The tech stock that has failed to keep up with Afterpay

The tech sector has been in the limelight on the ASX as the WAAAX stocks (WiseTech, Appen, Afterpay, Altium and Xero) soar to amazing heights.

In the past two years their combined market capitalisation is up fivefold to $28 billion. This has led many market commentators to postulate that a day of reckoning must be coming soon.

WiseTech and Afterpay have price-to-sales ratios of 30, and of the three stocks that are profitable PE ratios range from 62 to 166. Only an outstanding growth trajectory will justify these heady valuations in the long run.

But not all ASX-listed technology stocks are soaring.

Citadel Group (ASX: CGL) is sitting 53% below its 12-month-high price. This has followed interim results that did not meet expectations, the resignation of the company founder as a director and most recently a disappointing earnings downgrade for the 2019 financial year.

The company is undergoing a transition as it shifts to a different revenue model. The question is: has the market over-reacted to the disappointments of recent months and undervalued the long-term prospects of the business?

Citadel is a technology business.

It builds enterprise software solutions for large clients such as governments, defence, education providers, corporates and healthcare organisations. Traditionally this has been in the form of long-term managed services contracts.

Contracts typically average four years in duration. These types of contracts accounted for 84% of revenue three years ago but have now declined to 66%.

The declining contract revenue has been more than made up for by an increase in software as a service (SaaS) revenue, which is now responsible for 34% and is viewed as the path to future growth. At the half-year results Citadel had eight clients utilising 26,000 seats (users).

Another 100,000 seats were under negotiation and it is targeting 200,000 seats by the end of the 2020 financial year. SaaS contracts generate less in upfront fees but have higher value over the lifetime of a customer.

They allow the business to grow by adding scale at a lower marginal cost and spread income over a wider base of customers.

Citadel refers to the most secure part of a medieval castle. This name reflects the emphasis of its solutions on information security.

This is essential for areas such as defence, government and health. It is also a growing area in financial services, where the fallout from the royal commission has resulted in even greater emphasis on compliance and data integrity.

To this end, Citadel announced the acquisition of Noventus at the end of May.

Noventus has a strong position in defence and national security. The acquisition is expected to provide an immediate uplift to earnings per share before considering the benefits of any consolidation synergies.

The earnings downgrade in May was blamed on customers pushing out projects into the 2020 financial and also a lower level of customer spending in the final quarter of 2019.

Some of this is attributable to the federal election, with government departments waiting until the election result was known before committing to further spending. The upshot is revenue for 2019 will probably be lower than in 2018 and earnings per share could fall by as much as 50%.

Returning to the comparison with the WAAAX stocks, Citadel is trading on a historical price-to-sales ratio of two and a PE ratio of 13, a different realm from WAAAX.

Looking at the forecast valuations, the PE ratio is much higher given the lower expected earnings.

Whether it represents value all depends on Citadel's ability to turn the growth potential into reality. It has a strong base on which to build and if it demonstrates it can turn earnings around it could also lead to a rerating of the valuation multiples.

An investment in Citadel at the moment requires faith that it has the people, processes and software to build a growing revenue stream well into the future and that the expected declines in revenue and earnings are a blip on the trajectory and not a sign that the business has peaked.

Most businesses that succeed in the long term undergo pivots in their strategy along the way. That can be a nervous time for all involved, but it can also be the time of greatest opportunity.

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