Fraedom to grow

Hogg Robinson Group 3 August 2016 Update

Hogg Robinson Group

Fraedom to grow

Software division insight

Support services

3 August 2016

Price

67.0p

Market cap

£218m

Net debt (£m) at March 2016

33.6

Shares in issue

325.4m

Free float

52%

Code

HRG

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(6.6)

(2.2)

0.0

Rel (local)

(8.1)

(7.3)

1.1

52-week high/low

76p

58.8p

Business description

Hogg Robinson is an international corporate services and software company, specialising in travel, expenses, payments and data management.

Next events

Interims

November 2016

Analysts

Katherine Thompson

+44 (0)20 3077 5730

Richard Finch

+44 (0)20 3077 5700

Hogg Robinson Group is a research client of Edison Investment Research Limited

Hogg Robinson Group (HRG) recently provided insight into its technology business, Fraedom, which offers payments, expenses and travel software tools. We explore Fraedom in more depth, looking at the growth strategy, competitive positioning and financial prospects for this part of HRG’s business. This well-established, profitable business looks set to contribute to the group’s growth over the medium term.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

03/15

330.1

30.5

6.6

2.32

10.1

3.5

03/16

318.3

32.2

7.2

2.51

9.3

3.7

03/17e

326.0

34.0

7.3

2.65

9.2

4.0

03/18e

321.0

34.5

7.4

2.80

9.1

4.2

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Fraedom puts cost control in customers’ hands

The Fraedom technology platform was formally launched in 2015, although was in operation for years before this through the combination of HRG’s in-house technology development and its investment in Spendvision. Fraedom provides software tools for customers to manage travel, expenses and B2B payments, giving greater visibility and control over spending. The platform is sold on a software-as-a-service (SaaS) basis to direct customers and via partner channels.

Contributing to growth and profitability

In FY16, Fraedom saw revenue growth of 14.3% to £25.6m and increased underlying operating margins to 23.0% from 14.3% in FY15 (versus FY16 group revenue decline of 3.6% and underlying operating margin of 14.1%). While the well-established expenses management customer base currently generates the majority of revenues, management expects its B2B payments business to grow fastest in the medium term. The Fraedom business expects to grow overall revenues at the mid-teens rate in the medium term, providing ongoing support to HRG revenues and profitability.

Valuation: Potential to support significant value

Hogg Robinson’s FY17 P/E rating is low (under 9.5x) compared with that of the FTAS UK Support Services sector (c 14x). The company is securely funded, highly cash-generative and committed to a progressive dividend (+8% in FY16). Fraedom’s underlying FY16 operating profit of £5.9m is c 15% of the total. In this note we estimate a potential enterprise value for Fraedom of £75-105m, which compares with Hogg Robinson’s current total EV of £251m.

Fraedom: The technology business within HRG

Technology lies at the heart of HRG. It is key not only to providing its current range of services, but also to extending the range of the services and clients served to exploit fully HRG’s knowledge, relationships and strategic position. It should come as no surprise therefore that HRG’s technology work has led to the development of a software business. Fraedom brings together HRG’s own internally developed products and expertise and Spendvision, an expenses and payment software company that started life in 1999 as mypcard.com and which HRG bought in stages from 2004 to 2012. Fraedom employs 365 staff (mainly in the UK and New Zealand) and in FY16 generated £25.6m in revenues from processing transactions worth £25bn for more than 135,000 organisations across 178 countries.

Fraedom – supporting self-service

In 2015 Fraedom was officially launched to provide payments, expenses and travel services for existing and new clients on a software-as-a-service (SaaS1) basis. The Fraedom platform provides a simpler and faster way for companies and their employees to manage expenses, make payments and book and control travel. The route to market is mainly via third-party travel and payment providers, most notably Visa, who see not only direct revenue benefits from the sale but also ongoing benefits from the increased usage of their cards/system that Fraedom can help trigger.

SaaS: software supplied on a subscription basis that is provided on computers/servers remote from the customers’ premises.

