Description

After years of overvaluation, we are finally seeing value in profitable software businesses.  Temenos is a quality, super-sticky, and highly profitable software banking software franchise that trades on the Swiss Exchange.  The stock now trades at valuation levels it hasn’t seen since 2014 (a 5% FCF Yield).  Stock comp is 5% of revs and is all options.  Temenos serves a large, secularly growing market with years of runway ahead of it and has a largely impenetrable position in its ex-US business, which is 80% of revenues spread across over 150 countries.  The opportunity exists due to a combination of near-term uncertainty around new sales, a term license model that makes the company susceptible to revenue and EBIT declines in a weak new business environment (see most recent quarter), weak senior management, and a tough environment for anything software.  On the flip side, we see the secular growth background, an impenetrable competitive position, a nascent subscription transition, recent activist involvement, multiple inbounds of private equity interest, and a generally good environment for banks as reasons to be optimistic that people are over-pricing near-term risk.  We believe downside is limited and beleive the stock is up 75% in a sale or as near-term fear dissipates over the next couple years.

Business Overview

Temenos’ main product is Core Banking System software (“CBS”), which makes up 60 – 70% of its revenue. The CBS is a critical system that forms the beating heart of the bank. It stores critical data (deposit balances, loan amounts, customer contact info), tracks / processes the flow of money between accounts and calculates interest income / expense. Every function of the bank feeds into the CBS, and all employees interact with it either directly or indirectly through 3^rd-party software integrations.

Temenos is a global business but mix is heavily skewed to ex-US (80% of revenue). On top of that, much of ex-US revenue is in a “long tail” of smaller countries in Asia, Africa, and Eastern Europe where larger competitors don’t typically play (for example Temenos has 40% share in Africa and 40% share in Cambodia).

Temenos historically sold software on a 10-year Term License + Maintenance basis, but launched SaaS in 2011 and a new On-Premise subscription model in 2022. ~70% of revenue today is recurring (Maintenance / SaaS / Subscription) with the balance coming from 10-Year Term License sales and Service revenue.

Why we think Temenos is a strong franchise:

CBS software is a concentrated industry at the country level; each market is typically dominated by 3 – 4 players. There are significant barriers to entry at the national level, including:

1. Long-term support needs: given they plan to use the software for 30+ years, bank customers are hesitant to use new vendors they aren’t sure will be around to support / update the software
2. Country-level customization: every country handles things like mortgages, taxes, and payments differently. A CBS vendor can’t just sell its existing software into a new country, it first needs local customization
3. Regulations: in many countries the local banking regulator needs to approve the CBS vendor before banks can use it

In addition to local players in each market (who generally struggle to compete), Temenos competes against a few large global companies: Oracle, Infosys, and Tata Consulting Services (TCS). While these global players are reasonably strong competitors, we believe Temenos has a few key advantages:

1. Configurability: non-technical employees at Temenos clients can customize the CBS through settings & menu options within the Temenos web / desktop apps. But competitors typically can only customize through writing custom code, making both initial customization and ongoing upgrades slower and more expensive
2. Product coverage: Temenos has a much broader set of features ready out-of-the-box (particularly in more niche countries), competitors again require more customization to meet customer needs
3. Technology: Temenos compares well to global players (particularly Oracle and TCS) on technology factors like cloud readiness, API support, and scalability

Recently a group of cloud-native start-ups (Thought Machine, 10X and Mambu) have raised significant capital and started winning CBS deals. These companies have modern, flexible code bases that customers can use to make nearly identical copies of their existing CBS (except in a modern programming language and hosted in the cloud). Market concern around these competitors accelerated this year in the wake of a few notable customer wins (Thought Machine won deals with JP Morgan and Lloyd’s) but we think these fears are overblown. These cloud vendors typically sell “skinny cores” that, while highly customizable / flexible, don’t have much of the functionality a bank needs (particularly in more niche geographies). To use the software bank customers have to write custom code on top of the “skinny core”. This is a great model for large Tier 1 banks with large internal IT staff, but it doesn’t work well for the smaller banks who make up 80% of the market. But we acknowledge these competitors are a threat and will continue to monitor their progress over the coming years.

Once a vendor wins a new client, CBS software is remarkably sticky. Experts we’ve spoken to have compared switching CBS to “doing open-heart surgery while walking down the street”. Banks are hesitant to switch CBS because of:

1. Customer data risk: while customer data is important to all companies, accurately recording bank customer data (amounts of money in accounts and associated interest rates) is the core function of the bank. Switching CBS vendors carries risk of customer data losses that could kill the business
2. Costly implementation process: CBS implementation requires heavy customization to meet specific customer requirements and integrate with 50 – 100 other software systems at the bank. This complex implementation process typically takes years and tens (if not hundreds) of millions of dollars to complete
3. Re-training needs: >half of bank employees work directly with the CBS software. If a bank switches to a new CBS, it needs to retrain all these employees on the new system

A botched CBS conversion can be a career-killing move for bank IT executives, who avoid switching CBS providers at all cost. An average bank customer uses its CBS for >30 years and only switches if the bank is acquired or the vendor stops supporting the software entirely.

Growth opportunity:

Banks started using CBS software in the 1970s through either internally-built software or software sold by external vendors like Hogan. Given difficulties in switching CBS mentioned above, many banks are still using this software today. But the software is old, inefficient and often written in obsolete programming languages. The number of people who know how to maintain / update these systems gets smaller every year, creating a catalyst to switch. Given only 1/3 of bank software spend is with external software vendors, we believe there is a long runway for banks to switch to external CBS software with the market growing 10% / year.

