Accounting software firm Sage has generated dividend growth of more than 8% per year over the last decade. That’s impressive, but is it enough to justify the company’s measly 2.4% dividend yield?
At first glance I’d say yes. After all, a 2.4% income growing at 8% per year will give you a total annual return of 10.4% if the share price grows in line with the dividend.
But investing is not quite that simple, so we’ll need to look at Sage and its financial results in a little more detail.
A world-leader in accounting and payroll-related software
Sage Group started as a three-man operation in the early 1980s after Graham Wylie developed what became Sage’s core accounting software while still a student.
The company was almost immediately successful and by the end of the 1980s it was listed on the London Stock Exchange. In 1999 it joined the FTSE 100 and it’s been there ever since.
As you might expect, this FTSE 100 company it is no longer a three-man operation. It now has 13,000 employees, over three million customers in 23 countries and, according to its website, is:
“the global market leader for technology that helps businesses of all sizes manage everything from money to people”
Moving from lumpy revenue to smooth recurring revenue
Way back in Ye Olden Days, software vendors used to sell software applications to customers, typically on some sort of disk (floppy or otherwise).
The customer would pay for the software, receive a disk in the post, install it and use it for all eternity without ever having to pay another penny.
The software vendor would bring out a new version of the software and then hope that its previous customers would buy the new version in order to use the new version’s awesome new features.
But many existing customers wouldn’t upgrade because the old version which they’d already paid for was perfectly adequate.
Clearly this was not advantageous to the software vendor. Fortunately for them, Web 2.0 technologies appeared in the early 2000s, bringing far more interactivity to previously static websites. On the back of those technologies, Software as a service (SaaS) was born (or more accurately, went mainstream).
SaaS allows users to access software applications through a web browser in a way that feels pretty much like an installed application rather than the old Web 1.0 static webpage.
Users like this because:
- They can access the same app (as software applications are now known) through their PC, Mac, mobile device or pretty much anything else that can run a modern web browser.
- Their data is probably safer because it should be stored in professionally managed servers rather than on their laptop (so if the user’s laptop is run over by a bus they won’t lose all their data).
- The software is automatically updated, so they always have the latest version and don’t have to fuss around installing new software.
As for the software vendor, they get to charge customers on a recurring basis for access to those software services.
Because of these advantages, the old model of customers paying a single lump sum up front is being rapidly replaced with a model where they pay less up front but more on an ongoing basis.
For companies like Sage this is excellent news because it makes their revenue streams incredibly reliable and robust and increases the lifetime value of each customer.
It also makes it easier for companies like Sage to up-sell and cross-sell customers onto more expensive versions or additional subscription software, because once the user is logged in the company can dazzle them whatever messages (adverts) it likes.
Customers for life (whether they like it or not)
One last thing I want to mention before moving onto some number crunching is the barriers to exit that Sage’s customers face.
Barriers to exit, otherwise known as switching costs, are a form of competitive advantage where it becomes hard for a customer to switch to a different supplier.
For example, the switching costs for Coca Cola are virtually zero because I can buy the much cheaper Tesco Cola for no extra effort (yes they’re different products, but to my taste buds they’re close enough to be substitutes).
But this isn’t true for Sage’s customers.
It wouldn’t be impossible, but I would have to fiddle around backing up financial data to spreadsheets, setting up my company on the new software and then becoming familiar with how the new software works.
So even if Xero was better than the Sage equivalent (I don’t use either so I have no idea) I would balk at the idea of switching, just because of the time and effort needed to do it.
A good company, but is it worth its current price?
In summary then, I like Sage. It’s a FTSE 100 company moving full speed into the world of SaaS and cloud computing and that’s probably a good thing.
It’s a market leader, it has lots of recurring revenue coming in from all over the world, and businesses need accounting and payroll software regardless of whether there’s a recession.
So it’s a defensive company and a steady growth company, but that low dividend yield still bothers me.
