Description

Executive Summary

Vitec Software Group AB (ticker: VITB SS) is the largest Nordic-based vertical market software (“VMS”) company with a market cap of $1.9bn USD. It a smaller, faster growing and arguably higher quality version of Constellation Software (CSU.CN) and it has also outperformed its better-known peer over the last 10 years producing a total return of +3,546% (43% CAGR). This is despite Constellation Software earning cult status by investors over this same ten-year period. Our base case target price is ~870 SEK providing a ~55% return over the next two years.

After >35 years of relative obscurity and only garnering research coverage from three local Nordic banks, we think Vitec is poised to become a more well-known entity that will be owned by more US and global institutions as shares continue to outperform. Currently CSU generates 30x Vitec’s annual revenues and US investors only own ~20% of Vitec shares vs. ~45% of Constellation Software’s shares. This highlights the large opportunity in closing the knowledge gap.

We believe organic growth will remain sustainably higher than its publicly traded VMS peers and under CEO, Olle Backman, who has been at the helm since April 2021, the company has doubled down on operational improvements, and it has accelerated its capital allocation. Their M&A velocity and target size have increased while its deal team and its total addressable market (TAM) have grown by a step change function providing evidence that this inflection is sustainable.

Moreover, Vitec and VMS companies are the optimal type of business to execute upon a programmatic aquisition agenda. This is because VMS companies, like Vitec, have an extremely attractive business model. A high percentage of revenues are recurring which provides stable and predictable cash flow. The software is oftentimes built once and it can be distributed many times over at almost no incremental cost leading to extremely gross margins. Moreover, the assets require little or no capex to grow sales leading to high returns on capital. In most cases, these businesses enjoy free float (aka capital) as their customers pre-pay monthly or quarterly. Also, the business is relatively non-cyclical as we saw during covid (’20-’22) and the Great Financial Crisis (’07-’09). This is because the product is at a low price point (~1% of OpEx as per CSU) but it remains mission critical for its users to run their businesses. Given the highly specific and embedded nature of Vitec’s software within their clients’ business processes, switching costs are high, churn is low and barriers to entry are elevated. Moreover, each software vertical is relatively small and their low price point creates limited incentive for new entrants.

Like Berkshire Hathaway, Constellation Software and Lifco, Vitec also offers a permanent home for the owner-founders of vertical market software companies. Vitec acquires these companies at lower valuation multiples (7-9x EV/EBIT) relative to Vitec’s valuation (>25x EV/EBIT) leading to immediate value creation due to a sustainable public/private market valuation arbitrage. Vitec can also effectively lower its purchase price by driving efficiencies and instituting best practices at its newly acquired companies. Given the low capital needs of software companies and their finite niches, Vitec can take excess cash from previously acquired companies and use it to acquire more VMS companies, which is a great type of flywheel to have for a Snoboll Compounder Roll Up company.

Company Overview

Vitec was founded in 1985 by Olov Sandberg and Lars Stenlund as a side project when they were researchers at the University of Umeå. Their first product was a software developed for monitoring energy usage at properties. The Co-Founders realized that property owners might benefit from measuring their energy usage and they built a program that achieved this. The company was immediately profitable and in 1992, after several years of >30% revenue growth, Vitec listed on the Nordic Growth Market, the local junior equity exchange. In 2003, Vitec commenced its acquisition driven strategy and they have continued to improve upon this strategy for >20 years. Yet it wasn’t until 2011, when Vitec was uplisted to Nasdaq Stockholm that they acquired a business in Norway, marking its first acquisition outside of Sweden. This was followed by the entry into Denmark three years later. In 2H 2021, Vitec announced the acquisition of Vabi in the Netherlands, its first acquisition outside of the Nordics.

The company has grown rapidly over the last ten years with revenues growing at a 17% CAGR while EBITDA has expanded at a 25% CAGR. This is thanks to solid organic growth (MSD-HSD), a kaizen-like focus on continuous improvement and a robust M&A program. This is augmented by an extremely decentralized operating strategy where each business is managed separately by its own dedicated management team. Vitec supports its subsidiaries with a lean corporate team that is mostly focused on re-allocating the platform’s free cash flow into highly accretive M&A opportunities. While many will say this all sounds a lot like CSU, Vitec’s co-founders claim they weren’t even aware of Constellation Software and Mark Leonard until well after they started their own M&A journey >20 years ago.

Vitec currently has LTM revenues of ~2.6bn SEK with ~88% recurring subscription revenues. It has 38 business units distributed across geographies and industries, minimizing customer and industry concentration risk. Its largest subsidiary accounted for ~10% of revenues, while the largest customer accounted for ~1.5% of revenues.

