Description

Recommend buying shares of Adesso SE (ADN1 GY) with a target price of €260, offering ~30% 12-month upside in a cheap (~11x ’22 EV/EBITDA) fast growth digitization winner which has several catalysts driving continued better than expected profit growth.

Adesso is a Top 10 German IT consultant with an expertise in developing industry specific software that helps to facilitate its customers’ “core” processes. While its lumped in with more traditional IT consultants (~10x EV/EBITDA), its higher value bespoke consulting work is more akin to Accenture (~18x EV/EBITDA) and its IT Solution products are similar to that of higher valued vertical market software (VMS) providers, which typically trade at 20-25x EV/EBITDA.

Over the past decade Adesso has successfully developed deep knowledge in several industries and has created standardized software solutions for the insurance, banking, and healthcare industries by leveraging this knowledge as well as it technological expertise. By combining high quality IT consulting services with its strong software development capabilities this has allowed Adesso to garner sustainable competitive advantages and become a leading IT player in Germany. Moreover, its business model promotes substantial growth driven by strategic relationships and enduring client proximity.

The Company was founded in 1997 and it has realized a >20% revenue growth CAGRs since inception. While its Founders have installed experienced managers, they still own ~45% of shares and remain deeply involved. Currently ~85% of revenues come from Germany with the rest of revenue coming from Europe. ~80% of revenues come from traditional IT Services, while ~20% of revs from proprietary IT Solutions.

Adesso targets growing 2x its TAM’s growth (>10% organic) and Adj EBITA margins of 11-13%, but it has handily outperformed its targets and remains extremely conservative with guidance. Its strong reputation for its digital solutions has driven consistent organic growth of 15-20% over the last 5 years (4x German mkt) and margins have expanded by 50-100bps each year (now ~12.5% vs. 8% five years ago).

Misleading 2022 Consensus Set to Re-set Higher

Bloomberg # are incorrect as they don’t adjust for an €18mn 1x EBITDA gain in 2021 and therefore it looks like ’22 revenues/EBITDA will be +14% y/y/ -4% y/y. Therefore, an uninformed investor sees EBITDA declines in ’22, and moves on, but this won’t be the case. Even on an adjusted basis, consensus ’22 only expects rev/EBITDA growth of +14%/+12%. However, I believe revenues will grow >20% and EBITDA to expand by >25%, or nearly 2x consensus growth rates.

Management consistently sets conservative FY targets and then boosts its targets a few times a years. In 2021, Adesso originally forecasted ~€600mn revenues and €72mn Adj EBITDA. However, this forecast was adjusted higher several times. On 2/13, Adesso preannounced that 2021 revs would be ~€677mn, or ~10% better than originally expected, while Adj EBITDA came in at >84mn, ~17% higher than its original forecast. In all, FY ’21 revenues/Adj EBITDA grew +29%/+39% y/y and they accelerated throughout the year. Q4 2021 was its strongest with Revs/EBITDA +29%/+56% y/y as strength in its high margin software business, in|sure Ecosphere, as well as success at recently acquired assets are helping to acc’l growth and drive margin expansion.

Beneficiary of Accelerating Digitalization in Germany

Adesso has been a leading digitalization player in Germany as its benefitted from rising IT complexity and a shortage of skills which has led to more investments in digital solutions. Also, mgmt confirmed that demand for its digitalization solutions has accelerated as a result of the pandemic and the reshaping of business processes and client relationships. This is a trend that is also playing out in most developed markets and industries.

However, the tailwinds in Germany are even stronger and more sustainable as they have been a severe laggard in regard to digitalization. The country now has new Chancellor, Olaf Scholz, who replaced Merkel after 16 yrs in power, and new leadership has pinpointed closing the digitalization gap vs. its peer EU countries as a key strategic priority and the nation will see substantial resources dedicated to this initiative.

On top of this there are significant ECB Stimulus funds (>$50bn) which have been earmarked for EU Digitalization projects. The budgets were allocated on a first come, first serve basis and Germany (and Greece) have emerged as outsized winners of these stimulus funds which should help bolster German IT spending over the next few years.

Given the accelerating demand for digitalization of business processes across various verticals, I think there is limited evidence that points to a material slowdown in 2022 like consensus currently expects.

Clear Growth Drivers Supporting >15% Organic Growth

Despite Adesso’s recent success, the company is not resting on its laurels. Unlike most European technology companies, Adesso has made it clear that growth is always its main objective. In fact, employees across its ranks have very specific comp plans tied to revenue and EBIT contribution growth targets and they don’t receive bonuses unless their targets are hit. On top of Germany’s accelerating digitalization agenda there several company specific catalysts where I don’t believe consensus is giving Adesso credit. This includes its maiden banking software wins, expansion of industry specific verticals in ‘22, geographical expansion and an increased focus on M&A.

Maiden Banking Software Wins

Starting in the 1990s, Adesso realized to stand out in an otherwise competitive IT industry, it needed to provide a unique and compelling value proposition and they set out to develop its first IT solutions (software) for the insurance industry. Its core insurance industry product, in|sure, is a software suite which is used by its insurance clients to handle different tasks and workflows specific to the German insurance industry. Over ~10 years Adesso has acquired a very significant skill set to serve this industry with unique IT and software solutions. This has driven steady share gains. Currently ~90% of its IT Solutions revenues are tied to its insurance product, but Adesso set out several years ago to replicate its insurance success and grow its TAM by creating a bank specific software product.

