Following the painful >12% share price decline after Sage’s FY’20 results, we see a buying opportunity for a company that is sticking to its transformation strategy and making the right long-term decisions. We maintain our strong buy recommendation and highlight:

• Investment in the right places. While the headline ‘up to 3%’ margin decline outlook may look concerning, it is important to consider its components.
  • 2% goes to accelerating the ramp up in product development and R&D. This will focus on the cloud native products to secure Sage’s longer-term revenue growth, which will increasingly move away from cloud connected. Given Sage is playing catch up on its cloud native offerings and this turnaround is key to our thesis, we believe it is the right decision not to delay this. We would be more concerned at maintaining margins at the cost of product innovation.
  • An optional 1% to deploy in digital marketing and brand building. While this expenditure will depend on market conditions, again it is a longer-term investment in the cloud native business, which requires enhancement of existing sales and marketing methods.
• Pulling forward investments is painful going in, but powerful on the way out. This margin pressure is also partially a function of lower top line growth in FY’21 than expected pre-COVID-19, meaning a lower revenue number to cover planned investments. While in survival mode, customers will likely not be focused on upgrading their accounting software. However, the crisis has arguably highlighted the value of cloud products and, upon recovery, we would expect a greater interest in cloud native solutions. Management highlighted on the earnings call that Sage is already seeing greater interest from medium sized businesses on how they can migrate. When top line growth accelerates, the already boosted R&D/marketing cost base will have less to catch up, raising margins.
• Bringing the fight to Xero and Intuit to recapture lost UK market share. For years, Sage has lost market share in the UK smaller business segment to Xero/Intuit given its lack of a high quality, cloud native solution. The Sage Accounting product now removes this gap and paves the way for Sage to recoup lost market share. Management’s comment of ‘fully intending to defend and enhance market share’ in the UK is one of the strongest we have heard to date.
• Huge opportunity in adjacent verticals. As highlighted by our previous note, Sage continues to build a package of products in adjacent verticals, such as HR and budgeting/planning. This is a significant market given – for example – ~46% of businesses with $1-5bn in revenue in North America still use Excel as their primary budgeting tool.
• Simplification continues. The business is continuing to divest lower growth, local products that are not part of the cloud strategy, adding, as held for sale, assets that generated £98m revenue at ~15% margins.
• Resilient revenues. Renewal rate by value was 99% in FY’20, despite COVID-19 pressure in H2, highlighting the sticky customer base.

Conclusion

Overall, while trough margins are lower than we anticipated for the transformation, ultimately this accelerates investment in the business and does not alter our fundamental thesis.