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

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

FreightCar America -- Railcars

FreightCarAmerica (“RAIL”) makes and sells 80% of the coal cars in the United States. Its customers are railways, power companies, and leasing firms. 

RAIL has a couple of competitive strengths: 

• many railcar purchasers prefer to maintain a standardized fleet of railcars, making RAIL, the incumbent, the preferred supplier of coal cars; and 
• it has the capacity to manufacture 15,000 units a year in its plants at Danville and Roanoke, meaning that, in most years, it operates below capacity. 

Competition based on design is therefore as unlikely as competition based on cost.  And, given the high cost of transporting railcars across the ocean, competition from provenances with low cost labor is not a concern  

Looking back

The business has generated an average of ~$34 million per year in operating profit on average operating assets of $96 million, for an average return on invested capital of 35% -- a fair reflection of its competitive position

18% of this operating profit was used to close down a unionized plant, a nonrecurring expense, and 45% was paid out to owners. 15% of the operating profit was reinvested for growth.

The story in railcar units:

Looking forward

Core business – replacement coal cars

There are currently 270,000 coal cars in operation in the US and 3.7% of them – 9,950  – have needed to be to be replaced in an average year, 7,950 of which have been manufactured by RAIL.

At an average selling price $75,000 and an average gross margin of 11.75%, this recurring, though lumpy, business of replacing old coal cars has generated $590 million in gross profit since 2005. 

The coming business cycle calls for approx. 79,000 coal cars – those aged 30 or more years old today – to be replaced. Moreover, the coal cars to be replaced are made of steel and need to be exchanged for the more efficient aluminum cars which are RAIL’s specialty. The average replacement rate, therefore, is going to be comparable to the past eight years: 9,875 cars per year, perhaps 85% of which will be supplied by RAIL at an average price of $80,000 per unit. 

After overhead expenses and taxes (net of the NOL carryforward), the average annual operating profit from this core business is therefore going to approximate $36 million a year. 

Leasing

In order, it says, to smooth revenues across the business cycle, RAIL entered into the railcar leasing business in 2008. Setting aside the long-term wisdom of competing with its customers, the minimum revenue schedule over the next few years from this segment is knowable – about $5 million per year. 

Services

RAIL has also, via acquisitions, strengthened its commitment to providing railcar maintenance services in the busiest rail traffic corridors in the US. We can expect this segment to contribute another $4 million per year in after-tax profit.

RAIL’s total minimum earning capacity over the next business cycle, is therefore, about $45 million per year ($3.78 per share). Bearing in mind that RAIL pays out what it doesn’t reinvest for growth, we can project that, in the absence of the an incident like the closing of the Johnstown plant, it will pay out its excess cash and at least 75% of its operating profit, for an average of $3.10 per share per year, which is not bad for a stock priced at $18 and change. 

More conventionally:

It's a wildly cyclical stock, so everyone tries to time it. Some brokers even have a sell rating on it. The only real risk with this stock -- the only one that I can see --  is that it might be acquired at $25 or so by an outfit like Berkshire. The concerns over the near-term death of coal are founded more on hope than fact. 

Disclosure: No position 

Edited for typos on Oct 19th

Instem Plc

Instem provides software applications to the early development drug and chemical R&D market. Its clients use these applications to collect, analyze and report complex scientific data; comply with regulatory reporting requirements; improve quality, consistency and efficiency of information reporting; and to reduce the time of critical path R&D activities.

 

Provantis

Its principal product is Provantis, a suites of modules for managing and recording Early Development Safety Assessment (EDSA)  studies, from receipt of the compound through to the automated assembly of statistical analyses and final reports, allowing scientists to collect, analyze and share data, whether at one central site or remotely. Provantis promises to make their work easier, faster, and less prone to error. Remote deployment of Provantis is made possible by secure centralized data centers in Shanghai and the US;  Instem has partners that maintain the system 24 hours a day, 365 days a year.

The EDSA market is a modestly-sized, and Instem has been, for more than ten years now, the market leading provider of information solutions for that market. Half of the world's pre-clinical drug safety data has been collected over the last 20 years via its software; it has over 9,500 users of its solutions and supplies over 130 customers, including sixteen of the world’s top twenty pharmaceutical and biopharmaceutical companies. It has two competitors – Xybion Medical Systems and Pathology Data Systems in the European and North American markets – but Instem’s user base is approximately double the size of these two combined.It has an average client relationship exceeding 10 years and a 95% customer retention rate. Approximately 65% of its  revenues are recurring.  

In any case, Instem has also been increasing its penetration in the established Japanese market as well as in emerging other-Asian markets, particularly China. Instem reports that it won the overwhelming majority of new EDSA business placed worldwide in 2011 and that it has secured a record evel of new customers for Provantis. The most recent upgrade of the Provantis offering, in 2012, places Instem in a position to capture an even greater share of the EDSA market and to expand into other, closely related, markets such as safety pharmacology studies, drug metabolism and pharmacokinetics studies.

Centrus

Its other main product line is Centrus,  an application which grabs legacy scientific research data, transforms it into an easy-to-use format, facilitates communication between the "discovery" & "clinical" functions in a drug development value-chain; and produces SEND datasets in a few simple steps (SEND is the regulatory standard for the transmission of research data). The Centrus offering was strengthened in 2011 by Instem's acquisition of  BioWisdom, an app for extracting intelligence from R&D related healthcare data. As it stands, Centrus is like CRM software, only for raw scientific data.

Centrus is making its market -- there were no competing products when it was launched some 5 years or so ago,  and there are none today. Instem "spotted a gap in the market", as Alan Sugar would say, and they have developed the product and the market from scratch.

In any case, one can, from the above, more or less divine what the numbers are going to look like: 

 

As laboratory working practices change -- the growing prominence of multi-site working and outsourcing to contract research organizations and so on, as well as the adoption of new standards – Provantis and Centrus are likely to benefit.

Instem is a good business with a 7% CAGR since its AIM listing. It shouldn't be yielding 15%. Still, there is some cyclicality to this business, especially in the awarding of new business, and a conservative 9% hurdle rate is probably called for, easily placing the value of its shares at more than 2x the current price.

Disclosure: No position

PS: The trick to valuing this stock is to normalize properly. It is a cyclical business, so taking the average NOPAT margin of 17.84% and applying it to this year's revenue will come close to specifying the current earning capacity of the business, £1.93 million. Discounting at 9% (or applying an 11x multiple) gets you to a no growth earning power value of £21.39  million. Screens can't easily capture this: to them it looks like Instem is currently trading at 11x earnings, as it should be.