I think it’s time to do a bit of number crunching to see if an investment in Sage has any reasonable chance of producing the 10%+ annual returns I’m aiming for over the next five years or more.
Steady above average growth of revenues, earnings and dividends
The chart below shows Sage’s growth over the last few years:
Sage’s results aren’t perfect, but they are definitely above average:
- 10-Year revenue per share growth rate = 4.7%
- 10-Year earnings per share growth rate = 4.5%
- 10-Year dividend per share growth rate = 8.4%
- 10-Year “overall” per share growth rate = 5.8%
An average growth rate of 5.8% is pretty good and slightly above the 4% or so you might reasonably expect from an index tracker.
However, that figure is skewed upwards slightly by the fact that dividends per share have been growing faster than either revenues or earnings per share.
As attractive as that 8.4% dividend growth rate is, it won’t be sustainable unless revenues and earnings growth catches up.
If Sages revenue and earnings growth don’t speed up then at some point its dividend will exceed its earnings, and that situation rarely ends well.
I think a more prudent estimate of Sage’s sustainable growth rate would be around 5%, which isn’t bad, but it isn’t going to set the world on fire.
In other words, with a 2.4% dividend yield, a 5% growth rate gives a yield-plus-growth total annual return figure of just 7.4%, which is about what you might expect to get from a FTSE All-Share index tracker.
Of course, management are more optimistic and the company’s Investor Factsheet (pdf) cites a long-term revenue growth target of at least 10% per year.
But is a 10% growth target optimistic, or over-optimistic?
It’s hard to say for sure, but it certainly won’t be easy otherwise the company would already be doing it. Others analysts are far more negative than I am.
A strong balance sheet producing attractive returns
On a more positive note, Sage’s £1bn borrowings are not excessive for a company of its size, although they’re not exactly insignificant either.
£1bn of debt gives the company a Debt to Profit Ratio of 3.6, which is comfortably below my preferred maximum of 5.0 for relatively defensive companies like Sage.
The balance sheet is also producing good returns with an average 10-year return on capital employed of 14.2%, which is well-above the 10% average for stocks on my stock screen.
This supports the idea that Sage has some competitive advantages, which I think are primarily its brand name, its economies of scale and those customer switching costs.
I would definitely invest in Sage at the right price
Sage’s long track record of relatively steady above average growth, combined with its low-ish debts and good profitability, are exactly what I look for in an investment.
However, today’s share price of 660p is just too high for me.
With a 10-year average growth rate of 5% (an average which, for the record, has declined from 10% a few years ago and 20% a few years before that) and a dividend yield of 2.4%, I find it hard to see how an investment in Sage will produce the 10%+ annual returns that I’d like to see over the next five or ten years.
I’m not saying it can’t, but to produce 10%+ returns Sage would need to either:
- Start growing faster than it has done for many years, or
- Keep increasing the dividend faster than earnings, which is unsustainable, or
- Have its share price go up faster than the dividend, which is also unsustainable.
So if I wouldn’t invest at 660p, what price would I pay?
For a start, Sage’s yield would have to be closer to 4% at the very least.
That might seem unlikely, but Sage’s yield was around 4% in mid-2012.
Back then its share price was 270p, less than half its current value.
That’s because in 2012, investors had yet to fall in love with defensive dividend stocks. You could pick up solid performers like Sage and still get a decent yield.
And although investors love defensive dividend stocks today, that won’t always be the case.
At some point they’ll chase after a shiny new thing and dividends will be for old, boring investors like me, who simply want:
- a decent dividend yield
- some solid growth and
- not too much risk.
To reach my preferred 4% dividend yield, Sage’s share price would have to fall to less than 400p.
At that price it would be a top 20 stock on my stock screen, ideally placed for entry into my portfolio.
Okay, so Sage’s share price would have to fall by about 40% to get to 400p and obviously that isn’t going to happen overnight.
But the stock market is full of surprises and if Sage does go below 400p (or something close to it), I would gladly invest some hard earned cash into it.