One cheap software firm to watch

British software companies are undervalued compared to their counterparts in the US, says Tom Bulford. Here, he picks one cheap small-cap company that has bags of potential for profit.

Today we turn our attention to the topic of software technology. I've been thinking about the software sector a lot recently, trying to determine whether this is a good place a find a few superstar penny shares.

The question that occurred to me is: are the shares of small software companies undervalued? One man who thinks they may be is Chris Underhill, founder and chief executive of marketing software provider smartFOCUS (LSE: STF).

Underhill reckons that US investors understand all things technological much better than their UK counterparts. He may be right. Why else would smartFOCUS be trading on 21 times earnings, while a comparable US business Unica (NASDAQ: UNCA) is trading on nearly 30 times earnings on NASDAQ?

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If he is right then there is a great opportunity for UK investors to snap up some cheap shares. And I think smartFOCUS could be one of them, as I will explain in a moment...

Why UK software stocks are such a steal

But if UK software stocks are cheap, then why? There are two factors involved here. The first is still a hangover from the dotcom bust.

Too many tech-savvy entrepreneurs launched businesses in those days that failed dismally. City investors are still suspicious of this breed. Can tech geeks really make good businessmen? Certainly not all. And yet you need look no further than Bill Gates to see that geekery and business nous are not incompatible.

There have been success stories in this country too, headed by Autonomy (LSE: AU) and SDL (LSE: SDL). But the stock market still has a long list of small software businesses that have survived the high-tech crash of a decade ago without ever delivering much to their shareholders.

And even those software ventures that have been successful have had to change their business model a change that has done little so far to enhance their reputation with investors.

Most companies in this sector started out by selling software licences. These could sell for tens of thousands of pounds and in a good year would deliver a very handsome profit.

The trouble was that a good year might be followed by a bad year. City investors like progress to run in a nice smooth line, without the 'lumpiness' of unpredictable sales.

To counter this, software companies began to sell their products on a multi-year licence, in return for a stream of annual payments. Progressing still further they moved to the 'software-as-a-service' model. This meant they 'hosted' and maintained the server and the software programs allowing customers to tap in on a 'pay as you go', or subscription, basis.

This is a benefit for the customer who does not have to stump up the full cost of a licence at the outset, while the software provider gets to control the product and has a far more predictable stream of income.

Given the old City saying that 'investors hate uncertainty' this business model shift should have allowed software companies to be more highly rated on the stock market.

But investors can be slow to give companies due credit. Arguably that is the case with smartFOCUS. This is a company that has been listed on AIM since 2004. It is now one of the leaders, along with another AIM-quoted company Alterian (LSE: ALN), in the application of software for marketing campaigns.

Why smartFOCUS is one to watch

Underhill lives in the rural Somerset village of Wedmore and had his eureka moment when he realised why he kept on receiving mailshots offering him deals on agricultural machinery and chicken feed.

Both of his neighbours were farmers, and because of his postcode, the marketers of farm supplies figured out that he might be a farmer as well.

Today marketing campaigns are scarcely more sophisticated or successful, and huge sums are wasted on a scattergun approach.

At great expense, sends 100 million emails each month, the vast majority of which provoke nothing more than mild irritation. Now it is to pay a seven-figure sum to smartFOCUS to refine its marketing efforts, both to save itself money and to get a better response for its efforts.

This is typical of the work done by smartFOCUS for its 750 customers. Having made that important transition away from pure licence sales, it now claims that about 70% of its revenues are recurrent from one year to the next.

With this base and the addition of new clients which numbered 80 last year smartFOCUS should be comfortably able to grow its revenues. With little requirement to scale up its operation profits could grow fast.

smartFOCUS is a typical example of a small software company with a good proposition. But despite its progress its share price is no higher than it was five years ago and that too is typical of the penny share software sector.

This article was written by Tom Bulford, and is taken from his free twice-weekly email The Penny Sleuth

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.