Description

Webstep (WSTEP NO Equity)

Brief company description

Webstep is a recently IPO’ed Norway-based IT consulting firm. It has offices and operations in Norway (85% of revs) and Sweden. Clients are split into public (25%) and private. Webstep specializes in core digital transformation services (cloud migration and integration, digitization), data analysis and IoT and machine learning applications. The majority of earnings today comes from the first segment (core digital transformation), but in the future, faster growing niches like analytics, IoT and machine learning will be important growth areas for WSTEP. A lot of competent employees in these areas are now in place, and full utilization of these employees is yet to come. I believe this will help WSTEP grow at a higher pace than the market on average as these service areas will probably command a price premium (as will WSTEP’s senior consultant profile) and help open new and profitable growth opportunities in both existing and new verticals in the future. WSTEP’s key industry verticals today are finance, TMT, retail and transportation. Another incremental revenue driver will be a normalization of the Swedish operations, which have been through a period of restructuring.

WSTEP’s business is steadily growing due to long term growth in IT-spending in the broader economy Mid-single digits over the longer term looks realistic. It is low-cyclical and capital light with very high returns on tangible capital, highly cash generative and led by a competent management team with skin in the game. It is among the market leaders in terms of profitability (rev/head, EBITDA/head) while also paying the highest salaries in the industry, reducing employee attrition. Its cost structure is variable based on invoiced hours, providing a flexible and efficient cost base acting as a buffer against margin contraction when times get tough.

Is it cheap? Why does this opportunity exist? What will trigger repricing?

The small market cap and limited investor familiarity with the name combined with some uninspiring Q3 figures (largely due to increased onboarding costs from new employee additions and investments in new focus areas) are probably mostly to blame for the mispricing. Additionally, some investors are skeptical because a PE fund floated the company now, but I think that fear is overdone. This Reiten fund was mature, and has been invested since 2011. Reiten also has a record of leaving money on the table, take for example the Zalaris ASA IPO. ZAL was floated by Reiten at 21 NOK in 2014 but now trades at 58 NOK.

WSTEP is clearly undervalued both on a relative and on an absolute basis. This is an opportunity with substantial upside and a very limited downside in my opinion: My probability-weighted fair value estimate for WSTEP in 2020 is 40 NOK including dividends, implying >60% upside or an interim CAGR of 17% from the current price of 25 NOK. I expect dividend yields of 6-7% in ‘18/19/20, which makes waiting for a repricing here easier. Compared to peers on 2018 EPS, WSTEP trades at an undemanding 11.5x, a 26% discount to the peer group median. In a downside scenario, where growth stalls completely starting next year, dividends are cut in half and WSTEP ends up trading at 10x 2018 EPS in 2020, the downside is still limited to a few percent.

The catalysts for that re-rating are likely to be: increased analyst coverage and investor attention, earnings growth from both core digitalization ops and increased earnings potential from emerging business lines like IoT and ML, a recovery to normal earnings power in Sweden and high dividend payments. M&A is not impossible, though not that likely in the short term, I think – one may reasonably assume that Reiten has shopped the name around before deciding to take it to market.

Recent M&A in the industry supports the undervaluation thesis in Webstep though: Tieto just bought Avega at 15.6x 2018 consensus EPS. These are comparable companies in both services offered and size. The cash offer for Avega thus implies a minimum current fair value of 34 NOK for WSTEP and given WSTEP’s superior revenue generation and profitability per capita, one could easily argue a premium to the Avega deal would be justified. Weirdly, this acquisition has not been mentioned yet in analyst reports on WSTEP (granted, only two have been published so far). Another financial buyer could be interested as well: as I will show later, even modest leverage should provide a promising return even without successful new growth initiatives or any cost saving efforts.

Sector exposure and customer concentration

Key offerings. Potential for increased revenues as more offices start offering the higher value services (2,3,4).

Categories 2,3 and 4 only constitute 17% of revenues today - that should change over the next few years…

…as these are rapidly growing markets. (Source: Radar, Statista, company).

The key risk factors

Loss of qualified personell. Webstep operates in a sector where the best heads can charge the highest prices and are attractive assets for all players in the space. Employee churn is high relative to other industries (WSTEP’s churn is lower than the sector average at 15%, but still close to 9% p.a.).

