Description

Lectra is a little known 265m EUR market capitalization French company which sells CAD / CAM cutting equipment, software and services to customers with manufacturing operations involving the cutting of soft material and to fashion houses. They are the most dominant company worldwide in this niche with up to 80% market share in some verticals, and channel checking has confirmed managements’ claims about the quality of their products. It is an asset light business model with negative working capital and thus has high returns, with close to 60% of total revenues being recurring and low-churn. In addition it is extremely cash generative, exhibits upwards of 45% incremental operating margins, enjoys a research tax credit which enhances free cash flow, has 14% of its market cap in net cash and is 40% owned by the Chairman and CEO.

The company is going through a transformational period mandated by the management owners, in which short-term profitability has been sacrificed for the long-term development of the business. If the new sales force can perform on even significantly reduced productivity on a per person basis to the pre transformation sales force the company is vastly undervalued today – probably selling for half of its worth. For perspective: if Lectra achieves the targets that management has set for 2016 it is selling on less than 5x EBIT. These targets seem eminently achievable given the cost structure of the business and the historical performance of the sales force on a per person basis. In the case where the transformation plan fails to achieve the desired results and management can again take out unnecessary costs the price is something close to fair value. The combination of quality recurring revenues streams and high incremental margins represents a favorable risk-reward scenario.

Brief overview of operations and breakdown of revenues by segment, end market and geography

Lectra manufactures (it out sources most of production and keeps only final assembly and testing/calibration in house) CAD / CAM cutting equipment for cutting textiles and other soft materials. These machines are driven by external software that communicates with software integrated in the machines. They are technologically very sophisticated and include patented mechanisms for, for example, the efficient ‘feeding’ of material. It sells these machines to customers with manufacturing operations involving cutting soft materials - customers being automotive supply companies (including Johnson Controls, Lear Corp and Faurecia) and companies with clothing manufacturing operations (including Gucci, LVMH and Van de Velde lingerie).

Lectra also produces and sells multiple CAD / CAM software products including fashion design software, pattern/marker making software, nesting software, 3D prototyping and visualization packages and cut order planning and optimization software. The end users include what might be termed as the engineers of the fashion industry – the pattern makers, as well as designers. The job of the pattern maker is to most efficiently convert the design to pieces that can be mass-produced. The nesting software uses mathematical algorithms to ‘mark’ the patterns to be cut most efficiently on the fabric so as to minimize fabric wastage. 3D visualization allows for more productive collaboration between designers and pattern makers and also reduces the burden of having to produce actual samples.

The company also services its installed base of hardware and software with maintenance and support contracts, and spare parts and consumables. In addition it provides consulting and other professional services; using their accumulated industry expertise to advise clients on how best to implement a particular solution.

In 2013 Lectra generated revenues of 203m EUR and the breakdown by segment was 51 % in CAD/CAM hardware and spare parts and consumables (half being spare parts and consumables), 26 % in software and 23 % in support contracts and other professional services. 58% of revenues were recurring – 17 % in software contracts, 17 % in hardware maintenance contracts and support services and 24 % in spare parts and consumables. 42% of revenues were new system sales of which 27 % were hardware sales, 10% were new software licenses sold and 5 % were professional services (training /consulting / implementation and other).

By end market, approximately 50% of revenues were to fashion customers (including design houses, manufacturing operations and integrated outfits), 40% to automotive customers and 10 % to furniture and other customers. 45% of sales were in Europe, 27% in the Americas and 28% in APAC and other countries.

Value proposition to customers / Why should it exist?

Lectra’s cutting machines provide a return on investment breakeven period of less than a year for customers with sufficient volumes and material quality above a certain threshold. Its machines offer material savings and productivity gains by cutting more accurately (requiring less buffer between patterns) and cutting more layers efficiently, thus increasing potential throughput. They also offer industry leading uptime – boasting 98% availability and lowest total cost of ownership.  Material savings is extremely important for auto customers for example – whereby they may be cutting leather seating covers and any incremental material savings is extremely valuable since these compose a substantial portion of total costs (bear in mind that seat manufacturing is quite a low margin business in any case – something like mid-to-low single digit EBIT margins). Material costs might make up 40-60% of an apparel manufacturer’s total costs, so 5% material savings (which Lectra’s machines can offer) is something which genuinely and significantly adds value to customer operations. The ability to cut more layers has the tangible benefit of allowing more flexibility in product runs. Take for example a customer cutting denim for jeans – it may be able to cut four styles per day as opposed to 3 for a particular production run; a meaningful difference in an industry where fast-fashion has become the name of the game. In North America the company was recently in discussions with an apparel customer to replace their existing machines - on testing they would be able to produce the same volumes in the same time with six Lectra machines versus twelve of its main competitor’s machines and the payback period of their investment was ten months. In addition downtime represents a danger to high fixed costs manufacturing intensive business with potentially high throughputs – and thus the industry leading uptime value proposition which Lectra sells is particularly attractive to these customers.