While Fraedom’s roots lie in the corporate travel and expenses arena, it is not aimed solely at travel. Management regards Fraedom as a potential disruptor across the wider payments and expenses management sector, with payments being the area with greatest potential. Management has pointed to Visa and MasterCard’s own research, which suggests that while card transactions account for nearly $2tn of B2B and travel and expenses (T&E) transactions globally each year, the wider B2B transactions market is more than 50 times that size. The major card companies see B2B payments as an opportunity, particularly within the SME market, and Fraedom is eager to work alongside them to address the opportunity, helping to enable the changes in technology and behaviour required for this to happen.

The charts below show the split of revenue generation across the three categories (Expenses, Payments and Travel in FY16) and geographically (FY15).

Exhibit 1: Revenue mix by application (FY16)

Exhibit 2: Revenue mix by geography (FY15)

Source: HRG

Source: HRG

Exhibit 1: Revenue mix by application (FY16)

Source: HRG

Exhibit 2: Revenue mix by geography (FY15)

Source: HRG

Revenue model

Roughly three-quarters of Fraedom’s revenues are from usage-related and hosting fees and the remaining quarter consist of development and implementation (D&I) fees. We understand that Fraedom undertakes bespoke work for certain partners to integrate the software with their systems, and this drives the D&I fees. We would expect Fraedom to continue to earn D&I fees as more customers are signed up. Fraedom’s transaction-related revenues depend on the functionality used:

Expenses: Fraedom earns a fee per user, in line with the standard enterprise SaaS software model.

Payments: the model differs significantly from travel and expenses, with income based on a small proportion (basis points) of the value transacted.

Travel: revenues are based on simple low-cost fees and revenue from suppliers.

Software-as-a-Service (SaaS) offer

In the traditional software model there is a large upfront payment for a perpetual software licence, with the software running on the clients’ hardware, and typically ongoing revenues for software updates and maintenance. In all but the smallest of enterprises, this is typically accompanied by a significant installation or integration expense and often additional hardware costs for servers, PCs etc. Under the SaaS model the software is paid for on an ongoing subscription basis (usually annually or monthly) and it is run or hosted on the machines of the software company or, as is increasingly the case, the machines of a third-party service provider, such as Amazon Web Services, Google or Microsoft.

These advantages are particularly clear for Fraedom. The logistical and technical challenge of implementing and supporting software for 135,000 organisations would be a huge and costly challenge. Providing access to the software via a handful of hosting locations, while far from simple, makes this challenge readily achievable and allows Fraedom considerable flexibility with regard to increasing numbers of customers served and services offered.

In some cases, customers want the software to run within their own firewalls – in this case Fraedom will host a separate instance; it will still be charged for in the way described above, rather than via a perpetual license model.

Established direct and indirect routes to market

The way in which Fraedom reaches end customers/users is crucial to understanding how the products and markets are likely to evolve and why management believes that Fraedom is well placed to enable change in (or in their words disruption of) the B2B arena.

Fraedom reaches end users via both direct sales and partner channels. The vast majority of sales (we believe 80-85%) are via partners and this is likely to continue because Fraedom’s partner channel is not a simple agency fee-based model; partnering with Fraedom and driving its sales can bring significant indirect benefits to partners as well as their customers.

Fraedom’s partners use Fraedom to help them create and, importantly, brand Payment, Expense and Travel products for their business customers. Most Fraedom partners are financial services providers including Visa, BMO, Barclaycard, Lloyds Banking Group and ANZ. The most significant is Visa, which resells the Fraedom technology to approximately 100 banks globally. It is through its financial service provider partners that Fraedom is able to serve over 135,000 organisations. These partners typically see gains on several levels, including uplift in customer card usage and greater levels of integration with reporting and management information systems – with some of Fraedom’s partners claiming 25% uplifts in card usage.

In the direct sales channel, clients buy Fraedom to use in their own business as part of a Payment, Expense and Travel solution. Fraedom’s direct customers include Mitsubishi Motors, De Beers, IMG and Essex County Council.

