Scotia Capital Top Picks Scotia Capital analyst Kevin Krishnaratne thinks long-term investors could be rewarded by showing patience with Canadian software companies, which are battling through a difficult stretch.
“So far, 2022 has been a challenging year for the Canadian Tech sector, with the S&P/TSX Capped Information Technology Index down 40 per cent versus much more modest 9-per-cent declines for the S&P/TSX, with the stocks in our coverage down 47 per cent as a group,” he said.
“We can’t say whether we’re at or near a bottom for Tech, given the prospect of evolving interest rate moves and recessionary fears, which may continue to weigh on multiples, which for the Canadian Software sector are down 60 per cent on a NTM [next 12 month] EV/sales basis since September 2021. However, we think there are many opportunities for investors with a longer-term view, supported by strong business fundamentals.”
In a research report released Monday, Mr. Krishnaratne assumed coverage of nine companies and initiated coverage of one other.
He gave eight stocks “sector outperform” recommendations and emphasized three as his top picks in the sector. They are:
* Kinaxis Inc. with a $203 target. The average on the Street is $217.50.
“Kinaxis is perfectly positioned to benefit in an environment of increasing uncertainty and complexity, which we think is driving a higher level of IT budget being allocated toward the digitization of supply chains,” he said. “Momentum has been accelerating, with Kinaxis adding record new client wins, seeing an increasing pace of discussions with C-suite executives, and experiencing a shrinking of its sales cycle, unlike many other Enterprise Software firms that have recently discussed more cautious buying patterns and elongated deal dynamics given macro softness. Metrics are moving in the right direction too, with SaaS growth accelerating into the mid-20-per-cent range (constant currency) and EBITDA margins expanding into the high teens. We think multiple factors could drive upside to our and Street estimates in the coming quarters, including an expanded Partner channel (now including VARs and platform developers) and an acceleration in land-and-expand opportunities in the mid-market space. Kinaxis is a stock that we think can perform well in any market given its efficient revenue growth model, which balances strong subscription growth and high profitability, supported by a clean balance sheet (no debt).”
* Lightspeed Commerce Inc. with a US$30 target. Average: US$37.53.
“Lightspeed is our top pick for growth-focused investors,” he said. “Management’s goal is to grow revenue organically by 35-40 per cent via a combination of location adds, Software ARPU gains and evolving Payments adoption. We see multiple levers driving outperformance given the size of the TAM (approximately 166,000 Lightspeed merchants versus a global opportunity of 6 million complex SMBs), software upside (monthly subscription ARPU [average revenue per user] of US$136 in Q1/23 versus top merchant ARPU of US$300), and higher Payments uptake (just 15-per-cent penetration in Q1). New revenue streams, such as the Lightspeed B2B supplier network, also add to upside not yet considered in our numbers. Meanwhile, we think Lightspeed should benefit from the economy’s return to in-person habits, perhaps more than any other stock in our coverage, given that most of its business is processed at physical locations. Importantly, we think management’s measured approach to customer acquisition and operating leverage in the model should start to drive profits in F2024.”
* Open Text Corp. with a US$43 target. Average: US$47.75.
“Open Text is a name that we think should appeal to investors seeking a more defensive position in Tech given its high recurring revenue mix (80 per cent), strong EBITDA margin profile (+35 per cent), shareholder-friendly initiatives (dividend, buybacks) and discounted valuation (7.1 times pro forma F2024E EBITDA),” he said. “While the market didn’t like the deal for Micro Focus, which elevates leverage (3.8-times pro forma net debt to EBITDA post close) and tilts Open Text’s mix back toward lower-growth Maintenance revenues, we think the sell-off creates a unique opportunity to own a strong FCF-generating Software leader at an attractive valuation. Micro Focus had already been showing signs of stabilization, which we expect management to accelerate by employing its proven best practices and leveraging the cloud. We also think Open Text stands to benefit from digital transformation tailwinds given its broad portfolio of services used by many of the world’s top firms to save costs and drive new revenue opportunities in an increasingly complex and resource-constrained world.”