These are technologically advanced pieces of machinery and include smart functions like avoiding damaged leather etc. It has been clear from speaking to customers and industry players that Lectra’s machines are the highest quality and provide the best return on investment and they are priced at the premium point in the market as a result.

The nesting and opti-plan software offers similarly tangible benefits by passing the most efficient ‘marker’ to the cutting machines and in simulating costs which allows the cutting room to most effectively plan production – managing working capital most efficiently etc. For the other software products the benefits are perhaps less tangible but nonetheless are very much present. They improve the productivity of designers and pattern makers for example and reduce costs by facilitating virtual prototyping as opposed to having to manufacture multiple small runs.

In-depth industry knowledge as well as software expertise is needed in order to produce products which add most value to customers’ operations. While Lectra’s and its main competitors’ software cover the most applications within their product suites and boast the highest functionality (and are again priced correspondingly) there are a diverse set of competing software products in specific applications at lower price points.

Capital light

Since the company outsources the manufacture of the components of its equipment and only retains assembly, calibration, and testing in house (as well as the R&D function related to hardware) it doesn’t need to support high fixed cost manufacturing facilities. In addition Lectra receives 40% up-front payments for most of its machines which reduces the burden of working capital (one third of Lectra’s total revenues are paid in advance). The support and maintenance contracts actually means net working capital is negative and this is a key tenet of the business model which management emphasizes – it allows the company to generate cash as it grows.

To highlight this, in 2013 – a year in which ebit margins were depressed by the encumbrance of the costs associated with the transformation plan without their corresponding benefits – the EBIT ROIC was 25% (where 30m EUR of the approximately 50m EUR of invested capital, at 2012 year end, was goodwill). Returns on tangible capital are therefore extremely high.

Recurring Revenues

Lectra’s business model is much more durable than in years gone by and management emphasizes the downside protection afforded by their recurring revenues. This is demonstrated by the performance of recurring revenues in 2009 when they dropped by only 6% and quickly rebounded to their 2007 levels in 2010. Of the 118m EUR in recurring sales in 2013 69m EUR were recurring contracts (33.5m EUR on software evolution contracts and 35.5m EUR on hardware maintenance and online service contracts). Virtually all customers who buy a new system of either hardware, software or a combination subscribes to the yearly contracts. Lectra aims to have the churn on the value of these contracts below 10% and has been successful at this on a historical basis (it was 9% in 2013). These recurring contracts have inflation linked pricing and will be supplemented each year as a result of the new system sales – with something like 10% of the value of a new system – based on a typical sale – becoming recurring contracts.

The spare parts and consumables are directly linked to the activity levels of the installed base and are thus statistically recurring. Lectra instituted a global agreement in 2013 whereby the company offered customers discounts if they sourced all spare parts and consumables from them (i.e. the non-captive parts as well as the captive). This initiative was a successful one and enhanced profitability – given the extremely high gross margins on spare parts which compensates for any discounts. Approximately 60% of the spare parts and consumables are captive and can only be provided by Lectra and 40% are commodity type parts (including blades etc). The online monitoring (part of the service contracts) of the machines gives Lectra visibility in to their customers’ operations and allows them to preventatively conduct repairs and send spare parts in order to maintain the availability time of the machines.

The sales force are incented to generate sales in alignment with shareholders’ interests. Typically 50-60% of their yearly package is fixed with the balance being variable. The variable portion is not based on the value of the order, but rather on the value added for Lectra (cash margin) – 1Eur of software sales sold with a recurring contract is worth 2.5x as much in commissions to the sales people as 1Eur in hardware sales. They receive 50% of their commission on receipt of the upfront payment installment by the customer and the remainder when product is delivered and full payment received. In addition, the sales force participate in the risk of losing contracts – so are motivated to maintain them.

I have spoken with several customers who attested to the value of the maintenance contracts and of the necessity of the software evolution contracts.

Incremental margins

Gross margins on cutting machines are between 45% and 55% for cutting machines (depending on the model) and greater than 90% for software – and so incremental operating margins are extremely high. Management worked on improving the gross margins on hardware and believe this is sustainable going forward. The only other incremental costs are increasing incentive compensation to sales people and perhaps greater support costs. Management guide for 45%, based on average expected sales mix, but in 2013 the incremental margins on a like for like cost base were closer to 50%. This is what makes the management objectives seem so achievable.

