Description

PM's Summary:
In this market it is hard to find high quality companies that compound value at more than 20% per year, while trading at a cheap price. We believe Axway Software S.A. is such an opportunity and as such should be on investors' top list of potential investments.
Axway is a story of a business that has gone through transformation and is now growing again with clear evidence of acceleration in its trajectory. Over the next 5 years we see AXW growing revenues at 8% organically, expanding operating margins and generating 14% EBIT compounded annual growth rate (“cagr”).
Axway is cheap relative its quality and compounding potential as it currently trades for only 1.5x forward revenues and less than 3x recurring revenues. AXW also trades for just 13.0x forward PE and FCF yield of ~8%.
The combination of EBIT cagr of 14% plus dividend payments and accretive M&A will produce about 22% normalized earnings compounding for shareholders before multiple expansion. As AXW's compounding rate accelerates, multiple expansion will follow towards high-teens PE and total IRR on the investment should exceed 30% within 2-3 years.

Background:
Axway Software S.A. ("AXW") provides middleware solutions that deal with data interchange and operability. The company's specific niches of operations are MFT (Managed File Transfer), API Management (Application Protocol Interface Management) and OI (Operations Intelligence). All these domains of expertise revolve around helping companies move data inside the organization and mostly sharing data with outsiders, including customers, suppliers and partners. Products allow users to control how data flows in and out of the organization, in what format, to which authorized users and importantly also ensures that partners do not expose data to 3rd parties without prior authorization.
AXW's core business is MFT, which is a mature space growing at about 2-3% per year; the most classic use of MFT is for EDI, or Electronic Data Interchange between supply-chain providers (i.e. the IT process that a company such as Walmart applies to share information with its supply base). AXW is a top provider in MFT and is known for its robust systems and highly secure solutions. AXW consistently ranks as a top quadrant supplier of MFT by all the IT research companies. In this space, it competes with the likes of IBM and CA.
API Management is the new way of sharing data between organizations and was developed for internet applications and mobile apps. This is a rapidly growing space, expanding at >30% clip and is the main source of growth for AXW at the product level. Operations Intelligence is another field of growth that revolves more around big-data and how to harness the data that flows inside the organization and outside of it for insights. This is a space growing in the teens.
AXW began life as a division that developed tools and solutions for MFT inside Sopra Steria (SOP.FR), the French IT system integrator and consulting firm. As demand for MFT grew rapidly, Sopra spun off AXW into an independent public entity on June 2011. Sopra Steria currently holds 45% of the B shares and has effective control on the Vote. While this does limit liquidity, one can typically source about e1mm of daily volume in AXW from the open market, dark pools and OTC.

Business Model and Mix:
AXW look like a typical enterprise software provider. It sells new licenses mostly on 5-year term licenses, collects maintenance fees that make up 20% of the original deal price and charges fees for implementation and services. The company also has a small but rapidly growing Cloud business.
FY 2015 Revenue Mix:
% of Sales
License 28%
Maintenance 49%
Cloud (under Services) 3%
Services - Implementations 20%

Total Revenues: e284.6mm
Operating Income e44.5mm / 15.6% margin

Regionally the company is still European focused by the USA makes up ~40% of sales and is the fastest growing area
FY 2015 Regional Split:
% France 33%
% Rest of Europe 23%
% Americas 39%
% ROW 5%


Past performance:

Years 2011 and prior:
During the previous decade, AXW grew robustly on the back of strong demand for MFT solutions; toward the end of the decade demand starts to decelerate as penetration peaked. This led to deceleration in growth from double digit to high-single-digits levels previously, towards mid-single-digits. Recognizing that that the core market was maturing, the company initiated a new strategic plan.

Years 2012 to 2014:
From 2012 to 2014, AXW's strategy focused on transforming the company on two levels: Product and Geography. At the product level the company understood it needed to generate new sources of growth in addition to the maturing MFT market (which AXW calls "Foundation"), towards growth in API Management and Cloud based domain (which AXW names "Digital"). At the geographical level, the company realized that it needed to expand its reach beyond the core French and European market and launched an expansion plan in the USA. This strategy yielded the following shift in mix:

License Revenue Mix:
2013 2015
Foundation 100% 60%
Digital 0% 40%
License Revenue Organic CAGR 3%

Regional Revenue Mix:
2013 2015
France 35% 33%
Rest of Europe 24% 23%
North America 38% 39%
Rest of World 3% 5%
Total Revenue CAGR (organic) (4%)
As evident from the results above, AXW succeeded in shifting its product mix towards Digital but overall license sales grew at a meager 3% cagr. At the regional level, AXW failed to build meaningful incremental scale in the USA as revenues in that region grew at only mid-single-digits. Overall company sales performance was weak, with organic contraction of 4% cagr. Disappointed with the weak growth rates, AXW's main shareholder, Sopra Steria, ousted the CEO in the middle of 2015 and brought in Mr. Jean-Marc Lazzari as the company's new leader.

