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Investing in this small-cap could help you retire with a million

Tax is one of life’s certainties. We have to pay it at some point, and preparing tax returns is big business. Accountancy is a lucrative profession, and in recent years providers of accounting software have also started to reap the benefits as technology makes it easier for companies and individuals to compile their accounts without professional help. 

Sage Group, the FTSE 100 technology company is well-known for its accounting software packages, which have powered the firm’s growth. This high margin business has helped the group grow earnings per share by a third in five years. Over the same period shares in the company have risen 127% excluding dividends. But now there’s a new kid on the block and this small-cap’s ambitions should not be underestimated.

Huge potential 

Tax Systems (LSE: TAX) flies under the radar of most investors due to its small size, although the company has large ambitions. 

With a market capitalisation of just under £70 million, it is engaged in supplying corporation tax software to the corporate sector and the accounting profession. The firm was born when the company, formerly known as Eco City Vehicles, acquired software group Tax Computer Systems Limited last July. Since this initial deal, management has also acquired OSMO Data Technology Limited, a provider of automated data extraction software that connects to 295 versions of accounting packages. 

These two deals have built up the group’s offering for customers and Tax’s potential is already starting to shine through.

For the year ending 31 December 2016, the newly formed group produced revenue of £5.8m and EBITDA of £2.7m. City analysts expect the momentum to continue into this year with revenue of £14.8m predicted and a pre-tax profit of £5m pencilled-in, giving earnings per share of 4.2p. Further growth is expected for 2018 with EPS projected to expand by 13% to 4.8p, giving a forecast 2018 P/E of 15.6.

Uncovered growth? 

I believe these predictions could underestimate the group’s growth.

Tax is a highly cash generative business, producing £3.2m of cash from operations during the second half of 2016. During the same period, the company’s capital spending totalled only £400,000 with tax amounting to the same amount and interest on debt coming in at £300,000. Excluding other movements in debt and acquisitions, for the period the group generated free cash flow of £2.1m. This robust free cash flow gives it plenty of financial headroom, which it can use to increase its marketing spend and invest in technology to attract customers.  As revenue expands, free cash flow should expand with it, giving even more room headroom for fiscally beneficial activities such as debt repayment, dividends, and share buybacks. 

This year, City analysts are expecting its larger peer Sage to report a pre-tax profit of £407m on revenues of £1.7bn, if Tax can capture just 5% of this market, the shares could be a steal at current prices. 

Make money, not mistakes

Tax Systems has huge potential but the company is still in its early stages and has plenty of work to do to achieve steady growth. With this being the case, you should own the stock as part of a well-diversified portfolio, something many investors fail to do and suffer as a result. 

To help you avoid this key mistake, the Motley Fool has put together this free report entitled The Worst Mistakes Investors Make.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Sage Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.