R&D Tax Credit / Effect on free cash flow

The French government have long had an R&D research tax credit in place which allows companies to offset up to 33% of their R&D expenses below 100m EUR in France fully against tax. In the case they are not able to fully offset it they can claim the entire outstanding amount in cash from the administration after a period of 3.5 years. This provides an ongoing supplement to Lectra’s free cash flow and means that in normal years their free cash flow should exceed net income. The last couple of years have been different since the French government awarded the entire outstanding amount in cash to companies in 2010 to provide them some relief from the financial and economic conditions (take note of the large cash inflow in October, cited in Q3 report). There is a nuance to the way the credit is treated in the income statement, but it makes sense on an economic basis, since the company has persistently maintained this relationship between free cash flow and net income.

Balance Sheet / Cash generation

At the end of 2008 the company had net debt of 56m EUR after borrowing 50m EUR to buy back 20% of the shares outstanding. As of the end of 2013 they had 29m EUR in net cash and paid out 24m EUR in dividends in the intervening period. Notwithstanding the unfortunate timing of this capital allocation decision, the balance sheet morph demonstrates clearly the underlying cash generation dynamic of the business (the cash increase does include a 25m EUR litigation settlement and some other non-operating cash flows). At the end of this year they will have approximately 35m in net cash.

In addition, the outstanding claim on the French tax administration is 22m EUR and since this is what supplements free cash flow on an on-going basis I have excluded it from the EV. However, it provides added downside protection since Lectra would receive 22m EUR in cash in less than 4 years were it to stop operations today.

Transformation plan

At the end of 2011 Lectra had 1338 worldwide employees. A significant part of its transformation plan is a recruitment effort to bring the workforce back to its pre-crisis levels of circa 1550 but with a greater emphasis on strategic customers and increased focus on end markets and geographies with most potential. This includes increasing the sales and marketing team from 220 people (which included 85 sales people) to 330 – the increase of 110 including at least 80 new sales people. In addition the company will hire 40 new software engineers (bringing total to 260). To put some perspective on its 2016 objectives – in 2011 the sales force achieved a productivity of 1.15m EUR of new system sales per person. If this metric were maintained after the integration of the new sales force the company would generate 184m EUR in new system sales and coupled with only modest inflationary growth in recurring revenues would turnover well over 300m EUR in total revenues.

Management targets are total revenues of greater than 260m EUR and a 15% operating profit margin and doubling of net income from the 14m EUR achieved in 2012.

Some solace can be taken from the ability to take out costs if the new hires fail to have the desired effect. For a new software engineer hire based in France the cost of letting them go would be 3x one month of salary for 3 years under employment. A software engineer graduate costs the company approximately 40,000EUR in gross salary per year, (in addition to a social charge of 20,000EUR per year) – so would cost just over 10,000EUR to make redundant. The global sales force would cost less to restructure and the burden of streamlining therefore, if necessary, would be very bearable for the company.

Competition

Gerber Technologies is the only global competitor to Lectra across all product offerings. Gerber was taken private by Vector Capital in August 2011 and although the valuation details remain murky (Gerber also included a printing distribution business in Europe and cost allocation was ambiguous) it seems like that the multiple was close to 10x EBIT for the comparable earnings.

Lectra’s machines are priced 30-50% more expensively than Gerber machines; a premium management claim is justified by the marginal quality Lectra’s machines have over their closest competitors’. Gerber has historically been more dominant in North America with Lectra having a greater installed base in Europe – especially in software. This distribution breaks down in some verticals, however. Today Lectra wins 8, if not 9, out of 10 tenders in the automotive segment worldwide where its machines are clearly the technology leader and where the return on investment proposition is easiest to sell.

Management have told me that it is extremely difficult to replace a competitor’s software system, so that when they go after competitors it is always on the machine side. They then use the increased customer intimacy to attempt to sell the value of their software. This has been corroborated by the ex CEO (interim after private equity purchase) of Gerber, and attests to the stickiness of the CAD/CAM software.

All R&D is expensed as incurred and the company is clearly the industry leader in terms of dollar spend on R&D.

There are also smaller regional competitors in hardware and software including Morgan Tecnica, Assyst Bulmer and some low cost Asian competitors. In pure software plays there are Optitex, Centric, Tukatech and PTC, among others.

Channel checking has confirmed the quality of Lectra’s cutting machines and the functionality depth that their software provides (although it is less clear if the premium pricing relative to the alternatives is justified here).

