Description

Idea: Epsilon Net S.A.- EPSIL AT

Why Epsilon?

Epsilon Net (EPSIL GR) presents the opportunity to acquire the largest publicly listed software company in Greece. This is a business which I expect will grow organically at double digit rates over the next five years driven by regulatory tailwinds and government/ EU funding as well as increased investment in software by Greek companies to make up for a decade of under-investment. We are partnering with a management team, led by CEO Ioannis Michos, who own 65%+ of the business and who have successfully grown this business over the last two decades both organically and through opportunistic acquisitions to make Epsilon Net (EN) a dominant provider of enterprise software with what is close to a monopoly in HR/ payroll and accounting software and with a strong position in ERP. We can acquire a dominant business with less than 2% customer churn, pricing power and with excellent growth opportunities for c.12x my estimate of 2022 earnings.

I. Introduction:

Epsilon Net was founded in 1999 as the successor to a specialised training company for professionals in the financial field that had been operating since 1992. Epsilon Net was initially well known for publishing its weekly financial/ tax magazine Epsilon 7 which then evolved into an online database of fiscal/ labour/ tax legislation that is now known as e-Forologia and is the reference point for all things labour legislation in Greece helping companies to understand and apply the relevant law. Epsilon entered the software space in 2002 and since then has grown over the last two decades to become the largest private software enterprise in Greece to now have c.800 employees, and with products used by more than 75,000 customers.

Epsilon Net are effectively a team of experts in tax and accounting, with many of the Board of Directors having published books and articles on labour law, taxation as well as financial and economic issues. With this background, they eventually entered the software business to serve this same constituency. Their whole business revolves around accountants, from offering seminars, support, to education and software. Ioannis and his team understand and empathise with accountants and so are best placed to serve them in the Greek market which has led to Epsilon holding dominant market shares in both accounting and payroll/ HR software systems. Epsilon’s mission is to provide the best software in the market, with the best service at the cheapest price possible while taking on as many clients as possible and increasing penetration.

II. Industry Tailwinds:

(a) Decade of Under Investment by Greek Firms: Greece suffered the most of any EU country, or arguably any developed country in the wake of the 2008 Global Financial Crisis. It is well known that Greece was close to exiting the Eurozone numerous times as massive debt and huge unemployment combined to push Greece, and the EU to the edge over the last decade. Due to the extremely weak economic conditions in Greece, there has been a massive under-investment in software, and technology more broadly by Greek firms. Cloud adoption is low, with many Greek companies still running on Windows XP! I have heard reports of this under-investment from numerous sources and their comments are backed up by studies such as this report from the National Bank of Greece.

(b) State/ EU Funding for Software Investment: The EU has recently approved Greece’s recovery and resilience plan that will result in c.€30bn of grants/ financing being made available to Greece to improve the economy. Nearly a quarter of this will be particularly focused on Greece’s digital transition- improving the 5G network, digitalising the public sector and businesses as well as an allocation of €12bn to offering supportive loans for SMEs to invest in their businesses, of which about 8%, or €1bn is expected to be spent on IT software/ hardware. On top of this, there are also other funds such as the sustainability fund and the Digital Transformation fund where private companies will receive €400mn over 4 years to fund investment in digital initiatives.

(c) Digitalisation driven by the Greek Government: The Greek government, buoyed by the COVID-19 pandemic has modernised their digital infrastructure more in the last year than they had in the decade previous. Greece is currently second last in the EU's Digital Economy and Society Index (DESI) and the government has expressed the intention to catch up with the rest of Europe by 2025. As the public sector digitalises, we should expect to see private enterprise do the same as it complies with the new digital systems through which interactions with the Greek government will now occur.

Greece also offers tax incentives/ subsidies to facilitate the digital transformation of SMEs. An example of this is the introduction of mandatory e-Invoicing for Greek companies by the Independent Public Revenue Authority (AADE) whereby companies must adopt an eInvoicing solution to connect with the tax authorities (MyData). This is mandatory from October 1st and will be heavily subsidised by the Greek government as they are motivated to reduce black market activity and increase their taxation take through the regulated economy.

In sum, it is possible that spending on software by businesses in Greece could more than double over the next five years. Currently, c.40% of the 750,000 SMEs in Greece do not have software to cover their needs. As these businesses increase their software uptake, there should be around €200mn of additional revenue coming to the Greek enterprise software market over the next five years.