IT consultant brokers stealing business. In the Nordics, consultant brokers allowing customers to pick freelance consultants for jobs is on the rise. However, this is most prevalent in commoditized, shorter-term project based assignments. WSTEP mostly does not compete in that segment and is protected to a degree by its premium-heavy profile.

Loss of large public and/or private clients. While this is always a risk, the company claims no major contracts are being renegotiated at the moment. WSTEP’s top 10 clients constitute about 30% of revenue and its industry exposure is well diversified. The largest exposures are to finance (30%), telecom (18%) and retail (13%).

Development of (and earnings growth from) new focus areas don’t work out or takes longer than I expect, and/or Sweden fails to recover and stays at these rock bottom levels of profitability.

Company history (source: WSTEP)

Revenue history – flatter trend in recent years due to restructuring of Swedish operations (now complete)

Sources historical figures: Company, Proff, Arctic Securities, SB1 Markets

The company management team seems competent and trustworthy. Its track record in terms of capital allocation is not perfect, but they seems to have learned from the experience. CEO Kjetil Bakke Eriksen has been with the company for 10 years and has no intention of leaving, it seems. I view succession risk as low since there are probably several possible candidates for the job in house. The board raises no red flags in my book but is largely unknown to me with the exception of the chairman.

Board

The management team sold some stock in the IPO process, but I think this is natural as they had been locked in since Reiten took control in 2011. They still hold a considerable amount of stock and should be properly incentivized. It’s also positive that the company is introducing long term oriented stock based compensation programs, which is important to help build a solid, long term culture in a company where the employees are 100% of the assets. Recruitment bonuses have also been introduced, reportedly with very good results.

Competitive situation

The market for IT consulting services in the Nordics is large and fragmented and consists of different groups of players. It is growing at a steady 3-4% pace (Norway and Sweden. Source: Radar).

1. Large generalists – typically hired to execute large, complex projects. E.g. outsourcing services, ongoing system maintenance and integration. Examples: Evry, Atea, CGI, CapGemini, Sopra Steria.

2. Pure-play IT-consultants who typically focus on software development services. Examples: Webstep, Bouvet, Avega, HiQ, Knowit, B3IT, Sigma, Itera, Acando. These are WSTEP’s most relevant peers. As shown below, WSTEP performs better than peers on most per capita metrics.

3. Local niche players focusing exclusively on one or more verticals (e.g. Avensia).

Market overview Nordic IT consultancies (sources: company prospectus, Proff Forvalt).

B3IT: Fast-growing Swedish company that typically hires consultants with more than 10 years of experience. Listed on NASDAQ Stockholm AB with a turnover of SEK 489 million and an EBITDA of SEK 49 million in 2016.

Bouvet: Strongest within the public sector and enterprise customers. Its local network of offices allows Bouvet to provide specialist services aimed at specific local needs, which differentiates it from larger and more generalist competitors. Revenue for 2016 was NOK 1,331 million and EBITDA NOK 121 million. Listed on the Oslo Stock Exchange.

Knowit: Diversified service offering within several fields of IT consultancy. Revenue of SEK 2,426 million and an EBITDA of SEK 223 million in 2016. Listed on the NASDAQ Stockholm AB.

HiQ: Strong presence in both the public and private sector. Present in six cities in Sweden, in Moscow and in Helsinki. HiQ had a turnover of SEK 1,659 million and an EBITDA of SEK 219 million in 2016. Listed on the NASDAQ Stockholm AB.

Bekk: Recent focus on team and solution deliveries. Strong presence within the public sector and enterprise customers, with particular focus on software development. Headquartered in Oslo with a branch in Trondheim. Bekk is a private company owned by EVRY ASA (99.84%). The company had a turnover of NOK 564 million and an EBITDA of NOK 88 million in 2016.

Avega Group: Focused on both private and public sectors. Present in Stockholm, Malmö and Gothenburg. Revenue of SEK 428 million and an EBITDA of SEK 39 million in 2016. Listed on the NASDAQ Stockholm AB since 2010. (NB: recently acquired by Tieto).

Itera: Norwegian company with 400 specialists within communication and technology. Revenue of NOK 425 million and an EBITDA of NOK 56 million in 2016. Listed on the Oslo Stock Exchange.

