When investors think of the technology sector, often their minds drift to the sunny climes of Silicon Valley and the stock valuations of $1tn-plus Apple (US:AAPL), Nvidia (US:NVDA), Microsoft (US:MSFT), Alphabet (US:GOOG), Amazon (US:AMZN), Meta (US:META) and Tesla (US:TSLA). It is somewhat less likely that many UK-listed names come to mind, not helped by the belief (only partly true) that all of the decent UK tech has either been taken over or de-listed/re-listed on Nasdaq.
While perhaps the best UK-originated business, ARM, did choose to eschew the UK and list on the US exchange, cyber security business Darktrace succumbed to a US private equity offer and tech darling Blue Prism was snapped up by a US fintech, there is still a decent spread of UK-listed businesses across the four main areas of technology hardware, software, cyber security and services. What we do lack are the mega stocks, with the UK largest listed player, Sage Group (SGE), weighing in at a £13bn market cap, which makes it 250 times smaller than Nvidia or Apple.
A problem facing most of the UK technology players is that local IT spending between 2016 and 2022 has been lacklustre, growing at just 2.5 per cent annually, much lower than expectations. High research and development (R&D) and staffing costs (which drove uncomfortably high wage inflation) have saddled many UK businesses with unaffordable cost bases. There have been a lot of missed targets and the industry has been ‘right-sizing’, but it is forecast to perform a smart about-face and grow at a much more impressive 9 per cent annually through to the end of the decade. That said, much of the business executed by UK players is on the global stage, and many are leaders in their field internationally.
The UK sector has shown a positive return. However, the total return on the techMark index has totalled around 60 per cent over 10 years whereas the Nasdaq has returned almost 350 per cent. Despite this outperformance, leadership in the likes of artificial intelligence (AI) and cloud computing provision mean that this superior performance is likely to continue. Nonetheless, there is still good investment performance to be had selectively investing in the UK tech stocks.
In this first article in this mini-series, we will be looking at the sector’s larger and typically more mature businesses, which we will follow with a look at the sector’s smaller stocks, which have historically where the best returns have been seen.
Mature UK tech companies
Digital migration specialist Kainos (KNOS) is focused on the almost bottomless well of work in the digital transformation of the UK public sector. The UK government can only really hope to become more efficient if it moves the still myriad manual or paper-based systems and/or systems that run on local hardware into the cloud or to run as software as a service (SaaS). While forecasts have also been ‘right-sized’ through 2024 (estimates here are 30 per cent lower than in January), and the board recently issued a small profit warning, the shares have followed suit but should soon be bottoming out. Most analysts see fair value here at a little over 1,000p (today c770p) which, with a high yield for a growth business pushing 4 per cent, investors could pocket a 20 per cent total shareholder return (TSR) from here.
The sector’s largest stock, accounting software specialist Sage, is pretty mature, but has been a pioneer in the transition from boxed software to an SaaS or cloud-based subscription model rather than period licensing, and can still surprise – as its most recent results showed. The shares jumped more than 30 per cent after a year of underperforming the All-Share. Earnings per share (EPS) growth, from rising margins thanks to the progressive rolling of customers into the subscription payment model, is still forecast to be in the mid-teens through to 2028. At a year two price/earnings (PE) ratio of 27 this might not look cheap, but this stock has traded well above 20 times for the past decade; it just keeps delivering and clearly is still capable of surprises. The average TSR over the past 20 years has been almost 13 per cent and as a solid business staple with high revenue visibility, there is every chance something close to this remains the outlook too.
A rare UK IPO came in this sector this summer with computer hardware manufacturer Raspberry Pi (RPI). Having debuted at 280p and soaring 40 per cent on day one, the year-to-date performance might look disappointing, but the shares are up 30 per cent since the IPO. At first glance, this stock may look as though it only feeds the hobbyist market, but today three-quarters of the group’s chips and single-board computers (SBC) are sold to original equipment manufacturers (OEMs) for embedded systems. Low-cost, low-power consumption, very wide connectivity, high reliability, quick start and high raw processing (ARM CPU architecture) plus low/no additional licensing are the key attractions for industrial automation and internet of things (IoT) deployment. Exposure to semiconductors in the UK is rare, and this fast-growing business is attractive, innovative and unusual. It may look expensive (year 1 PE >40), but growth is explosive: 30 per cent on the EPS for the next two years, which means a PE of around 25 two years out. There is a chance to see comfortably double-digit TSR here.
Also in semiconductor intellectual property (IP) is Alphawave (AWE), which was overpriced on IPO coming to market just as the global tech shake-out began in mid 2021, and then delivered its own accounting scandal. The market has distrusted this stock ever since. This high-speed communications processing specialist has struggled to secure the hoped-for growth following its IPO, and the shares had fallen c80 per cent before a recent profit warning and cathartic rebasing of forecasts (which are half the level of just a year ago) triggered a 40 per cent rally. Even after this, the PE could be as low as 15 two years out. Markets have long memories and can often punish a stock (via a low rating) for longer than they should, and that could be the case here. Still risky perhaps, but if it delivers, the re-rating could be considerable.