III. Structure of Greek Software Industry:

The Greek enterprise software industry is made up of (a) local champions, (b) foreign companies and (c) small domestic point solutions.

Epsilon Net is a local champion. Also in this bucket are companies such as Entersoft- also listed in Athens who specialise mainly in ERP systems and SoftOne, who are privately owned. These companies (Gen 2.0) all came to prominence since 2000 and took over from another set of companies (Gen 1.0) who were dominant in the 1990s- Unisoft, ComputerLogic and Singular. While many of the new generation founders worked at the legacy companies initially, it is interesting to note that the new generation eventually acquired the legacy companies over the years. The Gen 2.0 companies all have different specialties, and while they do compete, ultimately, they are well positioned to grow the whole market and continue to consolidate market share between them.

Foreign competition comes from the likes of Microsoft and SAP, who operate through resellers and integrators in the country. SAP typically works with larger, more complex clients from countries other than Greece who want to continue to run SAP software in Greece. Epsilon’s main advantage over the large foreign competitors is that they are both cheaper (SAP costs about 3x the price of Epsilon’s ERP) and more accustomed to the local language, demands and business practices. One customer of a Gen 2.0 company said that domestic companies do not ‘feel the need to invest in a large software product like SAP because that would need, first of all, higher capital investment, and would also need human capital and resources, programmers, integrators and consultants.’

Finally, there are also some smaller local competitors who have offerings in specific verticals. An example of this would be Modus SA in enterprise content management, or Impact in eInvoicing. These types of companies are potentially attractive acquisition targets for the Gen 2.0 companies.

IV. Business:

Epsilon Net as a group combines three segments, these are: (1) Software & Services (2) e-Forologia and (3) Education Services. We are mainly concerned with the software business. However, it is important to understand the other two segments in the context of the wider group and how they help drive the competitive advantage of the software business.

e-Forologia, as I mentioned earlier is the source of a large part of Epsilon’s competitive advantage as it has made Epsilon the go-to source for anything tax law/ payroll related in Greece. I have heard that even the Greek government employees use e-Forologia as it is superior to anything they use for finding information related to current or historical rule changes. This is linked to Epsilon’s payroll product and ensures that Epsilon’s software is constantly updated as soon as changes are made.

The training business, Epsilon Net Training offers professional training and specialization through seminars and workshops for economists, accountants, and executives. It also provides the AIA International Certification Certificates in Greece (Association of International Accountants, one of the 6 recognized - certified Supervisory Organizations of certified auditors - accountants in the UK). The training business serves as another touchpoint that Epsilon have with the accounting profession in Greece, with accountants becoming part of the ‘Epsilon Family’ early on. As well as looking for the relevant degrees, employees also look for graduates to have training in Epsilon Net software, with many graduates including their Epsilon Net Training certificate on their LinkedIn profiles. This reinforces Epsilon’s competitive advantage as once people are trained and familiar with Epsilon software, they are more likely to have a preference to continue using it which raises switching costs.

The software business is made up of the following products:

(a) Payroll/ HR- (28% of 2020 Revenue):

Payroll is the product that Epsilon Net are most well known for. It is estimated that over 80% of Greek private employees are paid through Epsilon software. A good example of the importance of this product was during COVID, when changes were constantly being made to employment/ tax law which would be very challenging for any HR manager to keep up with themselves. Epsilon’s software took care of this as it is constantly updated with all the new law changes so users can be confident that they are fully compliant with the law, which allows them peace of mind and is what clients have called a ‘dream come true for a payroll manager’. Epsilon’s software directly integrates with the Greek tax authorities so you can complete your tasks and communicate directly from the software. Epsilon estimate they have 80% of the market in Greece and customers have said it is a ‘monopoly in payroll software’ in Greece. Customers have also said that ‘nobody is coming in’ to the market and that Epsilon made a smart move acquiring another large competitor which enabled them to meaningfully increase penetration with larger companies.