Acando: Swedish consultancy company working with digital transformation in public and private sector. Listed on NASDAQ Stockholm AB with a turnover of SEK 2,206 million and an EBITDA of SEK 224 million in 2016.

Sopra Steria: Focus on public sector and enterprise customers delivering projects and advisory services to mostly large clients. Has established a competitive position providing software, application development and maintenance services to the Norwegian government.13 Norwegian headquarter is located in Oslo. Sopra Steria AS had a turnover of NOK 1,733 million and an EBITDA of NOK 158 million in 2016, and is wholly owned by Sopra Steria Group SA, which is listed on the Paris Stock Exchange.

Source of text on peer companies: IPO prospectus

General industry outlook and the competitive strengths of WSTEP

I am positive in general on the outlook for the Nordic IT consulting industry. It will have tailwinds from what I believe will be a long lasting trend toward increased enterprise spending on digitalization broadly, and IoT, ML and analytics more specifically. I expect it to keep growing at roughly the current trajectory of 3-4% on average (source: Radar, company IPO prospectus). Other sources indicate a higher growth rate is possible, especially in Sweden – where Tieto e.g. expects the market to grow at 5-8% annually. I expect Webstep to perform slightly better growth wise due to a combination of modest headcount additions, positive mix shift effects (more ML and IoT e.g. should command higher pricing) and better economics in the Swedish business than what we have seen over the last few years.

According to Radar, real-time analytics, Internet of Things and big data are the most important emerging topics in the Norwegian IT-services market and the areas that will experience the most rapid growth in the coming years. Websteps efforts to strengthen its position here appears wise from a longer term perspective.

Businesses’ opex spending on software and systems will probably rise markedly in the future. With the pace of technological innovation seemingly picking up speed, keeping up with current technology will be increasingly important to stay competitive. This appears to apply to virtually all industries today, and we are seeing it very clearly in WSTEP’s key verticals already. So I think it is reasonable to say that demand for IT consulting services will increase, not decrease, as it is not feasible or cost-efficient to have this competence in-house for most companies out there. This, all else equal, should lead to higher hourly prices over the long term and increased organic revenue growth for the consultants (organic as in higher earnings per existing head). The growth bottleneck for Nordic IT consultants is that it is difficult to find qualified labor, not lack of demand for consulting services. Well run firms like Webstep probably don’t have too much room for improvement w/ regard to utilization generally, but there’s probably a little extra slack here currently because of the recent onboarding of 27 new heads in Q3. The sensitivity to utilization is obviously significant, for better or for worse, even with a variable salary structure. Earnings growth beyond that from profitable mix shift, cost cuts or utilization improvement must mainly come from adding more employees somehow. This will move relatively slowly. There aren’t enough highly IT-competent people out there today to allow the firms to add manpower at the pace they would like, resulting in fierce competition for the brightest heads, which in turn leads to relatively high labor turnover and a constant struggle to recruit the best. It also leads to wage pressure and may then lead to flat and hypothetically even negative revenue growth despite growing the number of employees. In a fixed salary model especially, the employees can end up extracting too much or all of the incremental profits from the incremental invoiced hours, and the business might see no improvement as a whole, numerically speaking at least. It also leaves the business vulnerable to a future downturn in new business since the cost base would then be at a higher level.

In Porter-speak, the bargaining power of suppliers is currently high in this industry. It is lower in the case of most attractive firms with strong reputations built over several years, like WSTEP which now has almost two decades of successful operations. At Webstep, they partly side-step the problem described above by offering employees a variable salary structure, in which consultants keep 60/65% of the total invoiced amount as base salary. This ensures both a more flexible cost base which is an advantage in tougher times to avoid margin contraction, but also incentivizes employees better (much better than say annual discretionary bonuses, e.g.).

