Description

Company background

Vitec (VITB SS) is a little known Swedish software company that operates in Scandinavia.  In fact, until 2015, its annual report was only published in Swedish. Founded in 1985 by Lars Stenlund (CEO) and Olov Sandberg (head of IR), Vitec provides business critical software to various industries including insurance, healthcare, real estate, energy, automotive and media. The ‘critical’ nature of the software is the source of Vitec’s competitive advantage – its customers depend on the software and replacing it with a competing product would disrupt business. This results in very predictable recurring revenue (2015: 78%) and cash flow streams.

Business model

Vitec’s business model is very similar to that of Constellation Software, a company that has an exceptional track record of allocating capital under the leadership of Mark Leonard. In fact, this is no coincidence as management is fully aware of the attractiveness of Constellation Software’s business model. Like Constellation Software, Vitec acquires companies that dominate a vertical niche market and have a high proportion of recurring revenue. These companies are typically mature with mid-single digit growth. Unlike Constellation Software, Vitec aims to integrate the acquired companies into the Vitec brand, thus benefiting from synergies.

We have encountered this business model numerous times over the years and are big fans when the model is under the stewardship of well aligned managers. This is the case with Vitec: CEO Lars Stenlund and Vice President Olov Sandberg have been leading the company for over 30 years since its founding at the University of Umeå. Together they control Vitec through their ownership of 53% of the voting rights and 13% of the capital.

Given the economics of the software business, Vitec enjoys high rates of ROIC. The company has been growing sales at ~25% per year and operating income at ~32% for the last 10 years. This has been a result of mid-single digit organic growth and a disciplined acquisition strategy.

The acquisition criteria searches for niche software businesses with high recurring revenue (60%+) which can be purchased at multiples of 5-7x income. The targeted market for acquisitions primarily remains in the Nordic region with Vitec estimating that there are over 100 possible targets on their list, with combined annual revenue amounting to over SEK4bn. This compares to Vitec’s current revenue of SEK618m. Given this run room management believes that it can continue to grow at the recent pace for several more years. In fact, it has taken a gradual approach to growth so far as not to overcommit themselves in terms of dealing with the time required to execute and integrate acquisitions. Because of the quality of the growth and the predictability of the business we believe that Vitec is substantially undervalued when we discount future cash flows. We expect to see Vitec growing rapidly in its markets through its focused acquisition strategy and the resultant cash flow growth.

Leverage

Vitec has historically financed acquisitions with a combination of debt and equity. Net debt/ EBITDA currently stands at 0.86 and is lower than it has typically been at over the past 10 years.

Liquidity

On an average day the shares are not very liquid (approx. $200k daily volume) but it’s a doable institutional investment as large positions can be purchased.   

Valuation

Vitec has an excellent track record of generating 20-25% return on equity. This ROE is not that surprising as it purchases companies at a 5-7 times earnings multiple.

If we assume a 20% return on equity, 9% discount rate and 2% terminal growth rate, the current share price implies an 8% growth rate for the next 3 years, falling to 2% thereafter. Note that Vitec’s earnings power is significantly higher than its IFRS income.

We believe that at this price, the shares are undervalued and give very little value to management’s ability to make further accretive acquisitions. Having followed the company for a number of years, we feel confident that management will remain disciplined in its acquisition strategy and that it will be a few years before Vitec runs out of attractive acquisitions.

In the long run, the share price of compounders like Vitec tend to grow at the same rate as the return on equity, assuming that the company can keep reinvesting profits back into attractive acquisitions. This, coupled with the fact that the share price at this level is undemanding should lead to an attractive return over the next few years as the company keeps growing and the earnings multiple increase to reflect the company’s ability to increase its earning power.

As a reality check we can compare Vitec with better known companies like Enghouse (ESL CN) and Constellation Software (CSU CN):

Enghouse:

5 year  average ROE: 15%

5 year revenue CAGR: 24%

P/ trailing earnings: 38

Constellation Software :

 5 year  average ROE: 43%

5 year revenue CAGR: 24%

P/ trailing earnings: 46

Vitec:

5 year  average ROE: 24%

5 year revenue CAGR: 14%

P/ trailing earnings: 25

Catalyst

1) Continued bolt on acquisitions at attractive valuations leading to increasing eps.

2) Increasing sell side coverage.