Value Investors Club / Software AG (SOW)

Description

Quick Description

As the name implies, they are a software company, but there are three divisions with different dynamics. Enterprise Transaction Systems (ETS) is their "legacy" business of database software & a programming environment. As customers move to newer platforms, this business slowly evaporates - it declined 7% in constant currency last year (12% reported), and the company guides for a decline of 9%-16% this year in constant currency (some structure in there as well). It is highly profitable, however, with contribution margins above 65% with R&D below 10% of revenues and sales, marketing and distribution below 20% of revenues. This business is a cash cow used to drive their growth business, Business Process Excellence (BPE). BPE will drive the business going forward, being active in areas such as big data, real-time intelligence, process automation (apologies for the flurry of buzzwords). It is faster growing but less profitable, having grown 15% in 2013 at constant currency (not all of which organic) with expectations of 12%-18% growth in constant currency in 2014. The contribution margins are far lower, at 28% in 2013 and 40% in 2012 (reason for the drop was investing in salespeople in 2013 - takes time for them to become fully productive). They also have a consulting business which is roughly breakeven following a turnaround in which they sold some non-core businesses. Some financials by division (together with our forecasts), to give a better picture:

This is in €000

The divisional reporting doesn't take account of the overheads, so with those included, the consolidated P&L looks as follows (including our forecasts):

It is a fairly conservatively-financed business, with net debt around €150m, though there is additionally some €105m in deferred income that one should account for as well. Cash generation from operations is quite strong, though has been depressed in the recent period by the declining top line in ETS, which has not yet quite been compensated for by the growing BPE segment, which currently lacks a bit of scale hence they are investing a lot in the business to the detriment of free cash flow in the short-term. Though FCF has declined only modestly in the last year or two (from €184m in 2011 to €171m in 2012 to €158m in 2013), that doesn't really tell the full story as capex is way below depreciation, with acquisitions in fact being a big drain on cash. Our view is that intangible capex is a fact of life in this business, so this needs to be accounted for in measures of free cash flow, and our preferred method of FCF calculation for the business is OCF - capex - acquisitions. 2013 was a particularly heavy year for acquisitions, which the market did not like, but from management commentary, we see the "acquisition drag" abating a bit going forward. The FCF build, including the drain from the acquisitions, is as follows:

We're factoring in some further acquisitions going forward as they build scale, but based upon management commentary we think it declines meaningfully. The "starting number" we've got for this year of €35m is arguably a bit on the low side, but then we're slightly below management guidance on the long-term revenues in BPE, where most of the capex will go, so a bit of a wash.

Company Guidance

The non-IFRS operating income of €260.7m in 2013 compares to the reported number of €190m - the main differences are restructuring costs of ~€13m and acquisition intangible amortisation of ~€40m. We're not a big fan of these adjusted measures, but the company argument as to why they publish this reconciliation is to do with analyst/investor pressure for them to publish an earnings number comparable to their peers.

Why The Opportunity Exists

It is mainly to do with the acquisitions they have been doing over the last year or so. They talk about it fairly extensively in the 2012 annual report, where they were flagging what was going to be happening. They saw that the business was changing a little and that the legacy business would be under continued pressure on the top line and that their business was migrating to other areas where they needed to build capability, so that is what they have been working to do. €130m has been spent on acquisitions in the last two years, and in 2013 they also hired a lot of additional salespeople to sell the products they were both acquiring and developing. This temporarily put pressure on both the earnings and the cash flow, and the market didn't like this as it would have preferred that they focus more on managing the cash flow from the legacy business and returning it to shareholders, and maybe expanding more slowly in other areas. This has been compounded by slightly mixed results in the interims over the last 18 months, with a couple of fairly large EPS beats and misses (probably fair to say more misses than beats). This has raised questions over the execution of the strategy and indeed the validity of it. Earnings revision momentum has been negative since the start of 2013, having been pretty positive in the six months before that

Our take is that it is a good example of inevstor myopia and focus on short-term EPS beats and misses obscuring the longer-term picture. License revenue in software companies is inherently a bit volatile so it is pointless analysts making far-reaching conclusions on the back of a quarter of information. Our view is that the company and the chairman have a long and proven track record of delivering value to shareholders, as evidenced by the following chart, which lays out the company's track record for return on invested capital over the very long-term:

The company have pretty much always beaten their cost of capital. Over the last 10 years they have averaged a ROIC of >12% - same for the last 3 years. Going forward, evern a somewhat cautious (we hope) consensus expects the company to generate ROIC of ~9.5%. The current valuation implies that they will do just 8.9% ROIC into perpetuity - the lowest they have done in the last 10 years is 9.0%, so our view is basically that the license growth the company has been showing in BPE in the last few quarters is evidence that the strategy they are employing is working to create a platform for value creation, as has been the case in the past. Consensus on the sell side and the buy side is discarding this history of value creation and the positive performance in the new business to instead focus on whether the adjusted earnings this year will be 2.1 or 2.2 or 1.9. Our view is that, yes, in the short-term it will have an impact on the share price, but for the patient investor it is of limited importance and that it would be better to focus a bit further ahead, using the ROIC history as a compass.

Value

We think that by 2018 the company can be generating revenues of about €1.3bn and that the operating income will rise to ~€385m, with EPS of about €3.20 as they build scale in BPE and benefit via improving margins. It is then a case of fun with spreadsheets, but the peers trade on about 14.5x forward earnings - on the EPS of 3.2 in 2018 which I think would be implied, the stock would be worth 47 in 2017 vs current 26 = 80% upside.

Risks

1. Lowered guidance from 2013 has had a bit of an impact on the credibility of the management

2. The middleware market is highly competitive with giants like Oracle, IBM, Microsoft stalking this space - Don't see them as a target as the founder controls 30% of the company via a charitable foundation

3. It is a difficult to understand company, both from a business and a financial perspective. We must admit to not being totally clear what exactly the source of their competitive advantage is in the new businesses. In the legacy it is easy to understand - if you switch over to another seller and you have database issues

it is a disaster so we imagine the customer base is sticky - in the new business - less clear - think it is a "show me"

4. Earnings momentum been pretty grim in the meantime as consensus realises this, with EPS forecasts for 2014 coming down 10% since this time last year - slightly feels like one is trying to catch a falling knife

5. I don't like the way they report - refusal to tell you what the organic growth is, some "naughty" classification of the free cash flow, etc

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

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			2014	2015
Price:	27.10	EPS	$1.77	$2.05
Shares Out. (in M):	87	P/E	15.3x	13.2x
Market Cap (in $M):	3,270	P/FCF	12.2x	10.9x
Net Debt (in $M):	205	EBIT	301	347
TEV (in $M):	3,475	TEV/EBIT	11.6x	10.2x