Target Price and Valuation

Our base case target is ~$870 (~55% upside) including two years of dividends (~1.4% yield) based on our 2025 EBITDA estimates.

We use 22x EV/EBITDA for valuation purposes as we believe this is a fair multiple based upon its own historical valuation as well as the valuations of its VMS peers (CSU CN, LMN CN, TOI CN), which trade at ~23x ’24 EV/EBITDA. We also believe that lower interest rates should help to support valuation expansion in the foreseeable future. Moreover, we find it tough to lose money in the company over the next two years given its ~60% EBITDA growth over this period.

VITB currently trades at ~20.2x consensus ’23 EV/EBITDA vs. its five-year average of ~20.3x and its previous highs of ~35x in 2021. Vitec has historically traded at a premium to the market, which is justified given its high mix of stable non-cyclical recurring revenues, its strong historical growth, its small scale, which provides a large M&A growth opportunity, and its scarcity premium. Vitec is one of the few publicly traded software companies in the Nordics with both strong growth and high margins. This is evidenced by its ~80% score when looking at the rule of 40 (revenue growth + EBITDA margins), which is used to assess software companies globally. A figure above 40% is typically used as evidence that a software business is of higher quality.

In terms of valuation, we must highlight that an EV/EBITDA comparison vs. CSU is not apples to apples as Vitec’s capitalized R&D is tangibly higher than the corresponding amortization of its capitalized development costs. The gap started back in around 2017-2018 when the company changed the assessed lifetime of such assets from 5 to 10 years. This has led to a ~800bps Adj EBITDA margin benefit relative to CSU over the last few years. Nevertheless, even on an Adj basis, Vitec enjoys ~31% EBITDA margins vs. its VMS peers average of ~28.3%. In addition, VITB has grown faster than CSU in each of the last seven years and by an ~8% advantage on average per year over the last five years. On top of this Vitec’s FCF margin has averaged ~27% vs. ~22% at CSU over this same time. So while its EBITDA margins are relatively juiced, its FCF conversion is still higher than its best-in-class peer.

On an adjusted basis, Vitec trades at ~21.3x cons ’24 EV/EBITDA (~17x unadjusted) whilst its lower organic growth peers trade at ~22.9x ’24 consensus EV/EBITDA. Year to date Vitec’s organic recurring revenue growth rate has been an impressive ~14% vs. its peer’s average of <6

OVERVIEW OF KEY INVESTMENT FACTORS (KIFS)

• KIF #1: Sustainably Higher Recurring Organic Growth than its Peers
• KIF #2: VMS Industry Leading Business Quality
• KIF #3: High Performing M&A Machine
• KIF #4: Step Change Acceleration in M&A Activity

KIF #1: Sustainably Higher Recurring Organic Growth than its Peers

Vitec has historically enjoyed 4-6% organic growth driven by: ~1/3 existing customers, ~1/3 price, ~1/3 new customers, which is ~2x CSU’s target. Considering organic growth is the highest value creating driver of growth this should support a higher valuation than its larger peers. Moreover, recurring organic revenue growth has accelerated to >10% since Q3 2022. In fact, right now its +14% over last twelve months, its highest recurring organic growth level in many years.

Vitec’s founders explain that their “approach comes from the industrial side; we are geeks”. Whereas they describe Mark Leonard as more of an “investment banker”. Vitec has a steadfast focus on product development and technology, rather than financial engineering. R&D is typically 12-13% of revenues, which is quite high in the space, and this supports sustainably higher organic growth.

Starting in 2017, Vitec combined its R&D approach with a new focus on driving recurring revenue growth as they initiated new strategies. The mindset shifted towards reducing reliance on all consulting and implementation costs and accelerating its mix of recurring revenues. They also started transitioning all of their products from on premise / license to cloud / SaaS based revenues. Given this trek was started six years ago the transition is mainly complete and >85% of revenues are billed monthly while one-time license revenues only account for ~2% of revenues.

In addition, most of Vitec’s contracts have built in CPI adjustments which supported mid-single digit price increases last year. VITB announces prices increases only once per year in December-January for most of its customers. As inflation remains elevated in 2H 2022 (CPI >7%), this should support low/mid-single digit price increases for 2024 contracts.

KIF #2: VMS Industry Leading Business Quality

On top of industry leading organic growth, Vitec enjoys high margins and strong earnings quality. EBIT margins have expanded from <11% in 2013 to ~22% in 2023. Ahead of 2022, the company boosted its EBIT margin target from 15% to 20% and it looks like 2023 will already surpass this target, which could lead to a new even higher EBIT margin target.

Following covid, margins have remained much higher and this is structural. Vitec’s EBIT margins had been stuck at <15% for years, but this was muted by license to SaSS transitions going on under the hood. In addition, Vitec had been making elevated investments in its infrastructure. Vitec now has six VPs which are each responsible for six-eight companies and it’s their job to oversee their operations. Prior to this it was just the C suite that was responsible for driving operational excellence on top of managing capital allocation.

