Three Companies that are Reinventing Themselves

Dueling Pianos Hit the Stage
Companies that are Adopting Cloud-Based Technologies
One Strong Stock I’m Following

Dueling Pianos Hit the Stage

There are a lot of people in this world who are in tune with fashion trends. I, however, am not one of them. I rarely give such things much thought, except when event-appropriate attire is important. On these occasions, I think I sport perfectly fine threads, but they’re never on the cutting edge of fashion design.

What does this have to do with investing you ask? I’ll get there. But first let me tell you about last Saturday night, when my wife and I headed out with a group to celebrate a surprise birthday party for a close friend. My three options for footwear were formal dress shoes, running sneakers or flip flops, and I went for function over form (running sneakers), a choice that was greeted with chastising comments from my co-conspirators (side note: my last pair of non-jogging sneakers wore out this spring, and I haven’t replaced them yet. One of the benefits of living so close to the beach in Rhode Island is that flip-flops are almost always appropriate).

The event we were going to, called “Dueling Pianos,” was being held at a nightclub (it’s been a while). As fashion-conscious people are likely aware, most clubs have dress codes, and running sneakers aren’t on the list. Luckily the doorman was far too distracted by the bump on my eight-month pregnant wife to notice my shoes, and I danced through the door and out of view before the alarm was raised.

My close call with the authorities led to a rare period of fashion enlightenment though. And as I sat there watching the show, which featured two pianists playing non-stop crowd requests at a disorienting volume level, I mentally segmented the crowd into two groups; those who were clearly in tune with fashion trends, and those who were not (or didn’t care).

Companies that are Adopting Cloud-Based Technologies

Awareness of trends in fashion might not matter a whole lot in life, other than to those who care (God bless them), but awareness of other trends does, especially when it comes to investing. Your ability to be on the right side of trends makes a huge difference in cumulative returns over the long term. That’s why many of us who research stocks for a living are so obsessed with certain trends—the miracle of compounding returns is only realized when the trend works in your favor.

One of the trends that’s making headlines this earnings season is the success of companies that are adopting cloud-based technologies. It seems archaic to me to think of purchasing software licenses these days, and when it’s necessary, I often encounter issues that require a session with tech support. This happened just a couple of weeks ago when I was installing a very advanced (and expensive) financial software program. It just seems like a far superior business model to develop a subscription software platform, stick it in the cloud, and provide all the updates and support services there, rather than on a user’s device. Of course, it doesn’t just seem superior—it is.

All a user needs is an Internet connection, and the cloud offers fast, flexible and secure access to software platforms. Consumers pay only for what they use, which is one of the key selling points of cloud-enabled technologies. The business model works well for solution providers too, as cloud-based subscription software solutions tend to generate higher profits over the long term than those hosted on premises.

While reading The Wall Street Journal on Monday, I noticed that Oracle (ORCL) CEO Mark Hurd spoke at the Oracle OpenWorld conference in San Francisco. Among his headline-worthy comments was the statement that Oracle now has virtually 100% of its portfolio rewritten, rebuilt and modernized for the cloud. That’s a big endorsement from a company with a $162 billion market cap. And Oracle isn’t exactly an outlier.

Another example of a company that’s reinventing itself through the cloud is Microsoft (MSFT), which just hit a seven-year high after reporting a stellar fiscal Q1 last Thursday. The company has been around for over 40 years, and it hasn’t always done the right thing. But its transition to the cloud seems to be the right move now, as the company beat expectations and surpassed a critical inflection point that shows the power of the cloud.

To understand what I’m talking about, you need to understand the strategic shift that Microsoft has taken with its cloud-based productivity suite (Word, PowerPoint, Excel, etc.), known as Office 365. Because it is now a subscription service, Office 365 can be turned on or off at will. It comes with 1 TB of online storage and 60 Skype calling minutes per month. And it works across most mobile devices. It’s pretty slick, and customers appear to love it—the subscriber count increased 156% year-over-year to 18.2 million in the first quarter. It’s also a really good business move for Microsoft.

The traditional consumer version Office license sells for $149.99, and the average consumer uses it for about six years before upgrading. That works out to roughly $25 per year. In contrast, a single-user subscription to Office 365 costs $69.99 per year. I crunched the numbers, and over the same six-year period, the subscription will cost $420.00, or 2.8 times more than the traditional license. A lot of that extra revenue becomes pure profit for Microsoft. But it’s still a win-win in my opinion, as consumers get a superior product with much more flexibility.

Over the last few years, Office 365 subscriptions have been cutting into Microsoft’s license sales, keeping revenue and earnings growth at bay. But in fiscal Q1, recurring subscription revenue from consumer and commercial versions of Office 365 more than offset the impact of consumers switching to Office 365. Put another way, the rate of subscription revenue growth is now outpacing the rate of license revenue decline. Since each incremental sale of Office 365 leads to more revenue and higher profit margins, over the lifetime of a user, Microsoft is likely to grow revenues and profits from Office 365. This same sort of thing is happing with its public cloud service, Azure.

The company’s strategic move to cloud services is the main reason I think you should consider buying shares of Microsoft stock (I have been buying over the last 18 months). But you should also consider investing in smaller companies that employ a similar business model to grow software subscription sales. There are a lot to choose from in nearly every vertical you can think of.

One Strong Stock I’m Following

A Stock that’s Modernizing the Public Sector
One stock that I’ve been following as it’s grown from a small-cap to a mid-cap is Tyler Technologies (TYL). With a $5.8 billion market cap, Tyler provides integrated information management solutions for the public sector. The name of the company was part of why it caught my eye, and I’m glad it did—it’s up nearly 80% over the past two years. It primarily services local government entities, including schools, counties and cities, which benefit from industry-specific software and support services. It provides schools and local governments with software for financial management, courts and justice processing, regulatory planning, land and vital records management, and property appraisal and assessment services.

These aren’t exactly exciting lines of business, but Tyler Tech is providing necessary, high-value services. And with local governments more or less back to pre-recession spending levels, and increasingly focused on efficiency gains from cloud-based offerings, Tyler Tech is growing quickly.

Cloud-based offerings now account for over 19% of Tyler Tech’s total revenue. And its quarterly report last week included revenue growth of 17.2% (to $150.8 million), EPS growth of 22.4% (to $0.71) and cloud-based subscription service growth of 28%. The sizeable acquisition of local government software firm New World Systems—which owns the Aegis software suite for firefighters and police officers, and Logos accounting software, for city and county government officials—has helped to keep the excitement in Tyler Tech high. The stock, which is by no means cheap on a forward earnings basis (forward PE is currently 50), is just a tick below its 52-week high.

Microsoft, Oracle and Tyler Technologies are three companies that are leveraging the cloud to accelerate growth in their businesses. There are many more out there, including Tim Lutts’ most recent addition to Cabot Stock of The Month. You can sign up for a subscription here, regardless of where you lie on the fashion sense spectrum.

Your guide to small-cap profits,

Tyler Laundon
Chief Analyst, Cabot Small-Cap Confidential


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