Year 2015 – new CEO and new strategy:
After examining AXW, Mr. Lazzari realized three things: A. that AXW's Digital offering was in good shape but needed some tweaking for the North American market, and that AXW Digital products combined with the core MFT offering held strong competitive standing with existing customers and enterprises that wanted to expose legacy data system to 3rd parties, B. that AXW was still a French company that wasn’t committed fully to the USA, and C. that AXW was spending too much focus on Services and Implementations (as a result of its legacy as a division within Sopra Steria) which was dragging down both growth and margins.
To address the problems in the USA, the CEO cut about half the sales people in North America and replaced the old guard with local American talent, and brought in a former IBM executive to lead the team; he also spent R&D to adjust the product to fit the USA market more tightly. The CEO moved the company's HQ and himself to the USA including major R&D functions and support staff, thereby signaling to customers that AXW was a USA focused company and “here to stay for them”. To fix the service and implementation part of the business, Mr. Lazzari decided to shift work away from internal service people to 3rd party system integrators, thereby freeing up resources and focusing AXW as a technology and product company, rather than a service provider.
After spending about a year improving AXW's position, the CEO was confidant in the company's trajectory and introduced a plan to double the size of the business by 2018 and expand operating margin to 20% (from 15.5% in 2015)

Year 2016 – clear signs of traction
So far in 2016 we can see clear signs that AXW has turned the corner and is benefiting from acceleration in growth on several fronts:

A. In the all-important North American market, the change in the sales force, and the full commitment of the organization to the region (i.e. moving HQ and R&D), resulted in 17% yoy organic growth ytd. This represents acceleration from 3% growth in the corresponding period in 2015 and negative growth in 2014. Going forward management sees north America growing 20% per year over the medium-term. Importantly, our research indicates that AXW’s offering in North America is being very well received as customers welcome the option to work with an agile provider that is not part of the large enterprise software providers (i.e. IBM/CA), yet not too small to be an ‘unsafe’ bet as a supplier of operationally critical software.

B. Digital license sales have grown 67% yoy organically and management expects 20-30% growth going forward. In this regard, we note that all the research firms such as Gartner and the likes foresee >30% growth for this space and Google’s recent acquisition of Apigee (a direct competitor of AXW in API Management) is an indication of the demand for software tools that allow companies to expose business functions to 3rd parties as well as to customers (via mobile Apps that link to internal data in the organization)

C. Company margins expanded 190bps yoy and operating income is up 28% yoy; management sees room for another 200bps of margin improvement just from cost savings and continued shift of implementation work out to the partner channel.

Outlook 2018 and beyond:
We believe that management has taken the logical steps to drive sustained growth and margin expansion of the business. With the USA region is growing 15-20% yoy and the Digital offering is expanding at 40% per year, we see the overall revenue base expanding by 8% in total (as maintenance revenue growth drags down overall growth rates). Management plans to acquire an additional e150mm of revenues, which will allow AXW to reach total sales of about 515mm by 2018 and operating income of 20%, or e105mm. Since there is no effective net debt, and the tax rate is 20%, this translates to EPS of e4/shr in 2018.

AXW deserves a multiple of 17 times forward PE on 2018. Usually companies such as AXW that have 60% recurring revenues (by 2018) with 90-95% retention rates, and are growing license revenues at 8% deserve to trade for 24-25x forward PE. Given the relatively illiquid base of the shares and Sopra Steria's control of the vote, we see a 30% discount as reasonable, but possibly a bit too punitive. Our sanity check for this multiple is also the implied revenue to recurring multiple of just 3x and an EBITDA multiple of 11.5x our forward estimate for 2018, which appear modest and conservative.
The math above implies a target price of e68/share for AXW by 2018. This compares to the current stock price of only e27.5/shr today, or an IRR of 55% in about 2 years. This type of IRR for a high-quality business such as AXW's is outstanding in a normal market, but in this market environment it is unique.

Risks and Downside
Competition: in the legacy Foundation business, AXW competes mainly with IBM, CA, TIBCO and Informatica. The competitive environment in this space has been stable and rationale. We do not see major risk on this front. However, in the newer Digital space, and particularly around API management, AXW competes with Apigee (recently acquired by Google for 5x revenues), Mashery and Mulesoft. These are younger players, which approach the market from a pure internet and mobile oriented architecture. Their strength of offering is around agility and quick deployment times and as such they can win share with smaller technology companies but also at departmental levels of larger enterprises. AXW's strength on the other hand is based on its ability to offer API management that integrates securely with legacy enterprise systems (often where AXW already has been deployed), but that require larger enterprise scale solutions, albeit that take longer to implement. We see the market as large enough for both types of players, but recognize that eventually growth will slow and AXW will compete ahead-to-ahead with the smaller players. Likely it will acquire one of these providers or be acquired by one of the bigger players altogether.

French market: AXW hold about 50% of the market in France, due to its legacy presence and the strong connection to Sopra Steria (which is a leading system integrator in that country). In France AXW is growing on the Digital front but the Foundation business is mature and effectively under attack by new entrants targeting share (mainly CA). Our channel checks indicate that AXW's standing within existing customers is extremely strong and customers will not switch MFT solutions to new providers. However, should AXW lose share in France, we think any loss will be more than offset by growth outside of France. At an entry, multiple of 1.5x revenues on 2017 and 13x PE on 2017e our downside is therefore quite limited.

disclaimer: our firm owns a position in AXW

Catalyst

- Further acceleration in organic growth and margin expansion leads to multiple expansion
- Potential acquisition by a larger software provider (such as CA or Software AG)