The Moneyfool: The classic money machine

he chances are that if you run a small business, you've heard of Sage. Or at least your accountant has. The company is the leading supplier of accounting software and related products for personal computers, and small business is its speciality. It all sounds rather innocuous.

However, if I told you that since flotation in late 1989, the Sage share price has jumped from 130p to as high as 2,250p, perhaps that would make you sit up and listen.

That's a compounded annual growth rate of 35 per cent. To put that appreciation in perspective, a pounds 10,000 investment in Sage would now be worth almost pounds 200,000.

Last week, Sage reported another impressive set of results, for the six- month period ended March 1999. Turnover rose 49 per cent to pounds 132.5m, and earnings per share (eps) jumped 40 per cent to 20.58p. The dividend was raised "only" 10 per cent to 1.18p net - well below the growth in earnings - but that is probably a good sign. It means the company wants to conserve valuable cash, as they see plenty of opportunities for future growth. It is only mature companies that should be keen to pay out a large proportion of their earnings in dividends.

With its interim results, Sage also announced that it is embracing the internet as an integral part of its business model. The excellent results, coupled with the mention of "the i word", saw the shares jump 10 per cent last Tuesday.

Sage has been a classic less-obvious great investment. It may well prove to be an obvious great investment in the future, in the mould of Microsoft. Sage has been able to develop an essential piece of software, then roll it out across many customers. The software development costs are relatively expensive, but are, in effect, a one-off charge. After that, the production costs for software are minimal, and that shows in gross margins of a whopping 90 per cent.

You can usually spot a great business by looking at its margins. A high gross margin indicates that the costs of actually making the goods are proportionally very small. As we see with Sage, software companies are great examples of companies with high gross margins.

Sage has built a strong brand name within the small business sector. That brand name means that when a new small business starts up, the chances are it will choose Sage as its off-the-shelf accounting package.

On top of that, it has the classic business model. Stock levels are almost ridiculously low, because the software costs so little to manufacture. Fixed assets are also relatively low, as Sage doesn't need much in the way of machinery in order to produce its products. Sage receives upfront cash for longer-term maintenance contracts, giving it a cash float. It's not quite the ideal "buy on credit and sell for cash" scenario, but it's not a million miles away.

On top of all this, Sage has the classic repeat-purchase product. No one likes to change accounting systems, so once a company has installed a Sage product, it is likely to stick with it. But companies need to update their packages. Sage must be crying out for a change in the VAT rate, because that would give it a great opportunity to sell upgrades to its 2 million customers. Every time Microsoft brings out an upgraded Windows operating system, Sage can sell an upgraded accounting package to its customers.

The foray into the internet is another example of Sage looking to leverage its brand name via its strong and loyal customer base. The internet, above all else, embraces the low-cost operating model. Build one site and the incremental costs of having 1 or 100,000 people visit it are proportionally minimal.

Sage is hoping that customers will take advantage of its web page. Six months down the track, when they are hooked on the idea, Sage plans to charge them for that privilege.

Stock market investors would do well to hunt for companies that have a Sage-type business model: repeat-purchase business, strong brand name, high profit margins and strong cash generator. Super-investor Warren Buffett is often called the Sage of Omaha. I bet he, like the rest of us, wishes he had discovered the real Sage back in 1989 and let the power of compound interest do the rest.

Motley Fool, www.fool.co.uk

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