Management

The Harari brothers, Daniel and Andre, are CEO and Chairman respectively. They own almost 40% of the share capital between them, and have been running the business for three decades; initially gaining control of the business in a re-capitalization through Andre’s venture capital fund. I believe the wealth represented by their ownership stake in Lectra is the majority of their net worth. In addition there are no other family members that I am aware of, waiting in the wings to participate in running the business. The company has been through the vicissitudes of several economic cycles and a few periods of self-induced difficulty. This has resulted in the brothers taking a very conservative approach to their balance sheet (a commitment to remain debt free and fund growth internally) and to running of the business (for example, a target to cover at least 75% of fixed costs from the gross profit on recurring revenues – a target which has consistently been achieved). Their interests are clearly aligned with those of minority owners and they do not take excessive salaries or benefits.


Valuation

Euros, millions              2013         2014e            2015e                2016e
Revenues                     203               212                226                240
of which, recurring        118               123                129                136
new system sales           85               89                 96                  104
EBIT                             17               20                 23                    30
% of Sales                    8.5%            9.2%        10.3%              12.6%
Free Cash Flow              6.6              14.1               15.5                24.0
% of Sales                   3.2%           6.7%                 6.9%           10.0%
                                                
Net Cash                      28.6            35.6                 43.9                59.7
EV / EBIT                 12.9x              11.7x                9.5x                6.7x
FCF RoEV                   3.0%              6.2%               7.1%              11.8%

Note that working capital movements are fairly insignificant but are included in the above figures.

The base case for my financial estimates are the company getting two thirds of the way to their targets by 2016, whilst the fixed cost base is aligned with what they have set out and growth in variable costs are congruent with growth in new system sales. I remain conservative relative to management expectations because the company has set out overly optimistic targets before and failed to meet them (see risks, below). Since the cost base is fixed, achievement of the growth in new system sales necessary to hit the company targets – an incremental 23m EUR – would bring an increase in ebit of approximately 12m EUR – for a total EBIT of over 40m EUR on 264m EUR in sales, a 15% margin. If the company meets its targets the FCF RoEV will be greater than 16% - more than 30m EUR in free cash and increased cash generation in the intervening period. The 2014 figures include 16m EUR in costs associated with the transformation plan so the short term multiples are inflated by costs which have not yet borne any benefit for the company. It is also interesting to consider that whilst the company has guided that their targets, which were originally set for 2015 should be pushed out to 2016 the global head of sales confirmed that he has maintained the 2015 target internally. I have not included cash inflows from options exercise nor dilution to existing share count – the cash somewhat offsets the destruction to value for current shareholders but this is clearly something you should consider when considering free cash flows and forward enterprise values. Also, 2014 and 2015 free cash flows are impacted by purchase of south Korean subsidiary for 1.6m EUR and by a one off capex expandion project at the Bordeaux site for approximately 2m EUR, respectively. I believe a 2016 fair valuation under the base case and attainment of management targets, respectively, would be 11eur / share and 15 eur / share based on 9x ev / ebit multiples (corresponding to approximately 8.5% FCFoEV yields) and intervening dividends.

The blue sky scenario would be that the sales force achieves a productivity level equivalent to the 2011 sales force (see above) in terms of new system sales per person and recurring revenues generate higher growth rates as a result. If these metrics were achieved, Lectra could generate 80m-90m EUR in EBIT on sales of 350m, corresponding to northwards of 30% FCF RoEV; although this would most likely be outside the time frame of the 2016 plan and is really the bluest of blue sky scenarios and clearly not very likely.

The company will pay out 33% of its long term sustainable earnings in dividends, although this ratio will be higher in the near term due to effects of transformation plan. If the company achieves its targets the dividend yield in 2016 will be 4%. 2015e yield is 2.6%.

I believe the downside is very much protected by the value of the recurring revenues. These alone could justify an enterprise value significantly higher than Lectra is given today. The  market enterprise multiples for software companies with recurring contracts are 4x-5x recurring revenues, and sensible multiples for the hardware maintenance contracts and spare parts and consumables revenues are somewhere between 2x-3x. This would infer an equity value of between 330m EUR and 450m EUR on 2013 figures.

In 2014 the company will generate 19m Eur in EBIT, which includes transformation related costs of circa 14m Eur. Giving the company the benefit of the doubt on a big chunk of these expenses being genuinely unnecessary to current business the company is generating, say, an underlying 30m in EBIT today and an ex-growth multiple of 7x gives a value of around 8 eur / share.

Thus I believe the distribution of fair equity values under different reasonably likely future outcomes is skewed between something around today's price and 15 euros.

