Description

CentralNic is a quality tech/ platform business with 90-100% recurring/ subscription-based revenues and >20% returns on invested capital (we think it should normalise out at 23-25%). Yet it trades on a pro-forma EV/ Sales c1.2x and EV/ EBITDA c7x and only 6.7x consensus 2020 EBITDA. We think that this is far too cheap and the rating ought to at least double if not triple pending a number of near term catalysts, independent of growth.

BRIEF DESCRIPTION

“CNIC is the developer and operator of software platforms providing web presence services to customers in almost every country in the world. CentralNic is a leading provider of tools required to create websites, use email, and secure business online. The Group generates revenue and income from the worldwide sale of internet domain names and hosting on an annual subscription basis.” A well-known equivalent would be GoDaddy in the US. CNIC focuses more on emerging markets, outside of the established presence of much larger competitors.

In 2016 CNIC sought to wind down its premium domain name sales business which generated high margins and profits but ultimately lowered the recurring nature of its revenues. It then undertook a series of acquisitions (equity and debt funded) to drive scale in its recurring revenue/ subscription-based services. The business last reported 90% recurring revenues although our conversation with management recently indicated this is now running at almost 100%.

As we outline in the valuation section, the business is now at significant scale with around $122m of pro-forma revenue and $19m of pro-forma EBITDA with a market cap of £86m and an EV of £110m. We think this is too cheap.

WHY SO CHEAP?

Woodford effect: we understand that the Woodford effect is dragging on several small cap managers. Either through fund outflows forcing sales to raise cash and/ or through managers aiming to move out of less liquid holdings. In CNICs case, we think there have been 2-3 forced sellers of size which has slammed the price. This is a temporary issue.

Debt: the company recently took on a 50mEUR bond to fund three acquisitions and pay down their existing facility. The bond has further headroom to 70mEUR. We think that the headline interest 7% spooked some investors, along with the quantum. For a first-time bond issue and given the (small) scale of the business, this seems a reasonable cost. And it was oversubscribed. We think that the recurring revenue model supports the debt fine and interest payments are less than 1/3 of FCF. UK investors are incredibly risk-off re. debt currently which makes sense with some models, but not CNIC, in our view.

Organic growth: organic growth is low in the underlying business around 6%. We aren’t overly concerned as the rating is dirt cheap and there are free options on new growth initiatives at this price. The ability to grow inorganically is also plentiful and now the business is at a critical mass in FCF terms (and with a further 20m headroom on the bond) we think there ought not to be any further dilutive growth required to continue to scale.

P&L understates cash earnings: the interim and full year results hide several P&L non-cash charges which drive significantly depressed operating profits and loss before tax. Yet underlying operating cash flow is positive, inline with EBITDA. Depending on your take on the lumpy working cap, EBITDA cash conversion is c100%, despite EPS losses. Amortisation is a material part of the P&L - $5.6m in the full year and $3.6m in the half year, which plays EBITDA of $9.1m and 9.2m, respectively. The other significant non-cash operating movement is in finance costs in the half year – a $3.2m reappraisal of deferred consideration on the KeyDrive acquisition. Effectively, due to that business exceeding its earn-out targets. The deferred consideration majority is paid in shares so whilst an economic cost to shareholders it is not a cash cost. Regardless, it drops an operating profit of $2.4m down to a pre-tax loss of -$1.6m and drives negative EPS. Meanwhile net cash from operating activities adding back a one-off working capital movement (we come onto that) was +$5.9m. See explanation below for why this is not an issue, in our view. The final non-recurring and significant element which depressed P&L earnings is in the full year was $5.8m of “non-core operating expenses” – i.e. excepetionals. The business regularly posts around $2m of exceptional costs, so we view the $2.8m balance as being truly exceptional and is mostly related to the large KeyDrive reverse acquisition which is one-off – we don’t see another happening of that scale. We are valuing the business in a steady state + low organic growth with the inorganic growth as an option, so we write off a further $1m as acquisition related exceptionals and assume $1m is recurring as restructuring related which we will assume is ongoing.

Working capital: working capital is not a drain on this model, customers pay in advance. There is a consistent large negative working capital position which we like as the business is self-funding. That being said, the KeyDrive reverse resulted in a very positive/ negative working capital movement in full year 2018 and 1h 2019, respectively. Despite being flagged at the full year – which saw a $7.8m w/c inflow – we think the market viewed the subsequent reversal of $6.5m in the following period as a significant risk and change in the model. We view the business as w/c neutral for our assumptions despite a positive cash collection cycle.

Margin decline: value screening will not uncover CNIC due to the one-offs above. A quality screen is also unlikely to uncover it as margins have declined materially in recent years. EBITDA margin has reduced from 25-30% to around 15%. This is due to management phasing out their “premium domain sales” business which was historically a material contributor to earnings and highly margin accretive. Our understanding is that prior to the KeyDrive reverse, shareholders explained to management that they would be more receptive of a recurring revenue model. Premium domain sales, while lucrative, were not recurring in nature. In our view, as the recurring business was sub-scale, these were a necessity to generate cash. However, with around $19m of recurring EBITDA (pro-forma) this is no longer a requirement. Happily, the business retains $3.9m of premium domain ‘inventory’ which may be disposed at any time for a one-off profit. Management’s intention is to do so at a time when the recurring revenue base is well demonstrated to investors.

Management: management and the board are a bit love or hate and we think that some execs may to too slick for more traditional city folk. However, we can get over than for the screaming valuation. The board is atypical at first glance with lawyers, bankers and investors. Though a closer read of the CVs and piecing together with referencing it begins to make sense. We dislike the CEOs lack of skin in the game (all options), though other insiders are material holders with over 30% of the equity. We think the city shares our view. 