(b) Accounting- (33% of 2020 revenue):

Epsilon Net offers their software to the nearly 20,000 accounting offices in Greece who are responsible for preparing accounts, doing taxes, payroll etc. for SMEs who choose to outsource their accounting function to the accounting offices in Greece. These offices play a relatively larger role in Greece than in other countries given firms with less than 20 employees account for 9 out of every 10 jobs in Greece. Epsilon serve more than 15,000 of these offices, who use Epsilon’s software as their chosen accounting system. Epsilon offers phone support for accountants, and for other users of their software, and customers have verified that they are very helpful, with a key benefit that it support is offered in Greek versus foreign competitors who cannot offer this. Epsilon’s software saves accountants a lot of time as the software automates processes that otherwise would take much longer. Epsilon also offers their software for use by auditors where their software supports over 20,000 audits per year for legal and tax purposes. The auditing software is used by several well-known consulting and banking companies.

(c) ERP/ Commercial- (22% of 2020 Revenue):

Epsilon Net completely changed the dynamic of the Greek ERP market earlier this year by completing the acquisition of SingularLogic which had an estimated 20% share of the ERP market (#2 operator). By combining SL with the #3 player Epsilon, the combined group will form what is close to an oligopoly with Entersoft in the domestic ERP market in Greece. Epsilon worked with another listed company who operate in the public software space called Space Hellas to complete what is one of, if not the biggest deals in the history of Greek software. EN and SH paid €18mn for SL and have split the company in two with both halves split 60:40. Epsilon has taken control of the enterprise software business and Space has taken control of the public software business. Epsilon will consolidate the private software business financials which SH will have a non-controlling interest in with the reverse true for the public software business.

Epsilon will now be able to operate their legacy ‘Pylon’ system and SL’s ‘Galaxy’ system off a common infrastructure (Microsoft.net) while keeping their UX separate. This will enable both ERP systems to retain their uniqueness while allowing Epsilon to leverage economies of scale in developing from one common platform. Epsilon will also likely look to cross-sell any of SL’s customers who do not already take Epsilon’s payroll product, which should result in revenue synergies as well. The main competitors in this market are Entersoft and SoftOne. My understanding is Entersoft are the main operators in the larger, more complex ERP systems for Greek customers and can charge premium pricing vs local competitors as they have the best ‘all in one solution’ currently. SoftOne are more focused on the commercial side. One customer of a competitor mentioned that the combined resources of Epsilon SingularLogic (ESL) could ‘tip the balance in favour of Epsilon’ in the ERP market with the combined Epsilon now having an estimated 35% share.

(d) Other- (17% of revenue):

The rest of the revenue is made up of the 4% of revenue from educational services with the rest coming from Epsilon’s eInvoicing solution whose growth is driven by the regulatory tailwinds mentioned previously. My understanding is that there are four main competitors in this space in Greece, three of those being the Gen 2.0 operators as well as a smaller domestic company called Impact. eInvoicing should grow materially over the coming years as mandatory adoption kicks in for Greek businesses.

V. Growth:

Epsilon’s main growth driver is customer count, rather than pricing. Epsilon’s pricing is very competitive and is cheap relative to European software pricing even after adjusting for local purchasing power. Over the long-term Epsilon has the option to flex their pricing power albeit this is not their priority currently. Epsilon Net will continue to grow through (a) organic growth driven by all the tailwinds already mentioned, (b) entrance into new business lines such as the eCommerce or the digital marketing space. Epsilon Net also have the optionality of (c) making further acquisitions where they have been active historically with a strategy of acquiring competitors, or partners who are a fit for the business. In the last year, Epsilon have acquired Data Communications (€6.3mn) and SingularLogic (half of €18.1mn).

Epsilon Net are in an ideal position to continue to consolidate the industry in which they operate given they currently have access to €14mn in cash and given that domestic banks are very willing to lend capital at low interest rates that would help to make any deal accretive. Epsilon Net also have the option to invest in (d) further international expansion. The group already has an international presence but have expressed a desire to expand more. This will likely be more of a focus in 2-3 years, as the focus right now is on integration of recent acquisitions and realising the organic growth potential in existing markets. EN already have 350 clients abroad and there is strong expansion potential in Central & Eastern European markets.

VI. Financial Model:

Epsilon’s revenue base is made up of 60% recurring revenue (and growing organically) with churn rates that are already extremely low and are decreasing further (98.5% customer retention in 2020). This recurring revenue effectively covers all expenses and gives great visibility to management so that they can plan with confidence. Epsilon is a typical software & services company from a gross margin perspective with c.60% margins. The company runs a very lean administrative base (<2% of revenue) with most of their expenses coming from R&D (26%) and distribution expenses (11%), all of which should see operating leverage over time. Epsilon Net reported 31% EBITDA margins for the 1Q21, and I expect this can get closer to 40% over time.