Risks and Negatives

As of the end of 2013, 2.5m options were outstanding and currently in the money, and all options vest fully in the four years following grant. If all are exercised the company will receive cash inflow of approximately 13m Eur (average exercise price of circa 5.20). During the crisis years the board gave away 1m options with strike price of 2.50 EUR - circa 3% of future earnings for less than 2.5m Eur – which is of course value destructive for equity owners. There seems to be a reluctance to offset dilution after the buyback in 2007 that left the balance sheet precariously levered going into the crisis. It would be good to see management at least signal their intentions by offsetting dilution, and they would, by no means, have to take on debt to do this. At the very elast however, management never gives options away with an exercise price of 0, and the x price is never less than the trailing 3month price - employees in receipt of such options are thus clearly incented to improve the operational performance of the business.

Management have made optimistic targets for the business in the past – in 2004 they outlined a plan to achieve 300m EUR in sales which, of course, failed. It is clear that the market doesn’t believe that Lectra will reach them this time, despite a more conservative target. Falling far short of their ambition this time will, most likely subject this management team to prolonged derision.

There is always the ‘everything’s a toaster in the long run’ risk. The inevitability of the technological catch up of low cost competitors in Asia is a risk for this business, but is a long way off today (according to management).

Lectra’s pricing policy is aggressive – I worry that they are limiting their own end market by not at least having lower priced options to compete like for like (their lowest cost machine is still 20%-30% more expensive than the more expensive Gerber machines).

A strong euro is negative for Lectra. A 5c rise in the rate as of the budgeting date for 2014 (Feb 1 EURUSD 1.35), parity of $1.40 / 1 EUR  mechanically entails a fall in FY2014 revenues of 3m EUR and of 1.6m EUR in operating income – so the FX effect is leveraged to operating income. Conversely a parity of $1.30 / 1 EUR increases revenues and operating income by the same amounts. Clearly the FX situation is currently benefitting Lectra and will make it possible  for them to surpass their full year guidance for operating income.


Why is there an opportunity?

Lectra has a free float of only 160m EUR (and considering some longer term large holders, actually less) and a trailing three month average daily turnover of around 200,000 EUR based on today’s share price. Thus size / liquidity are probably important factors.

Also, there may be an ill-founded perception of the company being French – but the reality is that only 8% of revenues come from France. In addition, the company has significantly restructured the global workforce in a short period of time before, during the financial crisis and thus management has the wherewithal to take out people costs if needed.

The market’s skepticism about how achievable the company’s goals are is clearly the most significant reason for a possible opportunity. Only time will tell whether the market is right or wrong. I feel that whatever transpires, the valuation today is below the intrinsic value of the business ex growth and, thus, there is a mispriced risk situation. The little sell side coverage that exists is generally in line with a 240m revenue figure in 2016.

Catalysts

Europe has been particularly weak for Lectra in the last couple of years, especially in France and Italy – demonstrating sharp declines in orders for new system sales. This presents an opportunity for Lectra to beat easier ‘comps’, given that Europe is still the company’s main market. Q3 was fairly good in this regard and I expect Q4 to be better (in Europe and APAC).

If the company were able to report a couple of quarters in a row where it looks like the sales force is beginning to gain traction in terms of orders or backlog the market may begin to believe that targets are achievable. Q2 was very positive whilst Q3 was acceptable and the company is expecting a good Q4. The next 2-4 quarters are important in terms of order intake.

The cash position will clearly soon become preposterous. It is very unlikely that they will have less than 50m in net cash by 2016. Thus should management or the board make an intelligent allocation of this capital, without putting on any debt, people may take notice.

Gerber Technology was taken private in August 2011, so it will probably not be coming out or sold to the trade any time soon – but were there to be increased news flow or any deals of significance from Gerber it may shine a light on the only other global peer – Lectra.

Lectra has been working on a Product Lifecycle Management (PLM) project since the mid 2000s. It has clearly been a failure so far but management continues to believe that it is the future for the fashion industry. A significant chunk of the software R&D teams are dedicated to PLM and yet the company only generated 3m EUR from the product in 2012 (no figure yet for 2013). Thus, any traction in selling their newest version will be news well received. The company announced they won a large PLM deal with Samsung's fashion subsidiary following the Q3 results. It is clearly able to compete, at least in some deals, with the big boys in the industry.

I believe the business is migrating, at least in part, to one much more focued on providing professional services - as can be seen in the strong growth in order intake for consultancy etc. The expertise the group has with respect to maximizing the efficiency of the creative and manufacturing functions of fashion is clearly valuable to customers. Additional progress here may change the perception of the business to one much more important to client operations and thus the market may assign it a higher multiple.

Catalyst

Action on Gerber from Private Equity
Action on cash heavy balance sheet
Order intake development
PLM traction
Further Euro weakness versus USD