Description

Based in Germany, P&I provides human resources software to middle-market (500-2,500 employees) companies around Europe.  Market cap of EUR 133M = 175M at EUR/USD 1.32.  Float is about 1/3 of shares outstanding, so in USD terms the float is around 58M.  Considering the size of the float, the liquidity is pretty good in my opinion.

11X forward FCF may not sound like an obvious bargain, but you’ll see that it is once you understand the exceptional economics and growth potential of this business.  The key here is that my forecast FCF growth of roughly 15% over the next few years is fairly well assured and will require only minimal capex (<10% of earnings).  So the earnings yield of about 8% (9% less 10% reinvestment) is a “true” yield that they can actually deposit in your account and still grow.   And they do (more on this below).  

So the shares are priced to return around 23% (8% + 15%) over the next few years.  If you think about it, a company with a competitive moat that can grow quickly on minimal capex should be worth north of 20X FCF.  Just do a DCF model using anything reasonable for long-term growth and discount rates and you’ll see.


Products:
P&I’s core product (80% of sales) is a payroll software package called LOGA.  This is a wonderful business with high barriers to entry and switching costs.  Employment laws (tax code, social security, collective bargaining agreements) in Germany are horrendously complex and the lack of this specialized knowledge keeps would-be foreign competitors out of this market.  Meanwhile, switching costs are high since payroll is a critical function that gets ingrained in back-office operations, yet represents a small % of total overhead.  P&I is able to raise maintenance fees every year yet loses only about 1.5% of its customers annually (basically due to customers going out of business or getting acquired).

The company also offers an HR software package called HCM (17% of sales) which basically puts all the HR department’s paperwork online (i.e. approving vacation and expenses, managing the hiring process, etc.)

Finally, P&I just started offering a time management software product they got in a recent acquisition.  This is like a PC-based punch clock that tracks hours worked and helps to schedule staffing.


Competition:
SAP bundles payroll with ERP and dominates the German market for larger enterprises.  SAP has talked about entering the middle-market for a decade, but its current solution is just too complex and costly for these customers and they’d basically need to do a total re-write to come up with something that would sell.  P&I will occasionally go head-to-head with them for larger contracts.

In contrast, the middle-market is very fragmented.  Good data is hard to come by, but I figure P&I has about 9% of the German middle-market for payroll software and is about 2X the size of its next largest competitor.  Organic growth has been about 10% a year and comes mainly from market share gains (the German economy is just now emerging from a big slump and so P&I’s main market has only been growing a few points a year).   The typical new customer was previously using a mom & pop solution that is no longer keeping up with their needs, or is about to become obsolete because mom & pop want to retire and won’t be providing any more product updates that incorporate new laws, benefits, etc.


Capital allocation:
P&I began to expand to other European countries over five years ago in recognition of the fact that Europe was becoming more integrated.  In other words, customers increasingly have operations in more than one country, driving the appeal of a complete solution.  The company went public in 1999 to raise the cash it used to buy a few payroll software vendors in Switzerland and Austria, and has built its own operations in the Czech Republic, Spain, the Netherlands, and a few others that I’m forgetting right now.  Foreign customers are maybe 20-25% of the total now.

Future acquisitions are likely, and likely to be small.  The goal isn’t growth per se, but rather the addition of new functionality, expertise (in local employment laws), or access to otherwise closed markets.  In the past 5 years they’ve done only two deals – ZHS for about EUR 2M in 2005 to add the time management product, and KSL for about EUR 1M in 2006 to gain access to public sector customers.

When you look at the capex and separate the organic from the acquired growth, you find that the roughly 10% organic revenue growth (and much higher EBIT growth) has required something around EUR 500K per year.  Cash generated by operations was about 2M seven years ago, and will be just under 12M this year.  In other words, capex is minimal.  I used the “10% of net income” figure to be conservative, but it might be less than that.

So what are they going to do with all that cash?  Lately, the answer has been dividends.  On 8/30/06 P&I paid its first regular dividend of EUR 0.56 along with a special dividend of EUR 2.43.  The special dividend represented several years of accumulated cash, and they still have about 10M of net cash on the balance sheet.  In the year ahead, the company will likely cover the regular dividend 3X over and I’m comfortable that we’ll either see more special dividends or some other smart use of cash (note that the board recently gave them the ability to buy back shares).  

I’m comfortable because the Carlyle Group owns 66.64% of the company, which helps ensure capital discipline.  They bought out the original founder a few years ago.  Obviously they’re in the driver’s seat here, but I really don’t think minority investors need to worry about unfair treatment.  There are no special share classes or anything like that.  German law is pretty good about protecting minority shareholders.  I do not suspect that Carlyle intends to take the company private, but even if they made some low-ball offer you would likely end up getting your due (e.g. Celanese in 2004 and Freenet/Mobilcom 2005+  In both cases the holdouts got(or will get) squeezed out at a fair price).  I don’t suspect Carlyle has some portfolio company that they could sell this to on the cheap, but I do wonder if perhaps they might try to sell it to SAP, as this would provided them access to the middle-market they supposedly have wanted for so long.


The model:
Organic growth rate will likely get a boost in 2H07 when P&I releases a new version of LOGA that fully integrates the new time management product and incorporates some new HCM features.  I’m guessing that organic growth goes from 10 to 15% for the year.  Plus, KCL adds 1.8M.

Operating leverage has been huge over the past few years, in part due to management’s focus on efficiency gains.  That focus is now shifting to revenue growth, and it’ll be interesting to see what happens.  I’m keeping gross margins flat at 70% for the time being. Likewise, selling expense will likely grow in-line with revenue as the current salesforce is stretched pretty-thin these days.  

I think operating leverage will still be quite good, however, as R&D will trend toward 17% over time and admin costs are fairly fixed.  Operating margins are just starting to rise above 20% and it’s fun to ponder just how high they could go.  I’m not sure, but it’s interesting to note that Paychex had almost identical gross and operating margins back in 1995 and now has operating margins around 40%.  They’re not perfect comps, though.

Corp tax rates in germany are about 38-40%, 25% in Austria, and 21.3% in Thalwil (Zurich canton) in Switzerland, their most important subsidiaries.  So I would
expect some blended tax rate of, maybe, 33%-34% over time.  (Note that the German parliament is currently considering a cut in corporate taxes to roughly 25% (incl. local taxes) starting in 2009, which would be added upside.)

Putting all this together and adding goodwill amortization from some old acquisitions, I estimate “Cash EPS” of EUR 1.50 for CY07 (Fiscal year ends March 31st).  So on a share price of 17.26 that’s 11X if you net out just a bit of their net cash.

An added benefit here is that working capital is a source of cash as long as P&I continues to grow.  Customers pay maintenance fees for the current year in the first quarter, so P&I will have collected a big pile of cash at the end of each fiscal year (3/31), but recognized only a 1/4 of associated revenues.

Catalyst

1) this writeup. This is cheap due to obscurity - not much attention focused on small cap German stocks with no analyst coverage
2) accelerating growth in 2H07 due to new product release
3) additional special dividends or buybacks in coming year