Regarding operations, Vitec operates like a kaizen with a focus on making many small continuous incremental improvements. All employees are required to take part in “Vitec Academy”, a company specific curriculum that highlights best practices across verticals and business lines. All new managers are required to participate in Leadership Training Program and all new employees attend New @ Vitec. This helps to foster a culture of continuous improvement. Each individual subsidiary also has the same three KPIs: 1) improvement in EBIT, 2) increasing recurring revenue/revenue, 3) recurring revenue/labor costs. However, individual targets are set for each subsidiary every year and it is expected that all subsidiaries improve upon each metric every year. While there are no bonuses tied to these metrics, this has been the case for the last fifteen years. Instead employees are incentivized to purchase and own stock. Vitec does not have a bonus system as senior executives believe that this will better ensure that the company is always managed for the long term.

Their most impressive KPI is tied to labor cost/recurring revenues. Here Vitec is in a league of its own at ~60% vs. its peers at ~76%. For Vitec, they commonly state that this is the most important KPI as it highlights strong earnings quality. For Vitec, anything service related is low margin and low value add. As Vitec has consistently done, they will look to standardize products and automate as many processes as possible. They will remove any hardware and consulting related sales, which are also lower margin and less scalable. What emerges is a higher margin and higher quality stream of recurring revenues. For the foreseeable future, management believes that revenues will grow faster than labor costs, the company’s biggest cost item at >45% of revenues, which means margins should continue to march higher.

KIF #3: High Performing M&A Machine

Since its founding, Vitec has completed 49 acquisitions and like most great programmatic acquirers they have very explicit acquisition strategy. First, they don’t buy turnarounds and they typically don’t buy companies with a high level of service revenues, unless it can be converted to recurring revenue streams. They target well-established, mature companies with a high mix of steady recurring revenues and good profitability. Companies must have a vertical market product that is standardized and loyal long-term customers. In addition, Vitec loves small niche markets where targets have a high market share. Also, the targets must have proprietary software. They won’t buy a company built on another’s applications or where product development has been outsourced. This element ensures that companies control their own destiny and it also creates strong barriers to entry.

While Vitec is industry agnostic, they do have a nearly exclusive focus on targets in the Nordics and the Netherlands, for now. Lastly and perhaps most importantly their acquisition targets must share similar values and corporate cultures to Vitec. Another recent change to the strategy has been a focus on higher margin acquisition targets. Whereas a few years ago Vitec might buy assets with 10-15% EBIT margins, they now routinely buy targets with >30% EBIT margins. In general, VITB highlights that most targets are just higher quality than they used to be as many have already converted to SaSS-based business models.

Vitec’s M&A team is all centralized and run out of HQ, which differs from Constellation, where its subsidiaries are also responsible for identifying and acquiring targets. Similarly, most acquisitions are sourced in off-market transactions where multi-year relationships with Founders/CEOs eventually lead to an acquisition. Once companies are acquired, they are all rebranded “Vitec” so they enjoy the same look and feel across subsidiaries. Vitec believes that this helps for recruitment of top tech talent and it helps build market share as Vitec believes its brand provides a coveted stamp of quality. Next, Vitec will centralize all back-office functions (HR, IT, and finance), which provides immediate synergies. Vitec is also known for saying to its newly acquired businesses “you drive the revenues; we do the rest”. All companies continue to remain autonomous, and in most situations legacy management remains on board. For Vitec it is essential to have the entrepreneurs’ running companies, but they also have a team internally that can be used to source new CEOs.

Upon closing deals, each company adopts Vitec’s standardized way of financial reporting and is assigned a VP that creates a specific action plan for each new company. All companies have the same KPIs, but each business has a specific strategy for attaining its goals. There is no set playbook, but in most cases price increases are implemented. Multi product lines are streamlined into one and hardware and services are re-oriented towards streams of recurring revenues. While bonuses are not tied to individual performance, Vitec distributes monthly rankings for each subsidiary companywide on every KPI. This fosters some healthy competition and bragging rights for top performers. Synergies and business growth are also attained through a systematic sharing of best practices across its subsidiaries. CEOs representing similar end markets or products are brought together on a quarterly basis and this creates a continuous flow of synergies and strategies for operational improvement. In addition, the company has annual offsites for operational level people across every function (product manager, developers, etc) where best practices can cross pollinate across businesses.

