Sage Has Reached the Inflection Point in Its Cloud Transformation

We are initiating coverage on the Sage Group SGE with a narrow moat rating and GBX 810 fair value estimate. Our fair value estimate is equivalent to a P/E ratio of 29 times, based on fiscal 2023 estimates, which is moderately above its historical average of around 25 times. We think the implied optimism is warranted given we expect profit growth to accelerate going forward now that Sage has reached the inflection point in its transition to the cloud. Our estimates are broadly in line with consensus. Consequently, we see the stock as fairly valued at current levels.

Sage’s narrow moat is based on switching costs. Sage primarily develops accounting software for small- and midsized businesses but has expanded its offering to other back office functions such as payroll and human resources. Back office functions such as accounting are mission critical for businesses. Once a software provider has been chosen, companies typically begin building workflows around the software. As workflows proliferate and become increasingly complex, switching software providers becomes increasingly difficult. These software products are not a large expense for a company, and hence, this dampens the motivation to switch as long as performance of the incumbent software is adequate.

We think Sage can deliver around 10% underlying revenue growth for the next few years as remaining customers with perpetual licenses transition to higher priced subscription contracts. Furthermore, we expect Sage Intacct, the company’s flagship product for midsized businesses, to continue on its high growth trajectory as it expands geographically, captures new verticals, and succeeds with upselling current clients to higher value add-on modules, such as planning and budgeting. We think margins have reached trough levels with the majority of the cloud transition now complete. We expect operating margins to rise slowly to around the mid-20s as the company starts to benefit from its high operating leverage.