While attractive to new hires, this does not, however, allow WSTEP to hire as many new heads as they would like (though modest net additions per year looks likely). As Webstep almost exclusively hires very experienced consultants with a minimum of 7 years’ work experience, and senior consultants are the best qualified and most profitable hires, competition for thes employees is tough for them too. The reasoning behind focusing on the senior employees is sound. Senior consultants have been shown to be much more efficient than their junior counterparts – a whopping 31x more efficient than juniors and 14x more efficient than medium skilled consultants according to Simula Research, Lyle M. Spencer - Competence at Work and Magne Jørgensen. (Source: Arctic Securities & SB1 Markets). Clients are willing to pay for this, enabling WSTEP to not compete on price alone. Engineering skills, ability to generate upsales with clients, pricing power vs the client and % utilization are all much better for more senior employees than for say a recent informatics graduate. The company does not disclose its % utilization or its hourly prices, but everyone I’ve talked to say utilization is probably a fair bit higher than the industry average at 80%). There’s been a tendency for senior hourly prices to grow faster than junior hourly prices, which have remained fairly flat for the last few years. The overall statistics on hourly prices are influenced by this. I think that masks a more favorable development at Webstep.

In summary, I think the better economics of Webstep vs the competition are due to:

1. The premium consultant profile (WSTEP can charge higher prices) and superior incentive structure

2. Higher average utilization of the consultant stock.

I believe this competitive advantage is sustainable for a longer period as WSTEP is very focused on building a long-term oriented culture. Combined with the best incentive structures and good opportunities for continuous competence building, that should help WSTEP stay a preferred employer. Of course, there’s no guarantee that competitors do not wise up eventually and adopt what looks like a superior salary model for example. Several data points indicate that for now employees at WSTEP are a more happy and satisfied bunch, though:

• WSTEP’s employees make more money on average than competitors’ employees

• Fewer consultants (10-12) than peers (20-30) assigned to each sales rep, leading to higher utilization

• WSTEP has consistently been ranked top 3 or better in the Great Place to Work ®Awards since 2010

• The sick leave is lower at WSTEP than at competitors’ firms and employee churn is lower than peers’

• The firm also works very hard at developing new skills in the employee base through educational programs/courses to satisfy employees needs for continuous competency improvement.

I mentioned above that the bargaining power of suppliers (in this case the employees) is currently high. Continuing to apply the Porter framework for a moment, I would say the threat of new entrants in IT consulting is high in some parts of the market. Capital investment needs are low, and there are plenty of firms to choose from. Consulting brokers now also allow freelancers to efficiently market themselves to would-be employers. Customer switching costs are thus relatively low, and the threat of substitute products also high.

However, I think this applies mostly to short term project work on relatively uncomplicated tasks and as I wrote above, we have seen some actual evidence of this in that junior hourly prices have been flat for several years while senior hourly prices have continued to increase more or less steadily. This suggests competition for the simpler work has increased while the assignments that requires more expertise are more insulated. Expertise built over a number of years is recognized by clients, and there is some brand value to WSTEP I think, they have been at this for almost 20 years. If you are in the process of making a significant investment in mission-critical new technology, you don’t give that job to a firm without a strong track record. WSTEP falls into what Josh Tarasoff calls the tie-breaker brand category (a middle ground between a brand franchise and a commodity-like business). Additionally, certain niches and verticals carry a price premium in the market place and may hold the promise of stickier customers (logically, machine learning, IoT and analytics work should be longer lasting and create stickiness superior to say a simpler systems integration job). WSTEP’s bet on IoT, ML and analytics makes sense in this context. The bargaining power of buyers is medium I would say. Yes, buyers can choose from a number of consulting firms, but the increasing need (both real and perceived) to stay technologically relevant weakens their bargaining position somewhat. Also, it is isn’t easy to secure all the necessary competence in-house for these buyers either, and it’s probably not cost-efficient in many cases. Industry rivalry is significant, but WSTEP’s consistently higher revenues and margins per capita suggests the company is not competing on price alone. There are no guarantees that this will be continue to be the case in the future, but this is what the dynamics of the industry suggests at the moment.

Relative revenue generation and profitability per capita WSTEP (source all figures: company).

Valuation

Assumptions

• I expect the full year revenue growth rate for 2017 to suffer from IPO costs, higher onboarding costs and investments in ML/IoT/analytics expertise and capacity, and also some calendar effects (2 fewer working days in 2017). There was also a higher use of subcontractors to develop new client relationships in Sweden in the last quarter than usual, that’s unlikely to repeat next year. Higher use of subcontractors impact margins negatively. As WS adds capacity in Sweden, this effect will diminish. The relatively high estimated revenue growth rate for 2018 is due to the absence of these effects and higher utilization of the newly onboarded consultants (27 new heads were signed in Q3) as well as continued improvement in Sweden. My estimated overall revenue CAGR for the whole forecast period 2018-2025 is 4.5%. For the period from 2017e-2020, the number is slightly higher (5.7%). This is in line with the company’s stated goal of around 5% long term. Revenue growth will be driven by a combination of both headcount add and business mix. Sweden should experience the fastest growth in 2018 (13%), with tailwinds from both headcount add, better utilization and higher hourly prices. After 2018 I expect the same growth rate for both markets (5% in 2020, 4% from there until 2025). The implication is that I assume Sweden will be back at ‘14 levels in terms of revenue by 2018.

