Lombard Risk Management - Enterprise Software

Lombard Risk Management (“LRM”) develops risk management and regulatory compliance software and licenses this software to financial institutions. 

Risk Management

The risk management business is long established and consists mainly of COLLINE, a collateral management product, and OBERON, an institutional trading software product. 

When banks and businesses lend to each other some kind of collateral is often required in order to reduce counter-party risk exposure. The types and varieties of collateral have become ever more complex over time. “COLLINE”, Lombard Risk’s 10 year old collateral management product, helps lenders keep track of these. COLLINE is licensed to about 50 financial institutions – including Northern Trust and Société Générale – and is probably the leading product in its niche. 

OBERON is software for processing, valuation and risk management of trades involving interest rate and inflation derivatives, currencies, and money market and fixed income securities. Its pedigree is longer than COLLINE's and dates back to 1996, is accordingly well-established. Mature enterprise software products tend to be characterized by stable revenue streams and high margins, and management reports that OBERON enjoys just that.

In any case, the Risk Management segment looks like this:

Regulatory Compliance

Regulatory Compliance is the segment that presents LRM with strong, sustained growth opportunities as the regulatory directives such as COREP & FINREP, Dodd-Frank, EMIR, Basel III's CRD IV and CRR, and so on, take hold in the immediate and medium terms. 

Needless to say, reporting requirements are about to become a great deal more complex and comprehensive than they were, and Excel and scratch paper will no longer cut it.

COREP: 10x times the data

LRM, already the leading provider of compliance and regulatory reporting software in the United Kingdom (and among foreign banks in the US), stands to benefit. 

That it stood to benefit was not so obvious in years past, at least to me: the very complexity of the reporting requirements may have led one to reasonably suspect that financial institutions would call in the Accentures and the Moody's Analytics of this world who would then sell their partners' or their own software solutions, leaving LRM out in the cold. It hasn't turned out that way: LRM is taking share and is signing up new clients at a fast clip. 

This is what the Compliance segment looks like:

Looks measly doesn't it? That's where the opportunity comes from.

LRM (along with most enterprise software companies) reports revenue on a percentage of completion basis and the finalization of the COREP/FINREP regulations was delayed by 9 months to January 1st 2014. Lombard Risk's fiscal year runs from March to March, so the revenue recognition from the clients won thus far will be mostly recognized in the second half of the year. 

The Big Picture

There is, at the same time, a great deal of operating leverage at work: ~75% of the company's current costs are fixed meaning that incremental revenue above, say, 9.5 to 10 million largely drops to the bottom line. This is what the operating leverage looks like on a consolidated basis: 

and this is what the consolidated income statement should more or less look like:

We know that the company is more than half way through its major software development program, so we can deduce that capitalized development expenditure will look like this:

and free cash flow will look something like this:

Management

It is clear that LRM's sweet spot is at the junction of risk and compliance and management is therefore in a tricky, game-theoretic spot. It would like to see itself as a consolidator in that specialty and is evidently averse to debt. It would therefore like a strong share price as  currency for so-called "tuck-in" acquisitions and it is perhaps this that has led them to talk up the value of the company -- not quite to the point of vulgarity but not far from it, either. 

In any case, I don't doubt that, in the final analysis, they could sell the company for two or three times its current valuation if they chose. (IDOX, after all, was spun out from LRM; they are no strangers to the M&A market). 

Value

LRM is worth more than its current market cap. Given its growth profile, 5 year contracts, and 95% client retention rate, 10x 2016 EBIT is probably at the low end of fair value, giving the shares a reasonable 100% to 150% upside.

Disclosure: I own some shares in LRM

Dart Group: Looking back & looking forward

When I looked at Dart Group last year it was undervalued: it could have easily generated unencumbered cash sufficient to pay off its liabilities to its creditors and to cash out its shareholders at the value of its market capitalization. In other words, it was a pretty good cigar butt at least and maybe more – one didn’t have to think too much beyond that. 

Since then, as everyone knows, the share price has almost quadrupled. A nice trade that I missed out on because I was thumb-sucking over the 10p that I’d have to pay for the airline (I valued Fowler Welch at ~60p and I wanted Jet2 for free).

At the current market cap, however, more scrutiny is required. Jet2 is a low cost airline. Or rather, Jet2 competes with low cost carriers. Now, in that particular market, what matters is unit cost: people will fly with you if you’re cheap and they won’t if you’re not.

 Jet2's route map. 50% of its traffic is to Spain.

To date, competition has been muted: Ryanair and Easyjet have been busy frying other fish. So Jet2 has been filling its planes, earning profits on ancillaries, and funding its growth via 0% interest bearing loans from its customers in the form of deferred income. This has added up to a high ROIC.

But a high ROIC is not evidence of competitive advantage. Sometimes a high ROIC is built 

into the nature of the sector (every advertising company and recruitment consultant has a high ROIC) and sometimes it is a function of the fact that the competition hasn’t come for you yet.