The Payments element of the platform is principally sold via partners and so we expect to see the proportion of direct sales to continue to decline further over the coming years as Payments outgrows the other applications.

Partners typically sign up for five years; direct customers typically sign up for three to five years. Fraedom has a high retention rate, with the most recent data showing 96% retention by customer and 99% retention by revenue.

We discuss in more detail the functionality and growth strategy for each part of the Fraedom platform.

Expenses – Fraedom’s largest revenue generator

Within the area of expense management Fraedom gives companies an easier way to manage their non-production related expenses. The Fraedom platform is able to capture the data from card transactions, employee expense claims and receipts and smart scanning and to create a range of reports and statements, helping management to analyse and control expenditure.

This area made up the bulk of the Spendvision business and hence now the Expense application area is the largest for Fraedom at more than two-thirds of revenues. If it grows at the 12% per year rate that management alluded to in the recent Fraedom teach-in (March 2016), then we would expect it to be the largest source of growth for the next few years. As with Travel, improved mobile functionality is seen by management as an important enabler and driver of growth, and Touchless transactions in particular are regarded as a way to capture more spend through the system.

As this function is charged for on a per-user basis, it has a high level of recurring revenues.

Payments – highest growth potential

Although not the largest revenue source at present (making up just over quarter of FY16 revenues), Payments is the fastest growing of Fraedom’s applications and, management believes, the one with the greatest growth potential (c 25% pa). Management believes this lies principally in the growth in the use of cards and other such systems for non-personal business-to-business (B2B) payments. As previously discussed, financial institution partners are keen to offer this service to their customers to promote the use of their cards.

The first stage of the Fraedom Pay offering brings together a range of card and payment technologies within an authorisation, payment, receipt and reporting system. This is regarded by management as, in itself, disruptive. For the second generation of Fraedom Pay, anticipated over the next two to three years, management plans to bring together a far wider range of payment methods, including lodge cards, cheques and e-transfers and to not only combine authorisations, payments, receipt and reporting but also to select the best payment method for each transaction (“intelligent payments”). For virtual cards, management wants to be both scheme and commodity agnostic, ie capable of servicing Visa, MasterCard, Diners and AmEx cards, and for any type of expense.

Payment by card is the norm in travel and general expenses, but as the size of purchases becomes larger and more B2B in nature so the structure of billing, payment and pricing changes. Within T&E markets the vendor anticipates the use of card and will factor in the c 2% card processing fee accordingly. However, in the mainstream B2B purchases/payments area the fee is not factored into vendors’ calculations and so can be seen as an unwelcome hit to profit margins. Fraedom’s payments functionality will be able to take into account the full range of payment methods available to a customer, and assess which is most appropriate for a specific payment, taking into account working capital requirements, supplier preferences, the cost of the transaction and any available discounts.

Exhibit 3: Fraedom ‘disruptive technology’

Source: HRG

Travel – potential to sell more widely to Fraedom customer base

The primary objective in the travel area is to give the corporate user better and faster ways to find, book and manage their travel. Although travel is Hogg Robinson’s core business, Travel accounts for only a small proportion of revenues within Fraedom (<5%). The disclosed revenue figures do not include provision of software to the wider Hogg Robinson group.

The new Fraedom Travel is aimed at the SME sector in combination with expense and, ultimately, payment. Unlike HRG Travel, Fraedom's own OTE (Online Travel & Expense) does not manage travel and expense policies in support of large organisations. The complex large corporate tool is sold by HRG Travel.

Management suggests that medium-term growth percentage in this area could be in the high single figures per year over the short to medium term. This is not as rapid as the Expense and Payments applications but is still, in our view, attractive. A key driver to this growth is expected to be the increased mobile functionality and ‘Touchless Transactions’ that Fraedom is developing. As Spendvision’s roots were in the Expenses business, Fraedom is now looking to sell the Travel component to the existing Expenses customer base, representing another source of growth.

