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Spare a thought for listed information technology companies. Cash-strapped Federal and State governments have cut IT spending and corporates have deferred more projects. A sluggish IT investment cycle in the past few years has weighed on technology service companies.

No immediate improvement seems likely, judging by comments in the latest profit-reporting period. Data#3 and other small listed technology companies said demand this year would be similar to 2012: flat, as chief information officers delayed projects and as State governments shed costs.

The Queensland government has put a chainsaw through public-sector spending and the New South Wales and Victorian governments are understood to have deferred some technology projects. The flow and timing of project tenders is slow and there is pressure to lower technology service prices.

In its latest profit report, Data#3 said 60 per cent of projects it had tendered for were still undecided in the December half. That reduces earnings visibility and makes it harder for companies to provide forward guidance. Understandably, Data#3 did not provide earnings guidance for its second half.

But even the most stubborn industry cycles eventually turn. The good news for technology service providers is that Federal and State governments, and many corporates, will have to play serious catch-up on their technology investment after cutting back during the Global Financial Crisis (GFC).

For all the challenges, Australia has some terrific technology service companies.  Technology One, SMS Management & Technology, DWS and Data#3 are among the market’s higher-quality small- and mid-cap stocks. Oakton is another technology provider.

Technology service stocks can be terrific investments. Being mostly people businesses, they usually require less fixed investment and produce higher rates of return on equity than most similar-sized small stocks. They often grow without having to load up on debt or engage in excessive share issuance that dilutes the share price.

Technology One, for example, has an average 10-year total shareholder return (assuming dividend reinvestment) of 27.5 per cent. Data#3 has returned an annual 37 per cent over that period.  SMX has struggled in the last few years, but still has an average annual 22 per cent return over 10 years.

UXC has starred this year, returning 128 per cent over 12 months as the market re-rates its turnaround prospects, and Technology One is sharply higher. However, Data #3, SMS, Oakton and DWS have underperformed the S&P/ASX 200, which is up 18 per cent over 12 months.

That could be an opportunity for long-term value investors. At some point this year or next, the market could start to price in a turn in the technology investment cycle. A big headwind for the sector will start to look more like a tailwind when companies and governments are forced to upgrade or replace ageing technology systems, or adopt new technologies to stay competitive.

The exact timing of a recovery is anybody’s guess. The technology investment cycle might not turn for few more years if global economic uncertainty remains. But the sharemarket will anticipate a turn well before it happens, and become more confident in a recovery as business confidence improves, companies start to expand again, and as consumer demand eventually lifts.

The resolution of the Federal election in September should provide more certainty to kick-start new technology projects and even State governments will eventually invest more in technology.

I like small-cap companies that can grow in good and bad industry cycles and maintain high rates of return on equity. Investing in beaten-up companies, in anticipation of cyclical improvement, is a high-risk strategy because industries often take longer to turn than expected, or recoveries are weaker.  

Take extra care when investing in companies with cyclical and structural (internal) problems. The last thing you want is a struggling company in a struggling industry – unless it is grossly undervalued.

Data #3 stacks up well on several fronts. A Return On Equity (ROE) above 40 per cent for the last five reporting periods is a stellar effort given the GFC and muted industry conditions. Data#3 has the highest ROE of its peers.

Data#3’s interim profit result looked better than that of its closest competitors. Although disappointing, a 5.1 per cent decline in first-half net profit for 2012-13 was better than several software stocks that reported double-digit profit declines and complained of tough market conditions.

Even so, the market seems in two minds about Data#3. From a 52-week low of 90 cents, it rallied to $1.42, but has since retreated to $1.22. Data #3 traded above $1.50 in early 2011.

With a first-half average cash balance of $50 million, Data#3 looks well placed to grow organically, make acquisitions, and capitalise on stronger demand for technology services in coming years. Better still, it should be able to grow even if industry conditions remain muted, given it has astutely reinvested in the business in the past few years.

A few big contract wins in Queensland and further growth in West Australia (Data#3 won a big healthcare contract there recently) could get the share price moving. With 60 per cent of its tendered work still to be decided, there is healthy pipeline of potential work – and disappointments, if it is loses tenders or work is delayed.  

Click on the links below to read other articles from this week’s newsletter

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18 Share Tips – 25 March 2013

U.S. Vs. China: Battle To Be The Largest Economy In The World

Twelve Reasons Why Globalisation is a Huge Problem

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Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Feb 14, 2013. The author implies no stock recommendations from the above commentary. Readers should do further research or talk to their financial adviser before acting on themes in this article.