CREALOGIX Group — Update 13 June 2016

Zurich-based CREALOGIX was founded in 1996 by Bruno Richle, Richard Dratva, Daniel Hiltebrand and Peter Süsstrunk, who all continue to work with the company and together own 70% of the share capital. CREALOGIX has c 420 employees and provides front-end banking software solutions that operate through multiple channels (essentially mobile phones, tablets and PCs). The group has established the leading position in the Swiss market, where 11 of the 30 largest Swiss banks are exclusively using its core online/mobile applications while a further seven are using some aspect of the group’s technology. The company has been boosting its international exposure and now has offices extending to the UK (London and Winchester), Austria (Vienna), Singapore and Germany (Stuttgart, Puchheim/Munich and Jever).

Each software installation involves a software licence along with significant professional services as each customer will require installation and customisation. Going forward, there are 18-21% annual support and maintenance fees. Further, there is a regular flow of follow-up services work in the form of change requests. Most installations are on its clients’ servers, though the group’s UK private wealth business operates a hosted SaaS model, and the international expansion is expected to involve further hosted SaaS sales. The company has a good profitability track record (underlying operating basis), only recording losses in FY08 (though this was after a CHF1.4m amortisation charge and a CHF2.1m impairment) and in FY15 due to the planned accelerated investment.

An economic downturn could slow investment in fintechs (eg, peer-to-peer lending and crowdfunding) and slow the pace of change in CREALOGIX's traditional banking sector customer base. There is a risk that nimble fintechs and challenger banks will make a bigger inroad into the traditional banking sector over the long term. Mergers in the traditional banking sector could reduce the potential customer base. Major back-end software vendors and ERP software providers could take a more active approach in the front-end while specialist direct competitors could develop better solutions or more attractive business models. There is execution and integration risk in the acquisition strategy and increasing currency risk as the company expands abroad.

The stock trades on c 743x our earnings in FY16e, which falls to c 42.0x in FY17e and to c 23.8x in FY18e. On our base revenue growth assumptions, we suggest a valuation range of CHF140 to CHF186 per share. The valuations have been adjusted for the dilution impact from the convertible bonds, which we estimate reduces them by c 9%.

CREALOGIX develops and implements software solutions that enable digital banking for “the digital bank of tomorrow”. The solutions are most often used by traditional banks to enable their journey to digitalisation, through the provision of a sophisticated, modern omni-channel offering to their clients. The group’s products are front-end solutions that integrate with the customers’ back end systems, such as a core banking system from Temenos, Avaloq or Infosys. CREALOGIX’s primary target customers are traditional retail, commercial and wealth banks that need to upgrade their legacy in-house systems to maintain competitiveness, reduce cost, differentiate and provide greater flexibility in a constantly evolving (swiftly digitalising) marketplace. CREALOGIX has a “customer centric focus” to optimise the user experience across the areas of mobility, security, personalised advice and education.

CREALOGIX sees itself as a pioneer in digital banking, having launched the first internet banking solution in Switzerland with Credit Suisse in 1997. The group has c 320 employees, including c 76 in research and development, c 162 in project and implementation and c 19 in sales (including pre-sales engineers). The acquisition of Elaxy in January has added a further 100 employees.

Digital banking remains in a major growth phase globally, boosted by the advent of smartphones and tablets; smartphones are expected to take 80% of the online banking market by 2020 (AT Kearney). Further, digital banking has overtaken compliance as the area of highest importance within banking sector IT budgets. Regulatory changes, like PSD2 (Payment Services Directive), put additional pressure on banks to upgrade their front end systems.

Digital banking essentially covers online banking and mobile (including tablets), as well as related services such as analytics and social networking. Substantially all banks offer online banking and penetration across the EU has been advancing at a healthy pace to 45.6%, up from 16.2% in 2004 (EU-Digital Economy & Society Index). In the UK and Germany, the penetration rate has risen from 22.3% and 20.7% to 58.4% and 51.0% respectively over 2003 to 2015 (EU-DESI). In Switzerland, e-banking penetration has risen from 21% in 2004 to 49% in 2014 (BHF 2014 Omnibus). Mobile banking penetration is lower but growing much faster. According to a KPMG report on mobile banking (July 2015), the number of mobile banking users worldwide rose from 0.6bn users in 2013 to 0.8bn in 2014 and is set to rise to 1.8bn by 2019.