VALUATION

We present several scenarios based on steady state earnings. We view any growth as a free option given the price + quality, though there are multiple initiatives to drive organic and inorganic growth. We do not view the catalyst in this instance as growth. We think that structural problems and misunderstanding have driven the pricing anomaly. Upon full year results we expect a cleaner and clearer picture of recurring P&L and cash, and certainly in 12 months-time with a full contribution from recent acquisitions, full pro-forma earnings will be evidenced and the stock ought to rerate on that alone.

It’s worth mentioning that “management is confident that the full yes result should be around the top end of the current range of analyst forecasts” as stated at the September interims (ie. c$138m revenue/ c$21m EBITDA)

Firstly, we build up pro-forma earnings:

FY 2017: Revenue $24.3m/ management EBITDA $6.6m

Add acquisitions:

SK-NIC: Revenue $4/ EBITDA $2.9m

KeyDrive: Revenue $58m/ EBITDA $5.9m

TPP: Revenue $12m/ EBITDA $2.7m

Hexonet: Revenue $19.4m/ EBITDA $0.9m

Ideegeo: Revenue $4.1/ EBITDA $0.6m

Total pro-forma: Revenue $122m/ EBITDA $19.6m

>implies 16% EBITDA margin

This is a bit rough and ready for the sake of this write up as the company doesn’t split out more decent underlying revenue and EBITDA so we have to go back to 2017. However we think it errs on the side of prudence. Management state pro-forma revenue of $130m @ 15% EBITDA margin = $19.5m. Market numbers with the first full year of contributions from the recent three acquisitions is $138.5/ $21.2m – this includes a bit of growth.

We take $19.6m and deduct $1m of non-exceptional operating costs from mgmt. expectations. We drop it through at 100% (remember w/c is positive) to operating cash flow and deduct cash interest on the bonds of $3.9m assume a cash tax cost of $3.8m. We arrive at net operating cash flow of $10.9m. Maintenance capex of around $0.5m gives us FCF of $10.4m under a no-growth scenario. This equates to >10% FCF yield versus an average market FCF yield of 6%. Businesses of this quality in our space typically have a FCF yield of 5% or lower.

RERATING

CentralNic is a quality business with 90-100% recurring/ subscription-based revenues and >20% returns on invested capital (we think it should normalise out at 23-25%). Yet it trades on a pro-forma EV/ EBITDA on only c7x and only c6.2x market 2020e which includes modest growth. We think that this is far too cheap and the rating ought to at least double to triple pending a number of near term catalysts (see below). Importantly for us – this rating is also supported by a bombed our FCF yield.

Historically, the business has traded between 12-15x EV/ EBITDA – this would imply a 76-120% return to our most prudent pro-forma view (supported by a rerating of the same magnitude on a FCF yield metric). On market numbers with some growth, we see upside of 96-145%. We would expect a rerating to at least this level based on:

a) Structural issues in the UK small cap market easing

b) Demonstration of the recurring revenues and pro-forma EBITDA dropping through

c) Demonstration of the flat working capital over a reporting period

d) Tidying up of the P&L exceptionals and other non-cash elements (although amortisation will continue to be a drag on EPS

e) Stabilising margin in line with management comments

None of these catalysts are based on growth, and while we do expect some growth, it is not a central part to our rerating thesis which should be delivered regardless, and in the near term – full year results Dec and half years in June (reporting May and Sep, respectively) so these price targets are <12 months.

Their peer group, while hard to identify on the same scale, trades around 18-22x. Mostly larger businesses. There is a good amount of consolidation from trade buyers and PE outfits throwing money at these roll ups. We think that when CNIC demonstrates around $20m of EBITDA it will be large enough to warrant attention from these types of buyers.

Management incentives kick in at 120p, almost 3x higher than the current share price.

There is an additional c$1m of synergies management expect to generate from their most recent acquisitions which we haven’t incorporated.

WHAT ARE THE (GROWTH) OPTIONS?

Organic: management state a 6% underlying growth rate. It’s difficult to pick this out from the reported results given the rate of acquisitions and the changing model. Frustratingly, they don’t give enough detail to do so, one of our bug bears which hopefully management will address going forwards. At the current valuation we think growth is a free option, but you can back out a valuation from our pro-forma numbers. In any case, the business degears completely over 4 years.

Following the recent three acquisitions, CNIC has taken in some expertise in bolt-on cloud-based services such as AWS. This is a new growth channel from a low base, but the margins are typically 50%+ and would be highly accretive. Too early to put any numbers around this for us, but we think management will give more flavour in next results. Crudely, could be mid-single figure million $. 

Inorganic: probably a more exciting prospect for most. Acquisitions have historically been completed around 6x EBITDA. We’ll assume 7x for our workings. They have an additional 20mEUR headroom on current bond facility – that could acquire $3m of EBITDA and would incur a further $1.5m of interest. After tax contribution to FCF would be in the region of $1-1.2m on a business already generating $10m+ of FCF which itself can drive further inorganic growth.

Domain sales: the business retains around $3.8m of premium domain name inventory. This historically generated EBITDA margins of 40-50%. A one-off profit.

RISKS

Besides the obvious market risks, the small business division which is 30% of revenues may be more susceptible to cyclicality.

CATALYSTS

As above – prove pro-forma revenues and earnings and UK sentiment restores somewhat. Demonstrate other material parts of the model which have been in flux.

Catalyst

As above – prove pro-forma revenues and earnings and UK sentiment restores somewhat. Demonstrate other material parts of the model which have been in flux.