Competition

Hogg Robinson Group is far from alone in seeing the value in developing travel, expenses and payments software but management believes it is uniquely placed with regard to the range of services it can combine, particularly in the payments space. The diagram below sets out how management regards the market. The closest competitors are US-based Concur, acquired by SAP in 2014 for $8.4bn, and KDS, a privately owned French business. Management is of the view that neither of these businesses possesses the payments integration that Fraedom is able to offer and that management regards as crucial to disrupting and capturing the value of the payments market.

Looking at the purchase-to-pay software market and the invoice networks that link buyers and sellers for B2B payments (eg Ariba, Basware), most software providers support the purchasing process as far as payment authorisation, but do not actually provide the means to make payment. Fraedom sees itself as able to provide the final step in this purchase-to-pay cycle.

Exhibit 4: Fraedom – competitive position

Source: HRG

Financials

Exhibit 5 summarises Fraedom’s financial performance since FY13. Fraedom has shown consistent revenue growth over the period, and operating margins exceeded 20% for the first time in FY16.

Exhibit 5: Fraedom financials

£m

FY13

FY14

FY15

FY16

Revenue

18.5

19.7

22.4

25.6

Cost of sales

(5.6)

(6.0)

(6.7)

(6.8)

Gross profit

12.9

13.7

15.7

18.8

Gross profit margin

69.7%

69.5%

70.1%

73.4%

Development expenses

(4.3)

(4.3)

(5.5)

(6.1)

% of revenue

-23.2%

-21.8%

-24.6%

-23.8%

Sales and marketing expenses

(3.2)

(3.7)

(4.8)

(4.3)

% of revenue

-17.3%

-18.8%

-21.4%

-16.8%

G&A costs

(2.0)

(2.7)

(2.2)

(2.5)

% of revenue

-10.8%

-13.7%

-9.8%

-9.8%

Underlying operating profit

3.4

3.0

3.2

5.9

Underlying operating margin

18.4%

15.2%

14.3%

23.0%

Revenue growth

6.5%

13.7%

14.3%

Source: HRG

Based on management indications of the revenue split for FY16 and targeted growth rates by function, we estimate that Fraedom revenues could approach £40m in three years (CAGR c 16%).

The current underlying operating margins are now at a similar level to traditional software vendors. Looking at quoted SaaS businesses, although 30-40% operating margins are often talked about as achievable in the long term, very few are yet to reach this level and many are in fact still loss-making.

Valuation

The impact of Fraedom on Hogg Robinson Group in terms of valuation is difficult to quantify. Although established, Fraedom clearly has some way to go before it can claim to have reached its goal. Furthermore it remains a core part of the group and, we believe, that much of what it does is intertwined with HRG. It is clear to us, however, that despite its present small size, Fraedom is currently of significant value and has the potential to be of considerable value.

We do not have sufficient detail on the Fraedom financials to undertake detailed DCF-based valuation calculations. We can, however, look at the valuations of listed entities within similar markets or with similar dynamics and we can consider prices paid in corporate transactions.

The most notable transaction in recent years was the purchase by SAP of Concur for $8.3bn equivalent to an EV/Sales (trailing) multiple of approximately 12x. Serko is the only listed focused competitor for Fraedom (NZX-listed, market cap NZ$44m), trading on an EV/sales (trailing) multiple of just under 3x and still loss making. There are no direct UK comparators, but Craneware (AIM-listed, market cap £229m) is an interesting example of a service business that has evolved into a subscription-based software business, in its case in US healthcare billing, and its shares stand on a forward EV/sales multiple of 5.8x and P/E of 29.9x on a forecast operating margin of 29%. In the procure-to-pay software market, AIM-listed Proactis (market cap £49m) trades on a forward EV/sales multiple of 2.2x and P/E of 17.1x at a forecast operating margin of 18%.

Based on the assumption of c 14% revenue growth in FY17 at a 20% operating margin and 20% tax rate, we calculate the value of Fraedom on a range of EV/sales multiples and calculate the implied EV/NOPAT multiple.