• The sales processes in the new focus areas are longer than in core digitalization, but prices will be higher and jobs are more sticky in nature I believe, which should lead to a higher share of recurring revenues and facilitate upsales of additional services over time. I believe this will help lift operating margins above what the limited consensus now reflects (more on margin assumptions below). The company feels that these new services are where cloud services were back in 2014: a relatively new business area that customers were interested in, but not willing to embrace yet. Cloud services momentum is now very strong, and willingness to pay is substantially up since then. In fact, WSTEP believes analytics/ML and IoT may generate the majority of revenues in as little as 5-6 years as investments in these areas become more mainstream.

• What were the problems in Sweden? The Swedish acquisition (bought Diversify in 2012) quickly became a real mess. Management quit, lots of the consultants there were not of the quality WS was led to believe, and severance payments/headcount reductions and management changes ensued. This led to lower revenues, loss of operational efficiency, extraordinary costs and and weaker margins.

• With Sweden now restructured and new hires and business accelerating (revs up 14% ytd, EBITDA up 8% ytd) and a higher part of revenues coming from the new segments, I think it’s realistic that the company wide EBIT margin climbs toward about 13% from 2019, given that Norwegian ops should be able to reach a 14% EBIT margin and Sweden should be able to get back to the current Nordic average of 9% over time from the current run rate of 7.4% (see table below for a hypothetical trajectory in Sweden). There is of course a risk that I am too optimistic here and that it will take longer to achive those margins, 13.2% would be higher than the limited consensus EBIT% that exists (at about 12%-12.5% over the next several years) and toward the high end of what management has said is the medium term goal. For reference, the industry average has declined from a peak of 12% in 2008 to a trough of 7% in 2010 and has since recovered to about 9% in 2016. WSTEP’s 13% EBIT margin would thus be higher than the peer group average, but lower than margin leader Bekk Consulting (owned by Evry) at close to 15%, for example. WSTEP has always had margins well above the broader industry.

• D&A will decrease markedly in 2018 onward as amortization relating to acquisitions ends (this amortization is also why FCF>EPS in 2017 in the chart below). Regular depreciation is usually around 1.6m NOK (2014/2015/16) and I expect that in 2017 as well, after which I grow it in line with revenue. Capex is kept at 0.4% of revenue going forward, in line with historical trends. I keep the tax rate at 22.6% throughout the forecast period (Norway’s tax rate will stay at 23% and Sweden is at 22%).

With 8% headcount growth until 2019 and some marginal improvements in revenue generation and cost efficiency WSTEP should get back to industry average EBIT margins in Sweden. A hypothetical scenario below:

NB: In the sell-side pieces I’ve seen on WSTEP, the estimated revenue pr capita in Sweden is only about 1.3m and the number of FTEs estimated to be 73 on avg in 2017. But looking at the Q3 report, Webstep Sweden has only 65 employees on avg ytd.  Annualizing the Q3 and ytd revenue figures, revenues should therefore be much higher in 2017 than sell-side estimates imply, 1.46m instead of 1.3m, in line with the company average for 2016. The sell-side EBITDA estimates however, look to be exactly the same when annualizing ytd results as done above. (NB: I assume the SEKNOK x-rate should trade around parity (0.99 now), so I’m not adjusting figures from Sweden in my model). I interpret the improving Q3 and ytd figures to mean that revenue generation is good in Sweden already, and that margins should follow with increasing hourly prices, increased utilization and decreased use of subcontracted consultants over time.

P&L

Expected returns

• P-weighted fair value estimate at 40 NOK, implying a 17% expected CAGR until 2020e.

DCF value: 40 NOK (NB: full forecast period to 2025 not shown).