After deep due diligence and analysis, Adesso decided to partner with an existing player given the high cost and time required to develop a product for the extremely complex German financial/regulatory system. In Summer 2020, Adesso create a 50/50 JV exclusively for Germany with Asseco (Poland), where they would just adapt Asseco’s existing product, currently being used by ~100 Polish banks, for the German market. Several months ago, Adesso disclosed it was in “active dialogue” with 10-15 banks in Germany and demand was high. Current software used by banks is said to be very old, rigid, and outdated. Adesso is on the verge of cracking the bank software market and I expect them to announce their first high margin banking software license win in early 2022. This would be very supportive for the stock as it would expand its software TAM and provide support for continued high growth rates in its high-quality IT Solutions segment.

Expansion of Industry Specific Verticals

Adesso combines industry-specific and technological expertise to addresses its clients' core business processes. The company is set up by industry verticals which allows them to become industry experts as they partner with industry operators. This benefits its core business process solutions and it is critical to driving growth. By becoming industry experts this allows Adesso to win an outsized share of IT projects where they can then cross sell its own software solutions.

Adesso’s main objective is to grow fast. They support the evidence that smaller entities grow faster than larger ones and they have used this belief to augment its growth. Every 2-3 years, Adesso will take a specific industry from its catch all “Cross Industries” and roll out a new industry group. Once an industry reaches critical mass, they are given their own independence. The new entities are then led by its own entrepreneurs with comp tied to its own growth targets.

In 2017-2018, this lead ot the development of its Automotive division. This was followed by Transport & Manufacturing BUs in 2019. The plan appears to be working and its newest verticals showed some of the strongest growth in 2021. In 2022, after a 3-year pause, Adesso will create two new BUs (Utilities & Retail). Adesso explains that these BUs already have large backlogs and teams in place to accelerate their growth in 2022.

Internationalization & Incremental M&A

To augment its organic growth, Adesso is also looking to accelerate its Internationalization, and growth outside of Germany. Starting in 2017, Adesso began to expand into nearby geographies with a preference for E. EU markets which are nascent and less competitive. Thus far, international markets have been strong contributors but expansion was slowed by covid and they will look to re-focus energy as covid restrictions are lifted. Recently the company has established subsidiaries in Italy.

Lastly, Adesso has net cash and its looking to accelerate its growth via bolt-on M&A, which is a newer growth addition. While Adesso has grown mostly via organic, they are targeting new international markets, new verticals as well as the expansion of its technology portfolio via capital allocation. In Oct 2021, Adesso raised ~€50mn in a secondary at ~€160 in order to facilitate M&A given their robust pipeline. Adesso also recently created a new M&A department headed by its former CEO of 15 years, who recently returned after spending >2 years in PE. Adesso is extremely disciplined and looking to pay 6-8x EV/EBITDA for private assets that can drive incremental growth acceleration in the coming years.

Margins Expansion Sustainable

On top of its consistent ~20% organic growth, Adesso has expanded margins each of the last 5 years. Consensus is pessimistic on 2022 margins and believes EBITA margins will contract, but I believe the journey will continue in 2022.

Adesso’s largest cost is labor (>65% of revs) and while wage inflation and labor availability is a challenge for most its peers in the IT services industry, Adesso is very well positioned. Its margins are mostly tied to utilization (daily rates, productivity) and Adesso sees tremendous demand for its products and this has allowed them to take price in excess of their 3-5% wage growth. Moreover, Adesso is a coveted firm in Germany and they oftentimes are mentioned as one of the best employers in the country. There drives extremely strong demand for seats and Adesso typically receives >40,000 applications each year for ~1,000 new hires.

Mgmt is actively taking price at new projects as wage growth rises from +LSD to +MSD and they should see some short-term cost pressure as selling/travel costs normalize, but operating costs will remain sustainably lower. Instead of sending its employees to sit on site 4 days/week Adesso is embracing more remote access and collaboration.

Another potential margin driver is offshoring of its labor. In regard to offshoring, Adesso has a much lower penetration vs peers as most of its work is extremely technical and white collar. While they have built up Turkey and Bulgaria as nearshoring growth venues and these should continue to grow, longer term they will seek offshoring growth in Asia

Knowledge Gap Closing

Despite Adesso’s success, I believe we are reaching an inflection point where the knowledge gap around the name will close and its valuation should re-rate higher. Its market cap is now $1.5bn and its daily liquidity is rising. In 2021, Adesso coverage expanded from two to four as Berenberg and Kepler, two leading European sell-side research providers picked up coverage. In addition, the company announced that its ~5% secondary offering was partly done to increase liquidity and institutional ownership in its shares.

Currently, Adesso is valued like commoditized IT consultants (trading at ~10-11x EBITDA), but it’s not the same animal. Its hybrid IT solutions and software approach is driving much faster growth and its high value proposition is highlighted by the fact that its average revenue/employee is >2x its commoditized IT consultant peers. Moreover, as its insurance and banking software businesses scale this should help to support sustainably higher valuation. Inevitably, I think Adesso will be recognized not only as a successful IT consultant, but also a fast growth software provider.

Catalyst

Maiden software liscense wins, Germany Digitalization Acceleration, Accretive M&A, Increased sell-side coverage and continued beats and raises