KIF #4: Step Change Acceleration in M&A Activity

Vitec doesn’t have any financial targets for acquisition activity and Vitec’s deal activity had been relatively modest with recent years seeing a few acquisitions per year. This pales in comparison to best-in-class peer Constellation Software which executes >100 VMS acquisitions per year. However, this is not a market constraint, but rather a resource constraint. In Sweden alone, the number of Swedish software companies with 1-99 employees has grown from 4,091 in 2008 to 9,330 in 2022, suggesting an expanding number of acquisition targets in this sector. On top of this there are thousands of acquisitions targets across the Nordics and the Netherlands, without even looking into the rest of Europe.

Vitec maintains a database that includes ~1,500 actionable targets that fit its acquisition criteria. Their CEO, Ollie speaks to 150-200 new companies/year and Vitec typically bids on 20-25 companies which has ultimately lead to 5-6 deals. Vitec also has no formal leverage target, but 2.5x ND/EBITDA would be the high end of its comfort level. Given ND/EBITDA is currently ~1.7x, Vitec can easily add leverage to increase its deal velocity and its target size. Also, Vitec has consistently paid dividends equivalent to >1/3 of earnings, which can be lowered to provide even more ammo for incremental M&A, if needed.

In recent years, Vitec has increased its number of M&A deals to about five acquisitions per annum from only a few per year previously and the company is undergoing a step change function in its M&A and integration capacity. VITB’s deal team has grown by 3x over the last 12-18 months as they went from one guy exclusively focused on M&A to a three-person team and the company is broadening its geographical reach. In 2023, the company has just closed its record high sixth acquisition and Vitec announced its two largest acquisitions in the last 1.5 years. Historically, Vitec’s acquisition targets would add <50mn SEK in revenues but ABS in July 2022 and Enova in Feb 2023, where both >250mn SEK revenue deals, which each added >10% to annual revenue growth. Vitec’s recent expansion into the Netherlands grows their deal TAM and it provides even more white space for potential acquisition targets. Thus far management remains very satisfied with its Dutch acquisitions, and they have had no issues replicating their proven business model in new geographies. In addition, management believes that higher interest rates and tighter private funding markets are leading to less deal competition and lower valuations.

In conclusion, management is comfortable continuously increasing its deal velocity and size to sustain current growth rates and they have a playbook to accelerate their growth from acquisitions. As the company scales they will simply need to add another member to its M&A team and an incremental VP, which are being trained internally. Nevertheless, sell-side analysts continue to underestimate Vitec’s potential to grow through acquisitions.

Thinking Backwards

• Macroeconomic Risks: Vitec said that negotiations in Dec 2022 started to get harder and they were seeing a tougher time adding new customers with more customers postponing new contracts. Attaining large price increases was also more challenging than the previous year.
  • Mitigants: Organic growth has shown no signs of slowing despite tepid commentary. Moreover, Vitec’s products are mission critical. If its customers shut VITB products down many businesses wouldn’t be able to continue operating effectively.
• M&A competition: Given CSU’s success and the attractiveness of the VMS industry the number of buyers looking to acquire VMS assets has increased over the years. Higher competition could lead to richer acquisition multiples, which could eat into returns on capital

• Mitigant: VITB says they rarely see Topicus (CSU’s European focused VMS asset) and claim they are also doing deals that don’t always fit Vitec’s criteria. Also, many private VMS acquirers took on considerable leverage before interest rates started increasing in 2021-2022 leading to less deal competition in 2023-2024. In general, management claims that valuations for the assets that they are looking to buy have not changed in years.

• Skin in the game: CEO Olle Backman who joined in 2019 initially as Vitec’s CFO only owns 0.2% of shares
  • Mitigant: Vitec’s co-founders, which have both recently retired, continue to own ~7% of shares and ~37% of the vote combined. Lars Stengard remains actively involved and speaks to Olle at least once a week.
• AI Risks: AI is being used to shorten the development time for new software as well as technology applications. There is risk that these developments could make software products obsolete.
  • Mitigant: VITBs products are missions critical and sticky. It would take a step change function vs. an already low price for customers to attrite. Moreover, VITB is now harnessing AI to shorten its own development times and to make its labor force more effecient. They consider themselves to be net beneficiaries of AI.
• Rising Labor Costs: Labor costs have increased by >20%/year, driven by >20% headcount increases over the last two years
  • Mitigant: Large headcount additions came from its recent sizeable acquisitions which are in the process of being streamlined. Salary increases are announced each April and Vitec has capped most salary increases at 2%. Moreover, price growth carries >2x the weight as labor costs and this should continue to grow in excess of salary growth.

Catalyst

• Continued beats of consensus estimates
• Higher mid-term EBIT margin targets
• Increased number and size of acquisition targets
• More transparency including quarterly analyst calls, roadshows and a potential CMD in 2024
• Larger company size and trading volumes leads to more sell-side research coverage
• Broader US/institutional ownership