Exhibit 6: Valuation range for Fraedom

Sensitivity analysis based on FY17 estimates

EV/Sales (x)

2.0

2.5

3.0

3.5

4.0

4.5

5.0

EV £m

58.4

73.0

87.6

102.1

116.7

131.3

145.9

EV/NOPAT (x)

12.5

15.6

18.8

21.9

25.0

28.1

31.3

Source: Edison Investment Research

Looking at the valuations of peers above, a valuation range of £75-105m would not be unreasonable for Fraedom. It compares with Hogg Robinson’s current total EV of £251m.


Exhibit 7: Financial summary

£'000s

2015

2016

2017e

2018e

Year-end March

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

 

330,100

318,300

326,000

321,000

EBITDA

 

 

53,400

55,500

57,500

58,000

Operating Profit (before GW and except)

 

 

42,500

44,800

46,500

47,000

Exceptional Items

(6,300)

(4,800)

(2,000)

(2,000)

Amortisation of Acquired Intangibles

(1,000)

(700)

(1,000)

(1,000)

Associates/JVs

1,100

1,000

1,000

1,000

Operating Profit

36,300

40,300

44,500

45,000

Net Interest

(13,100)

(13,600)

(13,500)

(13,500)

Profit Before Tax (norm)

 

 

30,500

32,200

34,000

34,500

Profit Before Tax (FRS 3)

 

 

23,200

26,700

31,000

31,500

Tax

(7,500)

(7,400)

(7,800)

(8,000)

Adjustment to tax for normalised earnings

(800)

(1,000)

(1,700)

(1,700)

Profit After Tax (norm)

23,000

24,800

26,200

26,500

Profit After Tax (FRS 3)

15,700

19,300

23,200

23,500

Minority charge

(1,000)

(600)

(600)

(600)

Average Number of Shares Outstanding (m)

322.7

324.2

325.4

325.4

EPS - normalised (p)

 

 

6.57

7.16

7.34

7.44

EPS - FRS 3 (p)

 

 

4.56

5.77

6.95

7.04

Dividend per share (p)

2.3

2.5

2.7

2.8

EBITDA Margin (%)

16.2

17.4

17.6

18.1

Operating Margin (before GW and except.) (%)

12.9

14.1

14.3

14.6

BALANCE SHEET

Fixed Assets

 

 

304,500

305,400

305,000

303,000

Intangible Assets

236,800

242,100

240,000

238,000

Tangible Assets

9,800

8,800

9,000

9,000

Investments

57,900

54,500

56,000

56,000

Current Assets

 

 

145,800

139,000

146,000

154,000

Stocks

0

0

0

0

Debtors

105,500

93,300

96,000

99,000

Cash

38,400

43,800

48,000

53,000

Current Liabilities

 

 

(167,700)

(159,500)

(165,000)

(188,000)

Creditors

(167,600)

(149,500)

(150,000)

(148,000)

Short term borrowings

(100)

(10,000)

(15,000)

(40,000)

Long Term Liabilities

 

 

(355,400)

(334,800)

(322,000)

(291,000)

Long term borrowings

(93,000)

(67,400)

(60,000)

(30,000)

Other long term liabilities

(262,400)

(267,400)

(262,000)

(261,000)

Net Assets

 

 

(72,800)

(49,900)

(36,000)

(22,000)

CASH FLOW

Operating Cash Flow

 

 

39,900

48,100

42,500

42,000

Net Interest

(4,300)

(4,200)

(4,000)

(3,700)

Tax

(4,000)

(5,400)

(9,000)

(6,000)

Capex

(11,300)

(8,300)

(12,000)

(12,000)

Acquisitions/disposals

0

0

0

0

Financing

(2,600)

(1,400)

(2,600)

(1,600)

Dividends

(7,100)

(7,700)

(8,300)

(8,700)

Net Cash Flow

10,600

21,100

6,600

10,000

Opening net debt/(cash)

 

 

65,300

54,700

33,600

27,000

HP finance leases initiated

0

0

0

0

Other

0

0

0

0

Closing net debt/(cash)

 

 

54,700

33,600

27,000

17,000

Source: Company data; Edison Investment Research

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

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