A CEO had a great comment about COVID-19. When asked how the pandemic was affecting his business, he told me: “In this market, companies are either very busy or very quiet.”
Black-and-white generalisations are, of course, dangerous. The late, great Hans Rosling, author of one of my favourite books, Factfulness, calls this the “gap instinct”. People simplistically divide data into two groups. For example, “rich and poor”, “developed and emerging markets”.
In doing so, they overlook the majority. Most people are not rich or poor. They are somewhere in the middle. Just as most companies are neither super busy nor super quiet during COVID-19. They are limping along in the middle, hoping business will pick up.
Caveats aside, it is clear that COVID-19 has been a boon for some companies. Think Netflix and the millions of extra subscribers it gained during the pandemic. Or fast-food companies that benefited as people sought cheap meals. Or JB Hi-Fi as people bought home-office equipment.
I suspect some Information Technology (IT) service companies are also run off their feet as government, corporate and not-for-profit clients are forced to change IT systems during COVID-19. No doubt there is plenty of frantic IT work underway and more contracts being awarded to IT service providers.
A friend who works for a large privately–owned IT service partnership has barely had a day off since the pandemic began. She told me the business had consecutive record months thanks to corporate clients and governments requiring urgent changes to their IT systems.
My gymnasium is an example. It has a swanky new booking platform that shows times, classes and sections of the gym available. You register, go to the site, choose your exercise and receive a confirmation email. It looks like costly IT work has gone into the site due to COVID-19.
Yes, investing on the basis of a few anecdotes is risky. More telling has been recent news reports attacking State Governments (that’s you, Victoria) for dishing out dozens of contracts to consultants during COVID-19. My bet is a lot of them are for new IT projects.
The market has picked up on the IT service trend. Technology One (TNE) has rallied from $6.70 in late March to almost $9. Data#3 (DTL) is up from $2.64 in March to $5.14. Integrated Research (IRI) has leapt from a low of $2.19 to $3.95. DWS is up from 55 cents to almost $1.
However, after soaring since March, some of these stocks have retreated in the past month, having run too far, too fast. Technology One, for example, is down from a 52-week high of $10.26. That is an opportunity for portfolio investors with at least a three-year horizon.
Make no mistake: COVID-19 will create years of work for IT service companies. Consider how much IT work will be needed to reschedule transport system for a post-pandemic world. Or to help companies sell more goods online or set people up for home-based work.
Clearly, COVID-19 is speeding up trends well-established before the pandemic: e-commerce, online banking, content streaming, e-learning, remote working and so on. Faster-than-expected digitisation of business has to be a multi-year tailwind for quality IT service companies.
My sense is to wait until the next market pullback, which might be starting as the market digests the bad economic news from Victoria’s latest lockdown and buy Technology One and Data3 at lower prices during a sell-off.
Technology One (TNE)
The Queensland company is the pick of the IT service providers for four reasons.
First, Technology One (TNE) has been a high-quality company for a long time. I met its management in the ‘90s (when I edited the old Shares magazine) and have liked the company ever since. Technology One’s Return on Equity (ROE) has averaged around 30% for a decade and was 54% in FY19, Morningstar data shows. Delivering high, rising ROE over a long period is the trait of exceptional companies. Technology One’s client-retention rates suggest service excellence.
Second, Technology One is less cyclical than most IT service providers. Many customers are in defensive sectors: local government, tertiary education, utilities, charities and healthcare. The company’s results show it can grow in good and bad economic cycles.
Third, Technology One is well positioned to pick up new contracts during COVID-19. Councils, universities, hospitals and big charities will need plenty of IT work to respond to the new normal during and after COVID-19. Imagine the IT work ahead for universities as more courses are delivered online and “virtual campuses” are developed.
Fourth, Technology One’s valuation looks more appealing after the recent pullback. Still, at $8.99, it is on a forecast FY20 Price Earnings (PE) ratio of 39 times on Morningstar numbers. The company, deserving of a valuation premium, has no room for error.
The first-half result, delivered in May, was a touch below some broker expectations. A big second half will be needed to meet guidance but TNE can get there if talks about growth in IT work during COVID-19 turn into more contracts and early revenue.
Longer term, TNE has good growth prospects through acquisitions and if it can expand faster in the UK (not easy due to the power of incumbent IT firms there).
Macquarie Wealth Management has a 12-month price target of $9.50 for Technology One. Morningstar values it at $8.50. Depending on which broker firm you follow, Technology One looks like it is trading just above or below fair value.
In a market rife with overvalued tech companies – many of which are nowhere near the quality of Technology One – trading near fair value is relatively attractive in this sector. Particularly if you believe, like me, that there has been a lot more IT work in the past few months – and will be in the next 12-18 months – as corporates, governments and NFPs adapt to COVID-19.
Chart One: Technology One (TNE)
Data#3 stands out among smaller IT service stocks. Like Technology One, Data#3 has come off in the last few weeks after soaring in the second quarter. It is down from a $6.07 high.
Also headquartered in Queensland, Data#3 provides a range of IT products and services. Like Technology One, Data#3 has had a high ROE (above 30%) for a decade. Excellent cash flow, no debt and a consistent record of rising dividends are other attractions.
Data#3 had a cracking half-year FY20 result in February. Revenue rose almost 12% to $719 million and earnings-per-share (EPS) and the dividend-per-share (DPS) leapt 41%. Digital transformation and cloud-based IT projects fuelled the growth.
If Data#3 was benefiting from digital-transformation work before COVID-19 (large companies prioritising digitisation in their strategy), it should do even better after the pandemic. More business than ever will be done online, requiring investment in digital-transformation projects.
Then there is the convergence of IT and operational technology, cybersecurity, artificial intelligence and robotics, big data and online customer experience – long-term tailwinds that Data3 noted in its interim result.
Like Technology One, Data#3 ran too far, too fast in the second-quarter rally and needed a pullback. Data#3’s valuation, too, is challenging. At $5.14, it is on a trailing PE of about 43 times on Morningstar numbers, although that should fall given expected EPS growth this year.
Data#3 has been a good company for a long time. It is not widely covered by brokers and does not have the market profile of Technology One. But it offers better quality – thanks to an excellent customer base and high proportion of long-term, contracted work – than many small-cap tech stocks.
Chart 2: Data#3 (DTL)
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 8 July 2020.