So, as I say, what matters in price competition is unit cost. And unit costs in the airline business are denominated in “cost per available seat kilometer” (CASK) in Europe, and “cost per available seat mile” (CASM) in the United States. 

This is how Jet2’s CASK compares with the two low cost carriers that are most likely to compete with it in the future:

Consider now that Jet2’s loss of the one quarter of the Royal Mail business will raise its CASK further. Consider also that Ryanair and Easyjet fly much shorter routes than Jet2 does (it costs a great deal more per kilometer to fly short routes than long ones).

Suddenly, there’s cause for concern: if Ryanair, say, decides that it wants to fly holidaymakers from Bradford to Alicante, it can price the flight much lower than Jet2, Jet2's bookings will fall, deferred income will fall, cost per passenger will go up, Jet2 ticket prices will have to go up,  and the negative spiral will be firmly  in place. 

What was a high ROIC operation frolicking in a Jacuzzi of cash can very quickly become a low ROIC business suffering from liquidity problems as the legacy airlines have long since discovered.

A note on the figures:
1. I have taken average stage length of each airline from a source I know to have been reliable:
http://centreforaviation.com/analysis/jet2com-strong-fy2013-profit-growth-hides-major-challenges-120030

2. Royal Mail flights are 10% of Jet2's departures and Royal Mail flights have numbered 16 per weeknight, implying that total annual departures for Jet2 = 16 x 5 x 52 x 10 = 41,600 flights per year.   

3. We know the composition of Jet2's fleet (and Ryanair's and easyjet's) so that we can use the maximum seat configuration to arrive at a figure for average number of seats per departure.

4. Together, these give us available seat kilometers (average stage length x annual departures x average number of seats per departure).

5. Short flights are more expensive per kilometer than long flights; they are more taxing on passenger, luggage, and aircraft handling, airport fees, etc. In order to adjust for this, industry convention uses the following formula: a multiplier  -- (average stage length of airline X/ average stage length of all airlines)^(1/2) -- is applied to the CASK of each competing airline to arrive at a cost per equivalent seat mile. If one wants to know how the cost structures of Jet2 and Ryanair would compare on the same route, the cost per equivalent seat mile is what one wants to know.

6. Applying the cost per equivalent seat mile to the distance between two airports (Leeds-Bradford ("Bradford") and Alicante results in a cost figure that can be used to compare the cost structure of two airlines. Small differences (10% or less) don't matter too much but large differences matter a great deal. In this case, it appears that Ryanair could price the flight at a 10% mark up and still charge half Jet2's fare.

7. That may explain why Jet2 is so keen to generate revenues from ancillaries: the more it earns from in-flight extras, the more competitive it can make its ticket prices. One can see that tickets are already priced at below cost. Can such a strategy survive the future attentions of Ryanair or easyjet? Each person must judge that for him/herself but I, for one, doubt it.

This post was corrected, amended & extended on August 21st

Disclosure: No position in Dart Group

Silverdell

This is what I saw when I looked at Silverdell a few months ago:

Reinvesting capital that costs 10% in order to earn 2.31% returns is an unhealthy practice.

Northgate's 2013 Results

Northgate  reported its FY 2013 results todays The company incurred a £54 million charge in order to reduce its interest expense from 7.1% to 2.8% . The lower interest charge translates into $20 million in additional annual after-tax cash flows to equity.

Here’s its free cash flow history:

Here’s what its valuation looks like:

Corrected:  July 9th

This is how I arrive at 700p:

Disclosure: I am long Northgate

Universe Group - Payment & Loyalty Solutions

Next up is the Universe Group.

Wexboy has written about this company in his own inimitable style and I have nothing to add to his analysis, which I think is spot on.

Now that the extraneous businesses have been shed, and the core petrol forecourt/retail payments business is all that remains, we can have a look at its historical, pro-forma profile:

A valuation of ~6.4p is not unreasonable:

Half-price is fine, but there are currently (still) many decent UK stocks selling at half price. 

I have included it in my UK picks for 2013 because I think that there’s a more than reasonable chance that it will be acquired by Vianet after all: Vianet still owns a substantial share of UNG, and UNG’s business would represent a common sense tuck-in acquisition for Vianet.

Disclosure: No position

Lamprell Plc - Jack-up Rigs

The Arabian Gulf is a low cost source of oil and gas production and the UAE is the hub for support services for the gulf region’s oil industry. 

And, in the UAE (and the region generally), Lamprell is the leading refurbisher and manufacturer of jack-up rigs and Floating Production Storage Offloading (FPSO) structures. 

Which is significant because the UAE is characterized by limited industrial refurbishment and fabrication facilities, and especially limited in facilities with quayside access. Why? Because the physical space for them is limited: a natural barrier to entry. (In this sense, the case for Lamprell echoes the case for Hawaiian Holdings).

