Share of the week: Second leg to Sophos rally

We covered security software group Sophos just three weeks ago when broker Liberum made sense of the company's "confusing" accounting policies. A strong set of maiden half-year results since has added fuel to the rally, with a 7% jump making it one of the FTSE 350's biggest risers again this week.

Upgrades to forecasts have overshadowed a pre-tax loss triggered by IPO charges. Strong billings were the main take-away in the first half, with better-than-expected organic growth of 24% to $242 million (£159 million) despite tough comparables.

Bosses are so confident they've upgraded guidance for the full-year from mid-teens to up-to 20%, and now think growth in cash profit will "slightly exceed" previous guidance of 21.3% for the 12 months.

Costs of $17.6 million relating to its IPO in July dragged the group into a £13.4 million loss in the first half. Deutsche Bank is certainly "comfortable" with the performance. Reported revenue rose 9% on the year to $234 million, and management still targets a dividend worth 20% of free cash flow, with an interim payout of 0.7 US cents per share.

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Clearly happy with its software, the average contract length in the year to September has remained consistent at 27.9 months. The group confirmed the release of its new XG Firewall product to unify its UTM and Cyberoam lines, which is the first step in driving synergies across endpoint and network security.

"We think SOPH’s midmarket focus makes it more likely to be able to deliver on this vision than enterprise-focused peers in the security market," said Deutsche Bank analyst Alex Trout.  "Following recent wobbles from some peers, SOPH’s overachievement in the first half is highly encouraging, and we reiterate our Buy recommendation."

It's been a tough week for the market and none of the FTSE 350 constituents has broken away from the pack. Sophos is one of the top gainers, however, not far behind scandal-hit TalkTalk, which managed to ease investor concerns over the impact of its recent cyber-attack; a £30-35 million financial hit is expected and there has been limited churn so far.

Sophos has had a promising first five months on the market, rising 20% to 269p and outperforming the FTSE 350 since floating at 225p in June. In all fairness, the shares have yo-yoed, surging by a quarter to 285p in mid-August before the wider market downturn unwound these gains. The shares are up 20% to 269p since October, and trade on 19 times forward earnings.

Although renewal rates, technology changes and acquisition integration pose their risks, the main challenge Sophos faces is the decline in sector valuations, warns Numis analyst David Toms. 

"In isolation we think our previous target multiple of 20x CY17 FCF for Sophos looks reasonable particularly given the H1 outperformance, but set against sector peers it looks exposed," he says. "In light of this we pull our target multiple back to 18x (still a sector premium, in recognition of the strong business momentum) and move to "Hold".

"The key risks we see are renewal rates, technology change/product cycles, and integration of past and possible future acquisitions."

The analyst has a more conservative 275p target price compared to Deutsche Bank’s 300p valuation.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.