Software Circle purchases businesses that perform menial but essential tasks
According to James Mackreides, it has a good chance of succeeding.
At the out-of-favour smaller end of the UK stock market, where hundreds of the smallest companies have been largely ignored due to years of outflows from small-cap funds, Software Circle (Aim: SFT) is a particularly intriguing company that presents opportunities for investors. By purchasing a number of specialized software companies, it hopes to increase long-term shareholder value. It is listed on the junior market. Although it's early, the company has a lot to offer.
Software Circle purchases established software companies that operate in specialized industries, like assisted living facilities. These are usually businesses with devoted clients, steady income, and founders who are getting close to retirement. The software itself is frequently boring, which is exactly what makes it appealing.
Initially, Software Circle was a printing company that had trouble with expenses and problems with operations. Nettl Systems, a lucrative software platform, was hidden within the organization, though. The management made the decision to sell manufacturing operations and give up on the previous printing model. The remaining funds were redirected into a new strategy that was solely focused on software acquisitions after the balance sheet was cleaned up.
Compared to manufacturers, software companies typically require much less investment. Software can frequently be repeatedly sold at extremely high margins once it is developed. Even better, clients frequently remain for years. These days, Software Circle concentrates on vertical market software specialty products made for specific industries or occupations. Although they can be very lucrative, these markets are rarely thrilling.
Highly specialized software is used by many small businesses to manage daily operations. They can be costly and disruptive to replace. Customers hardly ever switch providers as a result. Providers have pricing power because the software they use accounts for a very small percentage of total expenses. Even consistent yearly price increases are unlikely to generate a lot of complaints.
Recurring revenue, low customer turnover, and pricing power have all contributed to the success of some very successful software companies. In the fragmented software company market in the UK and Ireland, Software Circle is purchasing many of these companies.
The share price of Software Circle is in pence.
The acquisition strategy of Software Circle.
The company's acquisition strategy is surprisingly cautious, and management keeps an internal database of over 4,000 possible acquisition targets in the UK and Ireland. Crucially, management is price-conscious and typically won't pay more than seven times adjusted earnings for purchases. The average purchase multiple has been closer to six times for all software companies that have been acquired thus far. This is important because buy-and-build strategies frequently fall short when acquirers become overly assertive.
According to the most recent interim results, the strategy is starting to gain momentum. Subscription income now makes up about three-quarters of group sales, and revenue increased by 15% to 10.2 million. Because subscription software companies are typically more dependable and resilient than project-based technology companies, this recurring revenue mix is crucial. Additionally, underlying profitability increased while central overheads were kept under strict control. The education-software market did especially well, with 17% organic growth.
Although there is still an operating loss in the statutory accounts, this is primarily due to acquisition-related accounting charges rather than poor underlying trading. A better picture of the company is provided by cash generation. The management reports that its software asset portfolio is yielding returns on invested capital of about 25%, and operating cash flow has continued to improve. That is an extremely encouraging number for a serial acquirer.
Additionally, Software Circle is now big enough to obtain bank funding. As a result, the company will have more freedom to keep buying companies without giving them back to shareholders. The management's ultimate goal is for the company to become self-sufficient so that future acquisitions can be supported by regular cash flows. That might have a significant long-term compounding effect if it is accomplished.
A further positive aspect is the strong alignment with shareholders. Only a few senior employees work from the executive team's modest Manchester office, making it exceptionally thin. Shareholder returns are linked to long-term incentives, and management choices promote a longer-term perspective.
Likewise helpful is the shareholder register. A sizable portion of the company is owned by German investors associated with Chapters Group, another European software acquirer. Sun Mountain, an investment vehicle connected to Will Thorndike, a renowned long-term investor, owns about 10% of the company.
The risks are not eliminated by this. Software Circle is still a very small business that operates in a market segment with low liquidity. If management overspends, has trouble integrating, or accrues excessive debt, acquisition strategies may fail. Additionally, investors looking for steady income or fast returns are unlikely to find the shares appealing.
Nevertheless, the components are present for a compounder that is appealing over the long term. The company appears disciplined in its valuation, operates in a fragmented market, concentrates on sticky recurring revenues, and is expanding its access to less expensive acquisition financing. A UK-listed version of the specialized software compounders that have proven so successful in North America is being developed by Software Circle.
The company is still small and unproven. Nonetheless, it might be one of the more intriguing stories emerging in a neglected area of the UK market.
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