Note on the cost of capital:

I’m assuming a 9% WACC (9 CoE, all equity). One could argue that 100% equity financing is not optimal for a stable, very cash generative business – the cost of capital could be quite a bit lower with some debt added, say 3x EBITDA at 4% or so should be doable without problems. On the other hand, the all-equity profile could allow Webstep to make smaller acquisitions in relevant niches in the future (say smaller IoT/ML specialist firms) that it would otherwise have to forego to conserve the balance sheet, and acquisitions like that can be both strategically important and growth accretive. Which could turn out to be more important than optimizing the capital structure for current operations. Hence, I view the pristine capital structure of Webstep as a good choice for the company at this point in time.

Relative valuation: cheaper than peers on most metrics. 26%/23% discount on P/E and EV/EBITDA for 2018

• Note how WS compares favorably to Avega on per capita earnings metrics. Avega was just acquired at 15.6x EPS, implying at least a 34 NOK fair value for WSTEP.

• Without taking into account the superior profitability of Webstep: how would the economics of a buyout at 34 by a financial player look? A 16% CAGR can be expected with only 35% debt financing:

LBO scenario at 34 NOK – attractive even without assuming further operational improvements

* 15x = HiQ's EBITDA x for 2017. i.e. assuming a 20% discount. 34 NOK is also the implied value from the Avega transaction.

• 4.5% is the interest cost Reiten secured for Webstep before the listing, which extinguished the debt (WSTEP will have about 15m in net cash at year-end, I think), so assumed realistic

• No improvements in WC management or other cost reductions are assumed

• No new growth initiatives or M&A assumed

Conclusions

Webstep is an excellent business with moderate but fairly certain growth prospects longer term, and it is available at a very attractive price. It has a solid balance sheet and is well run by able management.

The biggest risks to the investment thesis are slower growth than I expect due to longer sales processes in the new focus areas or Sweden failing to recover (which would also lead to lower margins for longer), as well as loss of key personell and/or big clients. Other negatives include Webstep’s limited size and liquidity, but that is part of the reason the opportunity exists. This last point is not a major issue for us, but others may feel differently (and perhaps with good reason, depending on their mandate). Finally, consultant brokers could make further inroads in the IT consulting market, eroding margins and growth for the consulting firms.

WSTEP is trading at an undeserved discount to its intrinsic value, both on absolute and relative valuation measures. My base case value by 2020 including (undiscounted) dividends received in the interim is 41 NOK. That implies a target valuation in 2020 of 14x FCF (7.1% FCF yield), hardly demanding. My bear case is 10x 2018 EPS, plus half the base case dividends, a scenario which would entail a complete halt to growth starting next year. The downside in this case is marginal. My bull case is a valuation in line with that of the larger (but less profitable per capita) Swedish peer HiQ SS Equity at 17x FCF plus interim base case dividends. The P-weighted average yields 40 NOK, so I expect a total return of about 60% by 2020, or a 17% CAGR including dividends.

This is an investment with attractive return/risk assymetry as the risk of permanent loss of capital over a longer timeframe should be very low due to the robustness of the business model (its variable salary structure in particular stands out as a buffer against bad times - even during the financial crisis years, barely a dent was made in the revenue growth of WSTEP, and the EBITDA margin only modestly contracted from 18% to 15% in 2008 before recovering to 17% in 2009). Should the company grow more slowly than expected, the high dividend yield of WSTEP will help mitigate shareholder disappointment.

WSTEP is a very compelling investment at 25 NOK.

Appendix:

Largest shareholders pr november 13th 2017. (Colina = CEO. Xerxes, Illari, Pricia also insiders and employees).

Checklist score: 81%

Sources, links of interest and suggestions for further reading

Company reports and conversations with management

IPO prospectus: https://www.webstep.com/wp-content/uploads/sites/5/2017/09/Webstep-ASA-Prospectus-26092017.pdf

Reiten & Co website: http://www.reitenco.com/investments/

Annual and interim reports of industry companies (Tieto, Avega, Bouvet, Evry, B3IT, HiQ, Itera)

Sell-side research:

IPO & initiating analysis by Arctic Securities (Oscar Fredricsson) www.arcticsec.com

IPO & initiating analysis by SB1 Markets (Petter Kongslie) www.sb1markets.com

Catalyst

Increased analyst coverage