Why this tech stock is still profitable despite falls across the sector
In the past few months the technology sector has lost its allure and share prices of most technology stocks have declined. But technology stocks are not all created equal and so shouldn't all be lumped in the same basket.
The stocks most at risk in the current environment are those that do not earn a profit. Its valuations are based on the promise of future profits, and in an environment where inflation and interest rates are likely to increase, those future profits decline in value.
But there is another category of technology stocks that are already profitable, sometimes very, that generate strong cash flows, and have a mature customer base. Hansen Technologies (ASX:HSN) is one of these.
Hansen was founded 50 years ago. It designs and provides customer information and data management software systems for the utilities, energy and communications sectors. It has a well-established customer base, with its leading customers averaging over 10 years with the firm. Churn rates are very low at less than 2%, with 95% of its revenue derived from its own intellectual property.
It is also a global business with its revenue well-diversified throughout the world. Over half its revenue is sourced from the EMEA, followed by the Americas and then Asia Pacific. Revenue is split evenly between utilities (gas, electricity, water) and communications.
The business demonstrates steady, albeit not spectacular organic growth. Revenue grew 5% in the most recent half-year and profits 7%. Currently its revenue is about $300 million but it has a medium term target to achieve $500 million by 2025.
This will not be achieved via organic growth alone, so it also has a large focus on growth through acquisition, looking for opportunities to build scale. They have established a team focused on M&A to search and screen for value-accretive acquisition growth. It has had a long history of acquisitions, including purchasing Canadian software business Sigma for $166 million in 2019.
The business is highly profitable. It aims to generate sustainable earnings before interest, tax, depreciation and amortisation (EBITDA) margins of over 30%, and in the most recent half year achieved 36%. Its return on equity is a very healthy 21%. These earnings translate into very strong cash flow generation.
The balance sheet is very solid. The excess cash flow has been used to pay down debt, as well as paying dividends. Its net debt to equity ratio is only 18% which leaves them in a strong position to be able to absorb future acquisitions.
The three market analysts that cover the stock are forecasting revenue and earnings to be fairly flat for the next few years. That is not necessarily a problem given the stability of earnings, provided any investment in the stock is made at a reasonable price. There is also the opportunity for this to be exceeded if a good acquisition opportunity is captured. The analyst forecasts assume the status quo is maintained.
For the past five years, the shares have traded on an average forward PE ratio of 19. Prior to the pandemic it was trading around $3.50 to $4.00. It dropped to $2.70 in the early days of the pandemic, before rallying to $6.50 in November 2021. There was also a takeover offer from private equity group BGH Capital for $6.50, but that collapsed in September last year.
Since the November highs, the share price has retracted 25% to $4.85 in line with the general slump in sentiment for the tech sector. That means it is now trading on a forward PE ratio of 16.5, well below its average.
But unlike many technology businesses, Hansen is relatively low risk. The revenue base is stable and consistent, so risks to revenue are relatively low. EBITDA and operating margins are high, so earnings risk is low. Debt levels are low and cash flow is strong, so balance sheet risks are also low.
Following the recent retraction in the share price, the valuation risk is relatively low and given the overall risk profile and potential for blue sky from acquisition, the risk-reward equation is starting to look quite favourable. In a market filled with a high degree of uncertainty, Hansen is a solid business with a strong track record.
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