Company Spotlight: 'Choose well and the technology sector may reap some reward'

Many technology shares have been on a roll since March amid growing hopes of a revival in capital spending after a three-year recession, the worst ever in the computer industry. But recent profits by investors has taken off some froth, providing a second chance to pick up well established and financially secure software businesses at reasonable prices.

Two companies worth considering are Axon Group and RoyalBlue, with market values of about £150m and £60m respectively. Neither company's share price can be described as a bargain. But the industry's brightening outlook, together with their strong market positions, means the shares do not look too dear on a two-year view. Axon and RoyalBlue are also well placed to benefit from an upturn in the industry.

Axon is one of Britain's leading software consultants, specialising in installing IT systems based on technology from the German giant, SAP. About a quarter of Axon's business emanates from the public sector, which is immune to economic climate. Even so, the past two years have been tough; many clients turned off spending on big projects as profits came under pressure.

But now the pendulum is swinging back in favour of the IT market. Although the signs of an upturn are getting stronger, the most compelling evidence comes from major software companies, including SAP. They have painted an encouraging trading picture and SAP has highlighted the UK as one of the most promising in Europe.

Next week, Axon will provide more clues when it reports first-half results to 30 June. In May, it said that trading had been in line with forecast. Since then, it is believed to have reduced the number of consultants on short-term contracts, a sign that it is becoming more confident. As a result, expectations are building up in the City that Axon's figures will be accompanied by an upbeat trading statement.

Such a move is likely to prompt analysts to upgrade their profit forecasts for Axon. On current estimates, it is expected to make taxable profits of about £5m in 2003, rising to about £5.7m next year. That values the shares at about 20 times expected earnings this year, dropping to about 14 times for next. This is not too demanding for a group that boasts a strong balance sheet with £16m cash, and that is likely to continue growing as the business generates surpluses each year.

Whereas Axon's expertise is based on implementing SAP's technology, RoyalBlue sells its own proprietary system to stockbrokers and investment banks. Its main product, Fidessa, is an equity trading and automated order-processing platform. It is designed to dovetail with leading stock markets and already boasts a blue-chip customer base.

The group has demonstrated its quality during the bear market with impressive financial results last year. Taxable profits, before one-off factors, rose 6 per cent to £8.9m on a 1 per cent advance in group revenues to £57m for the year ended 31 December. Its resilience was amply reflected by strong cash generation. Free cash-flow, even after paying the dividend, topped £10m last year and helped to almost double the group's net cash balances to £23m.

The first half of this year was again a slog, forcing the group to warn that full-year profits would be slightly lower this year. One reason is that consultancy fees are weakening as some customers rent its technology, instead of buying it.

But with equity markets now in better shape, overall demand is likely to improve. Last week the group received a major boost by signing up the US investment bank Merrill Lynch for a $24m (£15.1m) contract. Part of the deal involves the adoption of Fidessa by Merrill in its US offices. This is a strong endorsement of RoyalBlue's product by a major US customer and should help open up new opportunities. Merrill seems to understand the wider implications of its contract for RoyalBlue's prospects, as it has taken up an option to buy 600,000 RoyalBlue shares at 550p, a 10 per cent premium to the prevailing share price.

Given its record and potential, RB's shares look attractive for the long term, even though they have more than doubled in the past year. For now, analysts expect the group to make £8.4m profits this year, rising to £8.8m next year. But these estimates could prove to be a tad low.

The shares are valued at about 22 times 2004 earnings, after excluding its cash pile. They are fully valued in the short term, but take advantage of any dip to build a stake.

Neil Thapar is equity strategist at the stockbroker Durlacher