1% of revenue to 2.8% of revenue in 2022. We expect this trend to continue given the significant efficiencies that software can achieve for universities. We also note 2022 university revenues were impacted by limited student migration activity, and we expect this to rebound significantly in 2023. TNE’s timetabling software acquisition, Scientia, is a market-leading product, and TNE has been able to roll this out as an additional module to existing customers. Scientia is currently a lower margin product (~8.3% PBT in 1H23) however we expect that as TNE continues to scale its offering, margins should improve towards TNE’s group target.
Local council spending on IT has also increased, from 1.2% of revenue in 2021 to 1.3% in 2022. Median council revenues grew ~5.7% in 2022, and we expect council revenues to grow in line with inflation and GDP measures. We note that the sample size for both universities and local councils is relatively small, however, we believe them to be broadly representative of the larger group.
Figure 3: Median IT spending as a % of revenue grew from 2021 to 2022
Figure 4: Median IT spending in 2022 grew above revenue growth
Where do Margins End Up?
Profit before tax (PBT) margins have been rising over the last decade as the company continues to scale and drive operating leverage benefits. At the 1H23 result, TNE reiterated its target to reach ~35% “in the next few years”. We believe that there is considerable upside risk to this being achieved earlier than the market is forecasting (FY26e). This is driven by continued operating leverage with scale delivering benefits, and a potential for R&D expenditure to flatten out.
Figure 5: TNE margins have been steadily increasing driven by operating leverage
We look at R&D spending in particular as a key component to drive down costs. Total R&D spending including capitalised costs have slowly been trending higher as TNE reinvests in itself, to create the best product offering. Recently spending has reached ~25% of revenue. We expect this level to remain relatively constant when we compare to peer spending levels. Other areas of savings come from operating leverage, with employee costs falling from ~36% of revenue in 2021 to ~34% in 2022. Marketing expenses will also likely fall as a % of revenue given scale and network advantages, where it has already fallen from ~2.5% of revenue in 2021 to ~2.4% in 2022 and we expect this to trend marginally lower as the revenue line expands. We note that for peers such as XRO and WTC, there were significant R&D programs in the most recent results leading to higher than usual spending. This also includes capitalised costs for fair comparison. As companies mature (like Oracle, Microsoft and SAP) we can see the R&D spend as a % of revenue fall lower, given a much higher revenue base as well as more of a transition into a harvest style strategy. We also see a relative corresponding level of % revenue R&D spend and the 3 year forward EPS CAGR. We therefore expect TNE’s growth rate to trend higher towards ~25% as R&D benefits become realised.
Figure 6: Spending likely to remain at ~25%, driving future product growth
Figure 7: Key peer R&D spend as a % of revenue and corresponding forward EPS growth rates
Valuation Considerations
Whilst on face value, TNE might look expensive, we believe that there is 1) upside risk to earnings and margins at the next result and 2) on a growth adjusted basis, TNE looks closer to a fair valuation. 12m forward EBITDA growth is expected to be ~16%, with TNE guiding to PBT growth of 10-15%. On the 1H23 conference call, TNE noted that this guidance was ‘conservative’. With there likely being upside risk to margins, we believe earnings growth may be understated. Looking back at TNE’s history, we can see that there is a strong correlation between the EV/EBITDA ratio and the 12m forward EBITDA growth rate. As we expect growth to continue or even lift higher, we therefore see the current multiple as fair value.
This is further evidenced by the growth adjusted multiple, where on a 10 year average, TNE trades at ~1.3x the EBITDA growth rate, although on a 3 year basis, TNE historically trades at ~1.5x. We believe the current 1.5x is more reflective of a better business model, with the transition to recurring revenues largely complete, allowing higher earnings visibility, and therefore a higher multiple.
Figure 8: EV/EBITDA multiple tracks EBITDA growth %
Figure 9: Growth adjusted multiple in line with 3yr avg
Another metric we look at to value growth related stocks is the correlation between the share price and the 12m forward EPS. If we assume that the earnings multiple stays the same, we therefore expect the share price to directly reflect the EPS growth rate. As we are conservatively expecting a 3 year CAGR EPS growth rate of ~15%+, we therefore expect the shares to deliver a similar return. This is on top of a ~1-2% dividend yield. The below chart is a large portion of our thesis to upgrade TNE to buy as we expect it to continue delivering EPS growth driven by an increasing adoption of its software modules and improving operating leverage.
Figure 10: TNE’s share price has historically tracked 12m forward EPS growth
Investment View
TNE is a high-quality business with recurring revenue and sticky customers. The migration of existing customers to the SaaS platform is largely complete, with revenue streams becoming more predictable. The customer churn rate has largely been below <1% over the last decade, indicating strong customer retention and deep relationships, especially in the government and education sectors. This is also evidenced through Net Revenue Retention consistently exceeding 100%, and through TNE driving average products per customer up from 4.9 in FY12 to 6.2 in FY22. TNE expect this to increase to 8.9 by 2031.
We believe TNE should be a company on everyone’s investment radar given its strong fundamentals and historic earnings growth, however the main investor concern is on the right multiple to pay for the business. Looking at an adjusted EV/EBITDA ratio, TNE trades in-line with its 3-year historic multiple of ~1.5x (EV/EBITDA of 24x divided by the 12m forward growth rate of 16%). We also believe there to be upside risk to earnings multiples, driven by increasing operating leverage and improving margins beyond what the company is targeting and what the market is forecasting.
If we assume that the multiple remains the same at fair value, we therefore expect TNE to deliver total shareholder returns in line with its forward EPS growth and dividend yield. We can comfortably expect TNE to growth its EPS by 10-15% for the foreseeable future, driven by demand for its products and continued operating leverage. Over the next 3 years, we expect EPS to grow 16-17%pa, and have a dividend yield of 1-2%. We therefore upgrade our recommendation from Hold to Buy.
Risks to Investment View
Slower than expected revenue growth either through lower organic sales or higher churn rates would pose a risk to TNE’s valuation. Increased competition would likely see TNE need to spend more on capex to continue taking market share. Acquisition and integration costs may not deliver synergies that the company expects, including growing into the UK market, where lower than expected returns would impact valuation. Cybersecurity remains a key risk for software related entities and its customers.
Recommendation
We have upgraded our recommendation from Hold to Buy.
