Software Circle (Aim: SFT) is a particularly interesting company at the out-of-favour smaller end of the UK stock market, where years of outflows from small-cap funds have left hundreds of the smallest companies largely ignored – thus creating opportunities for investors. It is listed on the junior market and is attempting to build long-term shareholder value by acquiring a collection of niche software businesses. It's early days, but the firm has many attractions.
Software Circle buys mature software businesses operating in niche corners of the economy, such as care homes. These are typically firms with loyal customers, recurring revenues and founders nearing retirement. The software itself is often dull – and that is precisely the attraction.
Software Circle started out as a printing business that struggled with costs and operational headaches. Buried inside the group, however, was a profitable software platform called Nettl Systems. The management decided to abandon the old printing model and sold manufacturing operations. The balance sheet was cleaned up and the remaining cash redirected into a new strategy focused entirely on software acquisitions.
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Software firms generally require far less investment than manufacturers. Once developed, software can often be sold repeatedly at very high margins. Better still, customers tend to stick around for years. Software Circle now focuses on the vertical market software – specialist products designed for narrow industries or professions. These markets are rarely exciting, but they can be extremely profitable.
Many small businesses rely on highly specialised software to run everyday operations. Replacing them can be disruptive and expensive. As a result, customers rarely switch providers. The software they use represents only a tiny proportion of overall costs, which gives providers pricing power. Even steady annual price increases are unlikely to cause many complaints.
This combination of recurring revenue, low customer turnover and pricing power has created some exceptionally successful software businesses. Software Circle is buying lots of these businesses across the fragmented UK and Irish market for software companies.
Software Circle's acquisition strategy
The company's acquisition strategy is refreshingly conservative and management maintains an internal database of potential acquisition targets across the UK and Ireland that numbers more than 4,000. Importantly, management is disciplined on price and generally refuses to pay more than seven times adjusted earnings for acquisitions. Across the software businesses acquired so far, the average purchase multiple has been closer to six times. That matters because buy-and-build strategies often fail when acquirers become too aggressive.
The latest interim results suggest the strategy is beginning to gain traction. Revenue rose 15% to £10.2 million, while subscription income now accounts for roughly three-quarters of group sales. That recurring revenue mix is important because subscription software businesses tend to be more predictable and resilient than project-based technology firms. Underlying profitability also improved while central overheads remained tightly controlled. The education-software segment performed particularly well, delivering organic growth of 17%.
The statutory accounts still show an operating loss, but this largely reflects accounting charges linked to acquisitions rather than weak underlying trading. Cash generation gives a clearer picture of the business. Operating cash flow continued to improve and management says its portfolio of software assets is generating returns on invested capital of roughly 25%. For a serial acquirer, that is a highly encouraging figure.
Software Circle is also now large enough to access bank financing. This will give the firm greater flexibility to continue acquiring businesses without returning to shareholders. Management ultimately hopes the business will become self-funding, with recurring cash flows supporting future acquisitions. If achieved, that could create a powerful long-term compounding effect.
Another encouraging feature is strong alignment with shareholders. The executive team is unusually lean, with only a handful of senior staff operating from a modest office in Manchester. Long-term incentives are tied to shareholder returns and management options encourage a longer-term mindset.
The shareholder register is similarly supportive. German investors connected to Chapters Group (another European software acquirer) hold a large stake in the business. Around 10% is owned by Sun Mountain, the investment vehicle associated with Will Thorndike, an investor with a famously long-time horizon.
None of this removes the risks. Software Circle remains a very small firm operating in an illiquid part of the market. Acquisition strategies can go wrong if management overpays, struggles with integration, or takes on too much debt. The shares are also unlikely to suit investors seeking quick returns or dependable income.
Even so, the ingredients for an attractive long-term compounder are there. The firm operates in a fragmented market, focuses on sticky recurring revenues, appears disciplined on valuation and is building access to cheaper acquisition financing. Software Circle is attempting to build a UK-listed version of the niche software compounders that have worked extraordinarily well in North America.
The business is still small and far from proven. However, in a neglected corner of the UK market, it may be one of the more interesting stories developing.
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