Successful software businesses can deliver rapid growth and huge profit margins. Companies of this kind are often able to expand their customer base without much additional investment.
Property listing website Rightmove (LSE: RMV) is a good example of this.
I’ll explain why Rightmove is so special in a moment, but first I want to consider another technology stock that’s delivering impressive growth.
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A big opportunity
An increasing amount of language translation work is performed by computers, rather than human translators. One of the companies at the forefront of this market is UK firm SDL (LSE: SDL), which has a market cap of around £450m.
The company’s services include the automated translation of large volumes of documents and software localisation. After a difficult period, revenue from continuing operations rose by 2.8% to £143.1m during the first half, but pre-tax profit climbed 30% to £7.8m.
When profits rise more quickly than revenue, it means profit margins are growing. In this case, SDL’s accounts show that the group’s underlying operating margin rose from 6% to 8.4% during the first half.
This isn’t especially high, but the group does appear to be highly cash generative. Free cash flow was £10.5m during the half year, and SDL reached the end of June with a net cash balance of £22.5m.
Should you buy or hold?
I can see long-term growth potential for SDL’s business. But I think it’s fair to say that some of this is already priced into the stock.
The shares are up by 2% to 516p at the time of writing. Broker earnings forecasts put the stock on a forecast price/earnings ratio of 22.7 for 2018, with a prospective yield of 1.3%. Earnings are expected to rise by 17% in 2019, giving a forecast P/E ratio of 19.4.
In my view this is a fair valuation. I’d hold the stock now, and top up during any market wobbles.
An exceptional business
SDL isn’t cheap enough to tempt me today. But I might consider making an exception for Rightmove.
This business is the dominant player in this sector, with a company-estimated 74% market share. It logged 830m visits totalling 6.5bn minutes during the first six months of this year.
This means that it’s almost essential for estate agents to list their properties on Rightmove. In turn, this means that the company can charge agencies much more than smaller rivals Zoopla and Onthemarket.com, even though their services are basically the same.
This has made Rightmove one of the most profitable businesses in the UK, with a 73% operating margin in 2017.
What could go wrong?
One risk for investors is that the company will lose market share to a cheaper rival. This seems unlikely to me because of house hunters’ strong preference for the Rightmove website.
A more pressing concern may be that growth will stall because housing sales are slowing. Rightmove’s half-year results show that it signed up just 23 new customers during the first half, out of a total of 20,450.
Buy on weakness?
Rightmove stock has fallen by 10% from June’s all-time high. The shares now trade with a forecast P/E of 27 and an expected yield of 1.3%.
That’s not cheap, but this company’s high market share and exceptional profit margins suggest to me that it could continue to beat the market.