The changing backdrop is driving increasing spend on front-end systems and CREALOGIX expects the front-end system spend to rise to c 50% of banks’ total IT spend within five years, from c 20% at present and c 5% traditionally. The front-end solutions in this space need to be more agile than the back-end core banking systems and must offer a seamless experience. Innovation is clearly much more prevalent in the front-end than at the back end.

The global banking sector is facing unprecedented challenges. Increased regulation in the wake of the global financial crisis means banks must hold significantly higher levels of capital against their assets, which puts huge pressure on profitability. At the same time their customer bases are being targeted by challenger banks entering the space as well as a plethora of new fintechs offering alternative products (such as peer to peer lending, crowd funding, bitcoin and various investing solutions). To maintain competitiveness, traditional banks must be able to offer modern solutions. While the large global banks have the financial resources to develop their own solutions in-house, the rest have no choice but to purchase technology if they wish to stay in the game. We also note that the numbers of banks have been in long-run structural decline across the globe, eg, in Switzerland the number of banks has fallen by 16% from 2004 to 2013 to 283.

Exhibit 2 shows that total European banks’ IT investment is expected to rise from $10.9bn in 2015 to $15.3bn in 2017, according to Celent. Of these, 30% are expected to be purchased from third-party software suppliers such as CREALOGIX in 2017, up from 22% in 2015. Of the amount procured from third parties, 40% is forecasted to be spent on “change the bank” strategies in 2017, up from 30% in 2015. This results in a 157% increase in the amount spent on such strategies in 2017 to $1.8bn, up from $0.7m in 2015.

Following a period of significant investment, the group launched its Digital Banking Hub last year. It gives small and mid-sized banks the opportunity to offer highly competitive Digital Banking offerings. The hub is a modular system that has been tailored for customers, having been developed in conjunction with them. It is a comprehensive platform for online banking across all channels (essentially PC, tablet and mobile phones). It covers eight fields of expertise, as shown in Exhibit 3. Each field covers a range of products, which are broken down into separate modules. It has a modern interface and APIs and includes pre-built out-of-the box modules. The APIs enable it to integrate fintechs, third-party modules and in-house built widgets.

The platform’s primary areas are Transaction & API Banking, Mobile Banking, Digital Payment and Digital Learning. Customers will take both the flagship online Transaction & API Banking and Mobile Banking solutions to create a multichannel offering. Additionally, CREALOGIX offers a range of online and mobile security products. The Digital Banking Hub is open and can be integrated into all systems; a user friendly navigation concept can link in various CREALOGIX modules and third-party applications. The product is white labelled, with each client bank adapting the style to suit its existing design. It is cost effective, because the system is based on a lean and open architecture and is perfectly compatible with all standard devices. The group uses java and HTML5 programme languages, with java in the back end and HTML5 up front. The product uses modern concepts including responsive design (resizes with different devices) and zero footprint (no software installation required on the device). The product offering has a six-month upgrade cycle, but the plan is to bring this down to three months.

Digital Banking is the group’s broadest offering and, along with related modules, generated c 60% of FY15 revenues, while Digital Payment generated c 20% of revenues and Digital Learning c 20%. The Digital Learning module is an LMS (learning management system) used by the group’s banking customers to train their clients and employees (typically young professionals) in financial literacy. It replaces paper-based systems, so helps reduce risk.

The implementation of the group’s solutions helps IT departments shift their focus from development to supporting the business and this is an attractive proposition from the business end of the bank. This is because banks need greater flexibility to cope with regulatory changes and to position themselves strategically to deal with fintechs. They also need the latest technology to help them in the fight to win new customers.

Founded in 1996, CREALOGIX offered the first 1997 e-banking solution in Switzerland with Credit Suisse, and Credit Suisse was voted the best internet bank in Europe in 1999. CREALOGIX floated on the Swiss Stock Exchange near the top of the internet bubble in 2000. The group underwent a strategic change in 2003 and again in 2010 when it decided to focus entirely on the banking end-market. In 2013, CREALOGIX took a 37% stake in Qontis in exchange for providing the technology platform to the Qontis start-up venture. Qontis is a Switzerland-based online personal finance management platform that was established in 2013 as part of a commercial enterprise between CREALOGIX and the Neue Zürcher Zeitung media group. The group acquired MBA Systems in early 2015 and announced the acquisition of the ELAXY group in October 2015. In January 2016 Bruno Richle stepped down as CEO, with Thomas Avedik taking on the CEO role. Mr Avedik has been with CREALOGIX for nine years, previously heading up the group’s e-banking operations. Mr Richle retains the position of executive chairman.