From a cash-flow perspective, Epsilon have €1mn of extra cash generation over their earnings power as the historical amortisation expense is higher than current capitalisation. Epsilon Net will consume some cash in the form of working capital as they grow and expect to have around 120 receivable days due on average, although I expect this will be offset somewhat by proportional payables growth. Epsilon typically invoice customers for yearly contracts at the end of the year which heightens the appearance of working capital intensity given the financial year ends in December and c.60% of the cash is received during January and February. Total CAPEX is less than €1mn p.a. and I expect most of the free cash flow over time will be used for acquisitions or dividends.

VII. Valuation:

Epsilon Net finished 2020 with just under €22mn in revenue while EBITDA margins increased over 5% during the year, resulting in a 24% EBITDA margin for the group. I expect Epsilon to earn c.€45mn in revenue in 2021 driven by organic growth and the SingularLogic acquisition with group margins remaining at a similar level to 2020. While Epsilon’s organic business (pre-SL) should continue to see operating leverage, the integration of SL into the group and the dilutive effect this will have on margins should somewhat offset. From there, I expect Epsilon to grow organic revenue at a mid-teens CAGR over the next five years driven by the tailwinds previously mentioned while also retaining optionality to grow inorganically. With operating leverage on G&A and R&D I expect profitability to grow at a faster rate than revenue with EBTIDA margins reaching c.40% by 2027.

Looking at comps, quality payroll/ accounting companies typically trade at c.30x FCF and above in developed markets. Given the macro risk that investors may see in Greece, lower valuations in this market, and given that Epsilon is a smaller company it is fair that some discount may be justified. I think that 15x FCF is low for a business of this quality and with Epsilon’s growth opportunities. I think that a dominant software company with accretive roll-up opportunities, aligned and intelligent management, strong organic growth and effectively zero churn with untapped pricing power could justifiably trade at multiples well above 15x FCF. However, I will not assume there will be much multiple expansion in calculating my expected return. Assuming little to no multiple expansion with an exit multiple of 15x FCF, I model Epsilon to produce a c.40% IRR over the next five years.

VIII. Risks:

Unique risks to Epsilon Net are (a) Greek macro-economic risk, although Greece can borrow at negative rates this is more likely due to loose monetary policy than any Greek fiscal strength. Another major Greek economic crisis akin to the last decade is a risk. The business also has (b) liquidity risk with only about €200k of shares changing hands on average over the last month.

IX. Summary:

Epsilon Net presents the opportunity to partner with high-quality Greek enterprise software founders who have demonstrated they can compound shareholder capital, (44% 10yr CAGR, 102% 5yr CAGR) that is at an inflection point of generational regulatory and adoption tailwinds providing strong organic growth prospects, while also providing further opportunities for accretive consolidation of the Greek software space. We can invest in a dominant business with minimal churn and with untapped pricing power for c.12x my estimate of 2022 earnings. '

(Note: I originally wrote this when the stock was trading in the €8 range, the stock has since increased past €11.

I updated the track record of value creation & the earnings multiples, now trading at c.12x 2022 earnings.

While this would ordinarily reduce my IRR, I also recently got confirmation that Epsilon expect their tax rate to be at or below 5% over the medium term due to the continuation of tax credits from the Greek government for investing in R&D vs the 24% Greek headline corporate tax rate I had at the time of initial writing.

The net effect of the tax rate change and the price increase results in my expected IRR decreasing from the low 40s to the mid to high 30s over the next five years.

More recently, Epsilon's close peer Entersoft announced strong H1 results which is further confirmation of the strength in Greek software demand right now and I expect Epsilon will also announce strong H1 results.

I continue to believe Epsilon Net is an attractive long-term investment.

I do not currently hold a position in Epsilon Net due to compliance reasons related to my employment.)

Catalyst

Catalyst

(1) Quarterly/ Annual Results: I estimate FY21 revenue of €45mn, much higher than any estimate I have heard for Epsilon Net for FY21 as people are failing to, or incorrectly modelling for the impact of the SingularLogic acquisition.

(2) Further investor attention from foreign investors as the quality of the company is increasingly recognised and as revenues/ profits increase over time.