In 2010, there were four competitors in this naturally protected market: Lamprell was the largest and the others were Dubai Drydocks, Gulf Piping Co., and Maritime Industrial Services. Lamprell acquired MIS in 2011, and now there are three.

Natural barriers to entry and consolidation should mean above-normal returns on capital. And it turns out that Lamprell returns 33% on its operating capital. It’s a good business.

Note: USD

Lamprell has a newish sideline in manufacturing vessels used in installing offshore wind turbines. It won a 320m contract to supply two such vessels to Fred Olsen, the Norwegian 

shipping firm. One of these ships has been delivered and the other will be, soon. 

Lamprell’s present share price problem is that this project wasn’t executed well: it was a fixed-price contract, there were cost overruns and supplier problems, and there will be late delivery penalties. The total cost of this snafu is in the neighborhood of $175 million (GBP 108 million).

One would expect, therefore, that this amount (41p per share) would have been knocked off Lamprell’s enterprise value.  The market has, spurred on by analyst downgrades and a suspension of the interim dividend, instead wiped 6x this amount from Lamprell’s implied value. 

The result has been to price Lamprell in such a way as to say that either (a) it no longer has a competitive advantage in its traditional oil and gas rig markets or (b) the banks will refuse to renegotiate its loan covenants and will pull it into bankruptcy. 

Both these arguments are absurd; the former implication is plainly wrong and the latter scenario is highly unlikely to come about: Lamprell’s order book stands at 1.5 billion; it is the rare company that finds itself in a leading, competitive position in an industry that will experience steady real growth for decades to come.

Lamprell traditionally converts 10% of revenue into earnings and easily earns 30p per share. The shares are worth more than 300p. My sense is that they will re-price in fits over the next twelve months -- which is why I included them in my UK picks for 2013.

Disclosure: No position

A UK Portfolio

I have been through hundreds of UK stocks over the past year. The ones listed below are, in my view, the best value stocks in the UK today. If I were to hold a UK only portfolio, I'd hold these stocks at the weightings indicated. If I were to include a short position, I'd opt for Finsbury Premier Foods. I'd venture that portfolio outperforms the FTSE 350 by at least 20% over the next year. I'd also wager that, over two years, it outperforms, on an after-tax basis, any statistical strategy targeting UK stocks -- F-score, net net, valuentum, or whatever else. We'll revisit it next December and and do a post mortem. Share Sleuth, Expecting Value & Wexboy have written about one or more of these stocks, and their posts are well worth reading. As always, though, please do your own research. Disclosure: I have a position in Northgate.

Northgate plc -- Part 2

This is an investment idea that requires very little imagination. It is premised on four factors:

Northgate’s business is sound. Stepping back from the accounting presentation of the business helps to reveal the underlying mechanics of the business. The table below illustrates what happens on a cash basis in rolling 20 to 21 month periods. The key to performance is the utilization rate: 90% is good; 83% is what happens when a quarter of your vehicles are targeted to the Spanish construction industry when the bubble bursts. 

The company's maintenance capex requirement is less than its depreciation rate. Subtracting growth capex (i.e. expenditure for fleet size growth and expenditure on goodwill & acquired intangibles) from total capex reveals that maintenance capex is about 62% of depreciation.

True earnings are therefore higher than may be perceived from a quick glance at the financial statements. In fact, at the current price, Northgate’s equity is yielding 34% on trailing earnings and 35% on average earnings over the past ten years.

As growth is interrupted - momentarily, at least - free cash begins to flow.  In two years, Northgate’s debt has been reduced by 300 million. In another year it will be down to 200 million, an optimal level. The year after that, if the economic environment is as it is now, it can buy back 40% of its shares. Et cetera. 

Nothgate's value exceeds 700p

Disclosure: I am long Northgate

Update

An update on a stock I’ve praised.

Instem’s Provantis suite is the de facto standard in preclinical software. In the last 20 years, half the world’s pre-clinical software data has been collected using it. 80% of the top 20 pharmaceutical companies use it. Its user base is twice that of its nearest competitor.

So, today's news should come as no surprise:

“National Institute of Allergy and Infectious Diseases (NIAID), part of the National Institutes of Health (NIH), has selected Instem's integrated Provantis® preclinical software suite to help advance research programs against infectious, immunologic, and allergic diseases.”

NIAID funds $30 billion in research at hundreds of organizations. That Provantis is now the preferred preclinical software suite for NIAID-funded preclinical research means future market share gains. Market share gains in a business model dependent on a loyal installed base and on its status as de facto standard means a wider and deeper moat. And a wider moat will mean more market share gains. That’s the logic of sustainable competitive advantage. 

Remember, this is a software business, so incremental revenue will fall unmolested to the profit line.

Of course, the market for small capitalization companies is often perverse in the short term, and Instem’s stock price fell modestly on the announcement of this contract win.

Disclosure: No position