Turkey of the week: over-valued software firm

Autonomy, Britain’s largest software firm by market capitalisation, is at the other end of the value spectrum from Aviva. Its shares trade at near all-time highs, having been worth only 140p back in 2004. The firm is a terrific British success story, but the price looks too high now.

Autonomy’s proprietary “‘e-discovery’ technology helps speed up complex searches through vast swathes of unstructured data trapped inside organisations. Its software can trawl through most data sources, such as Microsoft Office documents, telephone calls and online social media such as Facebook. Royal Bank of Scotland, GlaxoSmithKline and BAE, for instance, use the application to manage everything from counter-terrorism to research and development and compliance with statutory requirements.

Autonomy, therefore, thrives during times of crises when clients are forced to abide by tighter regulations and protect themselves from litigation – such as fallout from the sub-prime fiasco. It’s no wonder, then, that the 2009 figures were sparkling. Like-for-like sales leapt 16%, while operating profit margins nudged up 4% to 45%. This was thanks to strong organic growth, a full-year contribution from its $775m acquisition of Interwoven, and better cost control.

Autonomy (LSE: AU), rated a BUY by Nomura

But while the uniqueness of Autonomy’s software is compelling, I have my doubts over its longevity. The competition is catching up fast, so this lucrative sector could become far more cut-throat in two to three years’ time. In particular, Microsoft is beefing up its search credentials with its Vista and Sharepoint products. And Oracle, Google and IBM are hardly going to sit quietly without similarly aiming to exploit their huge resources in data searching.

Finally, although there are major advantages to buying Autonomy’s products, the firm is now seeing a gradual tightening of purse strings within its core customer base. This is being demonstrated by a slowdown in the rate at which it secures $10m+ deals. And given that enterprise software is known for being a late-cycle industry, many IT directors haven’t yet finished taking the red pen to their budgets.

I’m not knocking the business – it is now the world’s leader in enterprise-searching. The issue is valuation: the stock trades on a racy 19 times 2010 EPS and a staggering seven-times sales (nearly double the sector average). The firm also offers no dividend. I rate the company on a 12 times 2009 earnings before interest, tax and amortisation (Ebita) multiple. After adjusting for the $45m in net cash, that suggests an intrinsic worth of around £12 per share.

Recommendation: SELL at £15.22

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

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