Why the opportunity exists:

While Temenos’ existing customers are very sticky and there is significant long-term market growth, reliance on lumpy license sales (1/3 of software revenue) makes performance in any individual quarter highly sensitive to new sales. Temenos experienced this in 2020, when license revenue fell by 1/3 as banks delayed implementation projects amid the pandemic. New license sales recovered in 2021 but license sales started slowing materially in Q4 2021. Interestingly, SaaS ACV remained strong during this period, but net impact was still a drag on revenue given license sales are mostly recognized up-front whereas SaaS is recognized over time. Total revenue growth dropped from 11% in Q3 2021 to 5% in Q4 2021 and 1% in Q2 2022. Then, on 10/13/2022 company pre-announced disastrous Q3 results where license sales fell 50%, revenue dropped 8% and EBIT dropped 50%.

The company blamed slow sales on the macro slowdown, saying it had made banks cautious about switching CBS, but the misses have rekindled cloud competition fears and crushed the stock from $140 in late 2021 to $57 today.

However, our discussions with competitors, customers, and formers did not point to any meaningful change in Temenos’ competitive positioning. Rather, we heard that the slowdown was market-wide rather than Temenos specific, tying with public datapoints:

• FIS (US CBS software vendor) banking license sales were flat YoY in Q2 ’22 after growing 25% YoY in Q1
• Sopra (French CBS software vendor) CBS license sales were down 14% YoY in 1H ‘22

Based on our diligence, we believe Temenos is experiencing a short-term, macro-driven disruption to new license sales that will resolve in late 2023 / 2024 as macro stabilizes and bank CBS outsourcing recovers to long-term trendline. But even before that, we believe there are a couple tailwinds consensus is missing:

1. Inflation escalators: Temenos’ standard SaaS & maintenance contracts include inflation escalators that automatically increase prices annually by the greater of 3% or CPI. With CPI running HSD in many markets, we believe Temenos will get a HSD pricing boost in 2023 on 60% of 2022 revenue
2. Subscription transition: In Q1 2022 Temenos started selling recurring subscription contracts to On-Premise customers. Accounting treatment of these contracts is the same as Term Licenses, but the customer financing embedded in the subscription means Temenos will charge the same client >50% more over 10 years.  Benefits of this will become particularly apparent in 2027 as the first subscription sales renew.
3. Latent pricing power: Temenos strives to keep maintenance pricing flat upon contract renewals and frequently gives large discounts on Term License renewals. While we don’t think a change to pricing policy is imminent there’s significant opportunity to raise prices on existing customers given stickiness of product

Private Equity Interest & Activist Case

On top of that there have been consistent rumors around a PE takeout over the past year. Temenos’ stickiness, low capital intensity, growth opportunities and strong cash flow make it an attractive PE target, and there were multiple tranches of rumors over the past year:

0. October 2021: EQT & Thoma Bravo (stock @ $117)
1. April 2022: Thoma Bravo (stock @ $83)
2. May 2022: EQT & Thoma Bravo (stock @ $95)
3. July 2022: a Swiss newspaper reported EQT made an offer to Temenos at a 50% premium to its Feb 2022 share price (likely $140 - $150 / share)

In addition to EQT & Thoma, we think Vista Equity (which owns competitor Finastra) could be a logical acquiror, as could large-cap strategics like FIS, FiServ or Intercontinental Exchange. While we recognize rising rates / falling valuations mean above rumored bids are likely stale, we’d note Centerbridge & Bridgeport just acquired Computer Services Inc (a small, legacy CBS vendor in the US) for 5x revenue in August 2022.

In early October 2022 London-based activist Petrus Advisers announced a stake in Temenos and wrote a letter to the company identifying performance issues and asking management to present a plan to turn around the business. After the disastrous Q3 ’22 pre-announcement 10% shareholder Martin Ebner (a Swiss bank investor) publicly announced his concern with the share price performance as well. We’ve heard negative things about Executive Chairman Andreas Andreades’ leadership (accelerating staff turnover, poor culture, short-sighted focus on quarterly numbers, tendency to throw laptops at people) so we view any outside pressure on management as a positive even if it doesn’t lead to a sale.  Loss of investor and employee confidence in management is a significant issue, and meaningful change at the top could go a long way to getting execution back on track and attracting back investors.

Valuation and Forecasts:

Temenos is at (or near) 10-year low multiples across a number of valuation metrics:

We projected out scenarios for Temenos through 2025, evaluating 3 cases with different assumptions on New Software Sales (across both SaaS and Licenses) and Margins.

Our projections + view of a potential range of multiples indicate a highly skewed risk / reward with minimal downside.

Risks:

• Continued macro weakness: while we are positive on competitive positioning and long-term market opportunity we have no strong view on how long current macro headwinds will persist. It’s possible that Temenos faces several more quarters of weak new software sales, which would hurt revenue / EBITDA given reliance on licenses
• Continued mismanagement: Temenos mgmt. (led by former CEO / current Exec Chairman Andreas Andreades) has created a poor culture and high turnover. Continued departures of key executives could be a headwind to new software sales and growth
• Accelerated start-up competition: while we believe Temenos is well-positioned against start-up competitors today, these competitors are rapidly improving products and a few key customer wins could encourage more customers to consider them
• Neobank business: 5 – 10% of Temenos revenue (and a greater % of new sales) comes from non-traditional banks (online-only banks, payments companies, etc.), current tough VC fundraising environment could slow new wins in this segment and even lead some customers to bankruptcy

DISCLAIMER

As of the publication date of this report, the author has long positions in Temenos and stands to realize gains in the event the stock increases. Following publication of the report, the author may transact in securities of Temanos. All content in this report represents the opinions of the author who has obtained all information within this report from sources they believe to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind – whether express or implied. 

Catalyst

**Further activist involvement / management change / sale of company

**Eventual recovery in deal activity as current delayed deals work their way through the system