Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 370

Where we see growth opportunities in software stocks

In the current environment, finding companies with above-market earnings growth over the medium-term backed by positive catalysts is becoming increasingly challenging. In our view, investors looking for these attributes could consider enterprise financial software companies.

Favourable investment catalysts

We believe these companies should deliver strong shareholder returns over the medium-term given numerous favourable industry tailwinds and investment attributes, including:

  • Many legacy systems across the financial services industry are in need of major refreshing
  • Growing demand for customer-focussed offerings within the Australian superannuation industry
  • Heightened demand from customers of wealth management, pension providers and life insurance firms for mobile and digital solutions
  • Highly sticky customer bases
  • High degree of recurring revenue
  • Extended visibility into the sales pipeline creating greater earnings certainty.

Enterprise financial software firms will benefit from two key goals, which are often interrelated:

  • Migrating the middle and back office legacy systems to a current software solution as a means of improving efficiency.
  • Improving the customer experience given changing consumer demands.

These catalysts as well as a simple framework demonstrating our approach to investing in this industry are detailed below, in addition to ways investors can gain exposure to this sector of the market.

Industry snapshot

Enterprise financial software companies provide the core operating and product systems for a range of financial institutions including wealth managers, superannuation providers, insurers and often also the associated third-party administrators (TPAs). Their software products can touch the front, middle and back offices, with the majority of software firms having customers across multiple geographies.

It's the software providers that allow financial services firms to deliver new products with unique customer-focused propositions aligned to the constantly evolving regulatory landscape. These critical elements are either costly to manage or prohibitive to achieve on internally developed or legacy systems. New technology solutions allow financial services firms to focus on their core business and to compete more effectively against their peers.

The following diagram highlights the wide-reaching nature of the enterprise financial software providers within the Australian financial industry. This industry breadth and depth is a key value driver, and it's almost certain you have had a customer experience that was powered by these (mostly unknown) software firms.

Source: AMP Capital

Australian superannuation industry growth

Figures 1 and 2 below highlight the growth in superannuation where industry funds now have more assets and members than any other fund type. The average number of members per industry fund also far exceeds any other fund type, driving an increasing need for technology to manage scale and provide an improved customer experience, particularly as mobile savvy millennials become a larger portion of the member pool.

*Public sector assets have been restated to remove the adoption of AASB1056 for comparison purposes. Past performance is not a reliable indicator of future performance. Source: APRA June 2019

With this ongoing growth, super funds need improved customer service with a deeper, more targeted offering typically utilising technology via mobile oriented solutions. This provides an opportunity for super funds to adopt a technology enabled in-house model as opposed to utilising TPA’s or heavily manual processes.

A recent example of this occurring is the Iress (ASX:IRE) and ESSSuper agreement, where ESSSuper will transition to the Automated Super Admin product offered by Iress.

Such operating models enable super funds to more closely own the customer relationship, which will become even more important as the industry continues to scale and to offer broader, more compelling customer-focused products.


Register here to receive the Firstlinks weekly newsletter for free

Customer centricity

Many large firms both in Australia and offshore (particularly the UK) operate on legacy systems cobbled together from multiple acquisitions. Such systems prohibit a deep level of customer focus, typically resulting in customers being under-served relative to other industries. With heightened regulatory requirements, these legacy systems are an increasing cost burden on firms to stay relevant to new regulatory requirements.

A best-in-class technology creates the potential for wealth managers, pension providers and life insurers to regain control of the customer relationship. Achieving this should create long-term benefits through building a deeper and more meaningful relationship with the end customer, while also reducing the regulatory burden on firms.

A useful diagram contextualising this was provided in an ASX release from Bravura Solutions (ASX:BVS) and shown below.

Source: ASX Announcement (BVS) 20 February 2020

Manual processes unable to scale

Firms with heavily manual processes are under increasing pressure to find solutions that overcome issues with fluctuations in demand. This has recently been witnessed during COVID-19, where firms across multiple industries with heavily manual processes were unable to provide a consistent level of service in peak customer demand periods. We see this as a catalyst for financial services firms to revisit their business processes and believe technology will almost certainly be at the forefront of any solution that enables scale.

How we think about investing in this sector 

The decision for a business to change its core technology is by no means a small one. Costs are extremely high – generally upwards of $100 million on large deals – and unsurprisingly, it’s not straightforward to migrate to a new system, with new implementations typically taking up to 36 months. Cases of failed implementations are also not unheard of, although none relating to ASX-listed companies that we are aware of. Given these dynamics, there is a high degree of inertia with customers reluctant to migrate their technology.

Keeping the above factors in mind, our investment analysis within this industry is focused on answering two key questions:

  1. Are there significant reasons for financial services firms to review and migrate the core IT ecosystem? Put another way: What is the sales pipeline and how likely are these leads to convert into revenue?
  2. Which software provider appears to have the best-in-class technology offering?

These questions may seem simplistic, however when assessing an investment where opportunities for new sales could be lumpy but very significant when they come, it is important to clearly understand which software provider is likely to be the biggest beneficiary of an increased sales pipeline within the industry.

Furthermore, we are also mindful of valuations across the sector particularly as it relates to the earnings growth the company is expected to deliver over the medium term.

How we are gaining exposure

In our view, Bravura Solutions and Iress Ltd provide exposure to the market opportunities mentioned above. Both have an overlapping product suite, with Iress having a larger market share in the financial planning space and Bravura having a deeper offering and more customers in the enterprise financial software space.

We believe that both companies share similar characteristics with reasonable balance sheets providing the optionality for further acquisitions (Bravura more so), offshore exposure, high degree of recurring revenue and valuations that look reasonable in the current market environment. Bravura is likely to deliver mid-teens earnings growth over the medium term.

In summary, enterprise financial software companies have favourable attributes and industry tailwinds that may see investors rewarded over the medium term.

 

Kent Williams is a Small Caps Analyst at AMP Capital, a sponsor of Firstlinks. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs.

For more articles and papers from AMP Capital, click here.

 

4 Comments
Greg Hamilton
August 23, 2020

“Cases of failed implementations are also not unheard of, although none relating to ASX-listed companies that we are aware of.”

“That we are aware of” the key words in this statement. I am sure there have been failed implementations but by another name. The process is not easy and takes time and creates a significant amount of risk with all stakeholders. I am sure that those who got it perfect also got it wrong, there needs to be an extraordinary commitment to design, implementation and management throughout the process. With the final result on occasions not providing the initial offering. These may not be considered a failure but they are a huge disappointment.

Frustrated by Xplan for years
August 14, 2020

As a user of Iress product to financial planners, the product is on old technology with pricing for large corporates (now leaving the area) and not focussed on the end user being the financial planning business of the future. Selling to a few thousand small businesses is markedly different to a single sale to a large institution. I do not know the overall financials of Iress, but the culture is hanging on to how it was believing they can convince us we are wrong and they really are the best offer. Bring on individual licensing and direct charging to clients rather than having a licensee in the middle.

Donald Hellyer
August 13, 2020

One issue about working from home is that it is excellent for short-term productivity but lousy for project work and creativity. I will watch with interest to see if companies can spend well on technology when senior management is distracted, and staff struggle to innovate new ideas while working alone. It's a brave new world.

Pieter Kritzinger
August 13, 2020

Indeed. Well said Donald. Working from home makes sense up to a point only.

 

Leave a Comment:

     

RELATED ARTICLES

Check 6 key ‘moats’ around small stocks

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.