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Start me up: where next for IT stocks

This article appeared in the February 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Convergence and the cloud dominates, plus five tech stocks to follow.

Photo of Richard Hemming By Richard Hemming, Under the Radar Report

One of the big reasons information technology works is that outsourcing in business is thriving because it allows companies simultaneously to cut costs and increase sales. It represents nirvana for their owners - except perhaps those who own print media and department stores.

Below is a brief summary of the IT sector which Under the Rader Report has produced with the help of Nick Harris, who is the technology analyst at stockbroker Morgans. (ASX Investor Update readers can access a free 30-day trial of Under the Radar Report.)

Harris makes the important point that although we can categorise IT, the overall theme is one of convergence. Information technology is getting increasingly complicated and the lines are blurring between the different types of companies.

The cloud

The convergence of software and hardware is very much evident in the internet cloud. Until recently you bought software and downloaded it onto a computer. After five years you would have to replace it. In economic terms, software was capital expenditure rather than operating expenditure for business.

Now you can buy the software from someone else, the cloud provider, who does all the work for you. Instead of getting a guy to set it up, you set it up over the internet.

Harris says IT is analogous to electricity, when many years ago people had a generator in their back yard, which they needed to fuel with petrol. Then the city built a grid and you just flicked a switch and now electricity users simply pay for what they need. It becomes an operating expense.

Listed businesses are based on the fast growth of cloud-based technology. These include Next DC (NXT) and Macquarie Telecom (MAQ), which have set up data centres containing servers. These companies can achieve economies of scale and redundancy options (which means an IT backup).

(Editor's note: Do not read the following commentary as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).

Harris likes Next DC because of its first-mover advantage as the only national provider, while Under the Radar Report prefers Macquarie Telecom because it provides data centres for clients and also hosting services to big government agencies and corporates. We also like Melbourne IT (MLB), which provides hosting for predominantly domestic businesses.

The downside to the cloud is that the software it provides to customers is not customised. Another point often overlooked is that despite its growth, it only represents 1 per cent of Australia's information communications and technology expenditure.

IT services

Outside telecommunications, IT services are the biggest contributor to the ASX IT sector by market capitalisation and involve traditional consulting along the lines you would see in engineering. These companies have contractors who charge hourly rates and do project-related work.

After fast growth in the late 1990s and early 2000s, the sector has stuttered in the past few years as companies reduce their spending on IT.

Traditionally spending on IT increased at about 5 per cent a year, but in the past five years, in the wake of the GFC, this has fallen to 2 per cent, as companies and government departments cut costs.

IT services include implementation of software, but not the selling of the software itself. Rather, these companies make platforms such as Microsoft and Salesforce talk to each other.

The vast bulk of spending in IT is consultant related, however. Nick Harris believes that spending on the sector will increase from its historic lows and consequently advocates buying the leading lights among Australia's IT consultants: SMS Technology (SMX), UXC (UXC), Oakton (OKN) and Data3 (DTL).

Data3 is also an example of the hybrid nature of IT companies. It licenses software, sells hardware and also sells its services (software as a service - SAAS).

We would also include ASG (ASZ) in this sector. It has been a disappointment although its shares have shown signs of life, bouncing about 30 per cent in the past two months.

ASG has a good strategy, and provides its services online via the internet cloud. ASG has first-mover advantage in this department although has not capitalised on it thus far.

Software and hardware

High-profile software companies such as Technology One (TNE) and Xero (XRO) have their own proprietary software, which they license out and people pay for the right to use it. They also charge an implementation fee in some cases. For example, Technology One does, but Xero does not because it is focused on selling to the retail market.

Software is attractive from an investment perspective because for very little cost you can get access to a large global market. There is also a great deal of risk. There are many small listed software companies, but the reality is that many will fail.

Harris says: "The issue for investors to be aware of is capital requirements. The smaller ones not generating profits can spend a lot of money on research and development. If they get it wrong, money is dusted. If they get it right, the stock will make investors a motzer. The biggest risk is that you can build the best product in the world but if customers don't pay enough, then it's not going to be commercial and you won't have a sustainable business."

It is not just the small companies where there is risk. Xero has had massive success with its online offering of accounting software to individuals and businesses. It has a market capitalisation of more than $5 billion but is a number of years away from making a profit.

Harris says: "Xero is in customer grab at the moment and because capital markets are open (for fund raisings), it is not worried about raising money to fund (these losses). But ultimately you have to generate capital internally to have a sustainable business."

Mention needs to be made of hardware, which refers to the physical componentry in IT. Not much of this is produced in Australia, although there are some listed companies that sell it, namely Data3 (DTL) and Dicker Data (DDR). Selling hardware is a very low-margin business, and both these companies have other divisions that complement this business and produce higher profit margins.

Mobile technology

These stocks, which include eServGlobal, have been hot property on the back of developments at Apple Inc, growing use of smart phones and tablets, and people increasing their time spent on using these devices.

The technology centres around mobile payments. The companies are essentially facilitating an exchange of value between businesses and consumers. Other companies whose shares have gone up exponentially include Mobile Embrace (MBE) and Mint Wireless (MNW).

Although there are examples of big money being made, these companies are essentially software providers and the risks are the same.

Radar's top five techies

You could talk forever about technology companies and you could include another thousand words on the backbone of the sector - telecommunications. We could also write on the e-commerce sector. As we said, complexity and convergence are the big themes.

Below are Under the Radar's preferred technology stocks.

  1. Infomedia (IFM). It has been a big performer and consistency is this company's speciality as an internet-based seller of subscription product that is essential for auto dealers around the world. It provides them with a parts catalogue that is unavailable elsewhere. It is still not expensive, in my view.
  2. Macquarie Telecom (MAQ). This data centre owner and hosting specialist remains under-appreciated because of management's insistence on pursing long-term strategic goals that have affected short-term profitability. The second half of fiscal 2014 will show the benefits of big investing and a healthy cash position.
  3. eServGlobal (ESV). The company has a global presence and its underlying software licensing business is profitable. Its international remittance technology, HomeSend, now has a serious backer in MasterCard. This represents serious blue sky.
  4. MyNetFone (MNF). The quiet achiever of the telco space, having utilised next-generation voice over the internet protocol (VoIP) technology to build an Australia-wide infrastructure that sits alongside the likes of TPG, Telstra, Optus and iiNet. It has been a stellar performer, benefiting from uncertainty with the NBN, which we envisage will continue.
  5. Reckon (RKN). The accounting software specialist is in the fight of its life against Xero. It has a big client base of accountants and strong fundamentals.

About the author

Richard Hemming is the founder of Under the Radar Report, a popular investment newsletter on small companies. Access a free 30-day trial of Under the Radar report.

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