Another interesting area is infrastructure provision. Stocks such as Softcat (SCT) and Computacenter (CCC) sit at the larger end for the sector, with market caps of £3bn and £2bn, respectively. These both help public and private organisations with IT services, including cyber security, so are less pure-play tech stocks as they do not really own any IP. These businesses are essentially resellers of software, hardware and cloud-services, but in a tightening partnership environment (players like Microsoft and Amazon AWS want fewer but better partners) Softcat in particular looks set to do well. This can be seen as an indirect way to invest in the US tech giants and benefit from their product innovations in areas such as AI without paying top-dollar PE ratios.
While Softcat is largely a software business, Computacenter is more skewed towards hardware and, as organisations are pushing more towards cloud services, the need for local hardware will reduce. There is a drive to swing the business more towards service provision, but these operations remain relatively smaller versus the technology sourcing operations. Forecasts have been falling through 2024 and the shares have dropped by a quarter peak-to-trough this year. However, they may have fallen too far, now standing on a PE of just 12 despite the consensus indicating 8 per cent annual EPS growth in the coming two years. Softcat, by contrast, is trading on essentially double that PE despite only indicating 10 per cent EPS growth. Analysts’ target prices indicate an annual TSR for Softcat through to 2026 of c7 per cent, whereas for Computacenter they see more like 17-20 per cent. Softcat may have the more attractive operational profile, but a lot is already in the price, while Computacenter feels unfairly beaten-up.
In the key cyber security space, we have NCC (NCC) and GB Group (GBG), but we have lost Darktrace, Avast and Kape Technologies.
NCC had been in the doldrums as new software to be tested slowed after a Covid boom, and this collided with higher costs, especially wages. The business is pushing back, though, and although EPS growth is forecast to top 20 per cent, much of the value here has been eaten up in the 75 per cent rebound in the share price over the past 18 months. That said, the PE is still only around 15 and, for this business profile, something closer to 20 feels more appropriate – the rally probably has a fair way yet to run.
GB Group is in a sweet spot, with growing pressure on businesses transitioning to cloud services to ensure that customers accessing their services are who they say they are. While the rating might look up with events (PE:20) and the stock up 40 per cent in the year to date (YTD) and up more than 60 per cent over 12 months, EPS growth could easily top 15 per cent in the next two years. The rally still looks to have plenty of momentum and the shares could go 15-25 per cent higher still.
Tangential UK tech companies
Not all tech stocks have to be SaaS, semi-IP, cyber, software or hardware businesses – some are more tangentially connected. Financial app, or ‘fintech’, Wise (WISE), for example, is often seen as being in the tech universe, although runs a traditional(ish) business model (financial transaction processing and money transfer) using third-party cloud services and mobile networks. This is an important distinction from a pure-play tech business, but so-called ‘disruptors’ using cloud services from the likes of Amazon Web Services (AWS) or Microsoft Azure to upend an established industry can still be very attractive investments.
Wise had the misfortune (or hubris) to list in late 2021 just as the tech stock bubble was popping and investors from the IPO are still under water. But since the trough of the sector shake-out, total returns here have been almost 200 per cent, or a little over 50 per cent annual TSR. However, the period of supersonic growth here may be ending as scaling becomes harder. Regulations in and between many of its emerging markets are tightening, and heavy upgrades in operating infrastructure need to be made. Growth is likely to resume, but that may not be until 2028 and it may be time to cash out.
Another tangential stock is Ocado (OCDO). While retail is the public face of Ocado, below the surface the business sees itself as more of an intelligent automation provider for warehousing through its Ocado Smart Platform (OSP). Although the OSP has been licensed globally to other retailers such as Casino (France), AEON (Japan) and Kroger (US), the business is still barely Ebitda positive and the sizeable food retail business (£2.5bn of revenues but only c£40mn Ebitda, so a quarter of even Tesco’s lean margins) is a constant overhang. This stock is loved and loathed in equal measure, with the fans seeing huge and unrecognised value in the technology, and the haters seeing 25 years of unfulfilled promises. This is a highly speculative investment that has shed almost 90 per cent of its market value in the past four years and more than 55 per cent YTD, but online retail (as a sector) is improving and OSP demand and licence income likewise. Very risky still, but at the first sniff of more material net profit from OSP, we have seen from the previous highs how much the market might value this business.
Other more traditional business models but ported into a web service would be the likes of Trustpilot (TRST) or Trainline (TRN). Trustpilot is growing well, but trades on an eye-watering EV/Ebitda multiple of more than 50, which leaves it looking overbought. Trainline is benefiting from growing anti-driving government policies, but also could be at risk of a government drive to simplify and unify pricing for train travel, the navigation of which is the group’s bread-and-butter.