The group has been through a heavy investment phase, which peaked in FY15. It has been investing in the development of its software platform to address the challenges to the banking sector, spending 21.5% of sales on R&D in FY15, which resulted in an EBITDA loss of CHF10.6m. The major work on the platform has completed and R&D costs have been cut back, largely through a reduction in freelancers and the shift to near/offshore centres. The aim now is to seek the benefits from scaling the platform across a much larger international base and in 2014, offices were opened in London, Vienna and Singapore. Management believes there are also significant opportunities in Asia, where digital banking is less advanced.

The group has also made several acquisitions to gain access to new geographic markets and technologies. The MBA acquisition provided the group with strong experience in wealth management and added c 30 clients using hosting in UK. The hosting capabilities have been extended to the entire platform. The group’s international revenues will now move beyond the wealth management vertical, as the group has expanded its office infrastructure and also due to the acquisition of Elaxy in Germany.

In October 2015, CREALOGIX announced a long-term commercial agreement with Fiducia & GAD IT, the IT-service provider owned by the German Volksbank and Raiffeisenbank co-operatives. Fiducia & GAD IT was created through the merger of Fiducia IT and GAD in mid-2015. Fiducia & GAD's customers include all 1,100 local cooperative banks in Germany, as well as other entities. Fiducia & GAD has c 5,500 employees and generates annual revenues of c €1.26bn. The deal also involved CREALOGIX acquiring 80% of Elaxy Financial Software & Solutions (Elaxy FSS) and 20% of Elaxy Business Solution & Services (Elaxy BSS) from Fiducia & GAD. The two acquisitions were effective from 1 January 2016 and CREALOGIX has an option to acquire the outstanding shares. We have assumed the acquisitions cost €11m (c CHF12.2m), with a similar deferred payment, and we have assumed deal costs of c CHF1.7m. CREALOGIX plans to increase its shareholdings in the two businesses in the medium term.

Elaxy group is a leading German fintech provider for interactive advisory solutions for banks and financial service providers. Elaxy’s customer base includes c 380 Volksbanksand Raiffeisenbanks and over 120 Sparkasse savings banks. The acquisition broadens CREALOGIX’s product portfolio into the area of interactive digital banking advisory services, which includes retirement planning, financial management and financial planning. It also accelerates the group’s move into hosting/SaaS. Elaxy FSS is a product company providing software solutions and related consulting services in the advisory area, while Elaxy BSS is a hosting business specialised in the banking area with its own data centre. The two companies each generate around €10m (c CHF11.1m) in sales and each employ around 100 staff. The acquisition increased the group’s employees by c 100 to more than 420 and makes Germany the group’s second-largest country exposure.

CREALOGIX has had a presence in Germany since 2011, with an office in Stuttgart and over 40 people. Elaxy FSS has added offices in Puchheim/Munich and Jever. CREALOGIX was already supplying five of the 10 largest internet banks (online banks that do not have branches) in Germany. This includes Deutsche Kreditbank (DKB), which has built a credit card application using CREALOGIX’s technology for its own clients, and it is also running the application for third parties such as BMW.

Fiducia & GAD offers a core banking solution and the partnership will deliver combined offerings in selected fields. The deal provides CREALOGIX with an established route to the German banking market, which otherwise would be more difficult to break into. The Volksbanks and Raiffeisenbanks are facing increasing competition and now require modern digital banking solutions. We see Fiducia & GAD’s committing to a commercial agreement with CREALOGIX as a major endorsement of CREALOGIX’s offering.

Cooperative banks represent at least 25% of the German banking market, and CREALOGIX’s increased presence in Germany will also boost the group’s ability to target Sparkassen (38% market share) and private banks (<10% market share). Elaxy FSS has recently won a contract to roll out a digital solution at Bankhaus August Lenz in Germany for the needs of its financial advisers and their clients, exemplifying Elaxy’s strong position in the wealth management vertical.

In January 2015, CREALOGIX acquired MBA Systems, for c CHF8.7m, which includes an outstanding earn-out of CHF2.7m. MBA provides internet-based information and trading systems to the securities and wealth management industries. MBA supports and hosts systems from its own secure data centre for almost all of its clients (one has an onsite installation). CREALOGIX is now able to offer a hosted version of its Digital Banking offerings to MBA’s clients –which exceed 30 and include leading brokers, wealth managers and international banks – as well as to new clients.

