High-growth tech stocks are usually found in Silicon Valley, but there are also some fantastic software companies here in the UK. Ideagen (LSE:IDEA) is one such company that I’m watching this year as a potential addition to my portfolio.
A unique UK tech stock serving a unique sector
The firm provides bespoke software solutions for businesses in highly regulated industries, such as aviation, banking, and healthcare. More specifically, it suppliess governance, risk, and compliance (GRC) solutions.
The company serves over 6,000 customers, including the top 10 UK accounting firms and the World Health Organisation. The talent and reputation required to provide GRC services to highly regulated industries also means there are significant barriers to entry for competitors. I like that.
Initially, Ideagen generated revenue by selling perpetual licenses to its customers. However, while it still offers these licenses today, that’s no longer the primary strategy. The management team has switched its focus to creating a continuous stream of recurring revenue by providing its software as a service (SaaS). Today, 61% of total income originates from recurring revenue sources, whether it be software subscriptions or additional support services.
This transition has been, and continues to be, achieved through bolt-on acquisitions. In 2020, it acquired another three businesses, namely Redland Business Solutions, Optima Diagnostics, and Workrite. All generate recurring revenue, and the latter two enable Ideagen to provide additional services for its clients operating within the healthcare sector.
Recurring revenue streams generate a consistent and reliable cash flow that can be used to fuel growth. At least that’s what I think. As a result, the UK tech stock has achieved an average 27% annual growth in revenue. But it’s not all smooth sailing.
Acquisitions can cause problems
The most recent acquisitions are undoubtedly a complementary addition to Ideagen’s business. However, they have introduced some new financial speedbumps.
The total debt level has increased from £7.5m in 2019 to £33.7m today. Due to limited cash at hand, the company needed to borrow a significant amount to acquire these businesses. It also resulted in the stock reporting a loss for the year.
Temporary unprofitability in the name of growth is not overly concerning to me. However, the considerable rise in debt is. This additional borrowing has significantly altered the company’s capital structure, with debt now representing 38% of total capital.
While this debt level appears to be manageable, it does increase interest payments, which subsequently limits free cash flow. What’s more, integrating three business simultaneously may create complications that will put a damper on performance.
Another risk I spotted comes from its international operations. Many of the businesses that have been acquired over the years are based outside the UK. While this does help mitigate any impact from Brexit, it also adds exposure to fluctuating exchange rates of several currencies.
The bottom line – should I buy this UK tech stock?
According to Gartner, the integrated risk management market that Ideagen serves is expected to reach $8bn in 2021, growing 9% annually. Comparing this to the £57m of revenue generated last year indicates an enormous amount of room to grow.
Having said that, the aggressive, acquisitive growth strategy does give me pause. Goodwill now constitutes a significant portion of total assets, and sudden changes in capital structure might create issues. For now, I won’t be adding Ideagen to my portfolio, but I will definitely be keeping a close eye on it.
