We take a snapshot at the technology industry valuation multiples that IT firms and technology companies in Australia have achieved in the last 12 months and how the sector will drive revenue and profits in a low growth economy.
Industry valuation multiples for for the IT (or TMT - Technology, Media and Telecommunications) sector have increased over the past 12 months and this has been driven two factors (that are often related):
Growth in revenue and EBITDA
Increased merger and acquisition activity (#MnA).
IT Services (TMT) EBITDA Multiples
Interfinancial has reported (January 2019) an average TMT EV/EBITDA multiple of 13.7x (and increasing), where the ASX200 is running at 9.4x. There are also some big deals in the pipeline (such as the $2b private equity MYOB takeover over) which is likely to keep the #MnA announcements coming.
The industry valuation multiples trend reported by Interfinancial in May 2019 has continued its steady climb with the combined ASX TMT sector climbing to the stratospheric EBITDA multiple of 15.7x. This has been driven by larger businesses with enterprise values of greater than $500m.
We do note that the EBITDA multiples for businesses with enterprise value less than $100m averaged 4.6x in April 2019.
We have recently reported our own industry valuation multiples for the Tech and IT industry:
3.7x - 4.2x EBITDA multiples in our Valuation Affairs newsletter for Jan 2019.
3.6x - 6.0x EBITDA multiples in our May 2019 Valuation Affairs newsletter
What Drives Industry Valuation Multiples For IT Sector?
In looking at what drives the business valuations for the IT sector we typically see four key factors:
Revenue growth and size
Market share
Proportion of recurring revenue
Level of staff productivity and staff costs per revenue
Uniqueness and application of proprietary technology
In a recent IT industry merger where we undertook the business valuation the two key issues where the extent to which the combined revenue would continue on current trends and the expected staff productivity post merger. In this case the culture of each organisation and the HR management practices were considered critical in maintaining the staff productivity and therefore achieving expected EBITDA margins.
Where a business has developed specific technology and/or software, the key factor in securing an attractive EBITDA Multiple is often the prove-ability of revenue projections and the development phase of the technology involved. Technology that has secured customers in the marketplace can have less risk than technology still under development and limited acceptance in the market place.
In the case of hardware-related IT businesses, the cost of the hardware and installation is a critical factor that can influence the industry valuation multiple. Some IT firms have key skills and experience in installation projects and this can be a key revenue driver, especially in dealing with legacy systems.
Suitability of EBITDA as cash flow proxy?
There is a tendency among the IT sector to base business valuations on a multiple of revenue rather than an EBITDA multiple. We consider this to be more indicative of a market valuation method rather than an income method and often overstates the business valuation due to variations in costs. It is typically used as a business valuation method when the business is not generating sufficient profits to allow use of an income method.
Another issue in using EBITDA as a cash flow proxy is that does not reflect ongoing changes in working capital and investment requirements. We typically adjust our ongoing EBITDA projections for these factors, as well as other one-off costs. We also differentiate between R&D that otherwise would be expended on the development of the intangible assets (IP) of the business and ongoing development that is more of an operational expense.
So what are some of the key performance metrics of the IT sector and what are the key issues?
The IT sector is spread over two ABS sectors:
Professional, Scientific and Technical Services - FY17 revenue growth of 6.8% and EBITDA margin of 13.3%.
Information Media and Telecommunications - FY17 revenue growth of 0.6% and EBITDA margin of 24.5%.
The Information Media and Telecommunications sector results are skewed by the low growth performance of the ASX listed Telstra and Optus (Singtel).
Some of the key issues in the industry include (more details on our industry business valuations page):
High level of competition, especially for cloud-based services and MSP-style IT services.
Access to skilled workforce and management to maintain competitive labour costs per revenue.
Implementing new technology (Big Data, AI, Virtual Reality, Cloud services) and leveraging NBN opportunities.
Reaching an effective size and scale will drive EBITDA multiples higher so increasing the market share increases profits as well as business valuations.
We believe there are still many #acquisition opportunities that can drive strategic growth for the right acquirers. Some of the key #merger and acquisition lessons our clients have emphasised include:
Ensuring the transfer-ability of clients and doing effective client due diligence before closing the deal.
Making sure both employee cultures are a good fit and having a clear plan for building an effective team.
Have clear targets on staff productivity and how this can be increased to get the highest business valuation.
Being very clear on the benefits that are being sought by the acquisition or merger and identifying clear metrics on these benefits from the start.
Ensure the weaknesses of one company are balanced by the strengths of the other company.
We have provided some more broader advice on the selection of EBITDA multiples in our recent blog post How to Select an EBITDA Multiple.
If you want to learn more about the valuation of your business then contact us for an obligation free discussion.