CREALOGIX already has some success in cross selling products, eg, Medirect replaced Intelligent Environments with CREALOGIX Digital Banking Hub and the CREALOGIX payments module was added. In this case, Infosys runs core banking.

The R&D team is led from Zurich. Development work is carried out in countries where the group is active, with around a third of the work handled from nearshore/offshore development centres in Belgrade (with more than 50 employees) and Manila (with more than 20 employees). Belgrade handles both R&D and project implementation (as most skills can be used for both since they are the same systems architectures) while Manila handles bug fixing and project implementation.

We divide the group’s competitors into five categories:

In our view, CREALOGIX has a number of advantages over other specialist software providers, including the greater depth of its platform (eg some lack the banking functionality or the quality of the user experience), the proven experience gained in the Swiss market with top-class references and the transparency associated with being a public company, along with the strong balance sheet. In the client-centric game of front-end systems, it is all about building the best user interface, which gives specialist players an opportunity, and CREALOGIX has been able to develop comprehensive functionality.

The group’s wealth management offering competes with small local players and IRESS (ASX:IRE).

In November 2015 the company issued CHF25m of four-year convertible bonds. The bonds have a conversion price of CHF104.5 and a coupon of 2.375%. Management chose the convertible bond financing option because the company had the authorised capital available and it enabled it to issue new equity at an effective 26% premium to the-then current market price, assuming that the bonds eventually convert. However, the bond holders also benefit from an attractive coupon while the ordinary shares do not pay a dividend.

Assuming all the bonds convert, it will require the issuing of 239,234 new shares, representing 18.4% of the expanded share capital. Based on proforma numbers, that would return the group to c CHF9.6m net cash while nearly doubling net assets to c CHF49m.

The company offers a range of revenue models to its customers. The group’s traditional Swiss client base are all on the perpetual licence model plus implementation along with annual support and maintenance fees (in the range of 18% to 21% depending on the overall solution). We note that many banks in continental Europe prefer an onsite solution, due to attitudes towards security risks. The group’s UK clients (c 30 customers acquired via MBA) operate on hosted SaaS, committed for five years. We note that MBA has been incorporated into the Digital Banking Hub, and the entire platform is now available on a hosted basis. CREALOGIX also offers a SaaS licence for five to seven years while one company is onsite rental. CREALOGIX regularly receives change requests from clients (eg adding functionality, acquire an entire hub or a more general adaptation), which generates additional licence and services revenues.

Additionally, CREALOGIX is using the systems-integration reseller route to market via a partnership with Hewlett-Packard Enterprise (NYSE:HPE), which enables it to cover the entire value chain through consultancy and conception to suitable solutions as well as integration and operation. In the relationship Hewlett-Packard takes the services work.

The company sells to both the business side and the IT department. However, the position of chief digital officer is becoming much more common in banks and is typically the most effective person to sell to. The sales cycle is typically in the range of 6-18 months and averages 12 months. There will typically be a proof of concept, but the scale of this will depend on the requirements of customer. For example, the customer might simply be concerned with the look or feel for the end customer. Alternatively, they may wish to integrate third-party software or in-house widgets, or customise it so it looks and functions like the customer’s other corporate websites. Ultimately, the customer needs to make the decision of whether to invest in-house or in new front-end software.

Recurring revenues consists of support & maintenance (CHF12.4m or 54% of licence revenues in FY15), along with hosting SaaS services (CHF1.5m in FY15). In total, this came to 28% of FY15 revenues, but we expect this to rise significantly on that back of hosted/SaaS growth and the maintenance price increase and given that Elaxy has over 60% recurring revenues reflecting its substantial maintenance book.

Goods represents hardware used for secure online invoice payments. This consists of a payment scanning device and a payment slip reader. We assume this area continues to decline as the company focuses on software.

H1 revenue jumped 16% y-o-y to CHF27.9m. EBITDA swung to CHF0.1m from a CHF6.3m loss in the prior period, which reflects management’s planned actions to boost revenues while reducing costs. 37% of H1 revenues were generated from outside Switzerland, up from 32% in FY15 and 27% in FY14. This is set to move higher as ELAXY contributes to revenue from 1 January 2016. R&D costs were cut by a third to CHF6m from CHF4m in H115.

Licensing fees jumped by 18% to CHF11.9m (which we estimate c 55% are from maintenance fees). Services grew by 5%, while goods slipped by 13% and hosting/SaaS (MBA Systems acquired in early 2015) generated CHF1.7m against zero in the prior period.

Income from associates jumped to an impressive CHF571k, reflecting the group’s 37% interest in Qontis, due to one-off effects and we do not expect this level of profitability to continue.

In H1 there was a cash outflow from operations after interest (CHF0.1m) and tax (zero) of CHF0.8m. Capex was neutral after a small asset disposal, and hence free cash outflow was CHF0.8m. After the granting of a loan (CHF0.4m), sale of short-term securities (CHF2.3m) and release from pension surplus (CHF0.4m), this turned to a CHF1.6m cash inflow. After the net purchase of treasury shares (CHF0.4m), convertible bond sale (CHF24.4m) and small exchange movement (CHF0.1m), the total cash position rose from CHF10.8m as at 30 June 2015 to CHF36.7m at the end of December. The debt component of the convertible bond is CHF24.0m, leaving net cash of CHF12.7m. The acquisition of Elaxy group was settled after the period end (see Exhibit 5).

Management guidance is for revenue growth to exceed 20% in FY16 (including ELAXY), and it anticipates revenue growth to exceed 20% in the medium term. Product revenues are expected to generate 60% of group revenue in FY16 (50% in FY15) and to exceed 70% in the medium term. International revenues are expected to reach 40% in FY16 and 50% in the medium term. The EBITDA margin is expected to be positive in FY16 and exceed 10% in the medium term.

The near-term outlook is underpinned by a strong backlog, as well as the healthy pipeline, as shown in Exhibit 5. This outlook is significantly boosted by the ELAXY transaction that was effective from 1 January 2016.

We forecast revenues of CHF61.2m in FY16, which includes six months contribution from Elaxy FSS, rising by 20% to CHF73.7m in FY17 and by 9% to CHF80.1 in FY18. We forecast CHF1.4m EBITDA in FY16, rising to CHF5.2m in FY17 and to CHF7.3m in FY18. Much of the near-term growth is from Elaxy, which we forecast will generate c CHF11m of revenues on an annualised basis. To illustrate this point, the group generated c CHF56m annualised in H116, adding Elaxy takes the number to CHF67m, and hence the group needs to generate organic growth of c 10% over 18 months to reach our FY17 revenue forecast of CHF74m.

We anticipate the growth to be led by licensing and hosting/SaaS revenue segments, with services growing at a slower pace and hardware sales to continue their recent decline. For FY16, we forecast licensing fees to jump 29% to CHF29.7m, hosting/SaaS to more than treble to CHF4.8m while services rise 11% to CHF23.0m and goods slip 10% to CHF3.7m.

We forecast operating costs (including depreciation) to rise 1% to CHF49.5m, as recent cost reductions are outweighed by the inclusion of ELAXY in H2. We note that CREALOGIX expenses all its R&D costs. This leaves the group with a modest adjusted operating margin of 0.1% in FY16. While margins are difficult to forecast, we are taking a conservative view, forecasting operating margins to rise to 5.4% in FY17 and to 7.7% in FY18 as the group scales up its international revenues.

Associates represent Qontis, which is very difficult to forecast, and ELAXY BSS from 1 January 2016, which we expect to generate c CHF0.2m on a full-year basis. We are conservatively forecasting a small loss in H2, given the difficulty in forecasting Qontis, to generate CHF0.5m for FY16, slipping back to CHF0.2m in FY17, which represents what we expect from ELAXY BSS.

Net interest includes the coupon on the convertible bond, which amounts to CHF594k per year.

Goodwill is amortised over five to 10 years under Swiss GAAP and we are forecasting amortisation of CHF2.5m in FY16.

We forecast a tax rate of 28% on normalised profits in FY16, easing to 27% in FY17 and to 26% in FY18.

The minority interest represents the 20% outstanding in ELAXY FSS which we anticipate will be acquired by CREALOGIX half way through FY18, ie, three years after the purchase date.

We are forecasting capital investment of CHF0.7m (1.2% of sales) in FY16, rising to 1.5% of sales thereafter. We forecast working capital reductions of 0.5% per year, representing the cash generating upfront licence and hosted SaaS revenues.

We are not forecasting any dividends before FY19.

We highlight the following sensitivities:

CREALOGIX has established a strong track record of delivering software solutions to the banking industry in Switzerland through its established operations and it is now transitioning the business to the international markets. If management can successfully execute on the strategy, we believe there is significant potential upside in the shares for investors. We believe there are several reasons why it should generate stronger margins in the medium term than it has done historically, assuming the group does successfully execute its expansion strategy:

We highlight the following points on the group’s valuation: