Brady — Update 8 April 2016

Founded in 1985, Brady is a leading provider of trading and risk management software for global commodity markets. The group has 400+ customers worldwide, including some of the largest financial institutions and corporations, which depend on Brady's software solutions to deliver mission critical business transactions across their global networks. The group employs c 270 people with development centres in the UK (Cambridge), Norway (Bergen and Halden), Switzerland (Geneva) and India (Bangalore) and commercial offices in the US, UK, Europe and Singapore. Customers include Codelco, EDF, Gerald Metals, Glencore, HSBC, ICAP, Koch Industries, LG Intl, Noble Group, Norsk Hydro, Rio Tinto, Sims, Standard Bank, Statkraft, Statoil and Xstrata.

The group’s commodities, recycling and Switzerland-based energy scheduling unit typically operate a term-licence model, normally for five years. There is an annual 20% support and maintenance fee on top, along with services, which could potentially double the licence fee. The default delivery is a hosted cloud offering, which involves a recurring annual hosting fee. Close to half of new business is now hosted cloud and it generated c £1m of cloud revenues in FY15. The group’s Norwegian energy business operates an onsite rental model. Group revenue dipped 7% at constant currencies on FY15, having grown in year since FY06. 56% of FY15 revenues were recurring in nature, but this leaves a significant degree of lumpiness in the business model; much of the new business is signed in Q4. We are forecasting sales to grow by 6% organically in FY16 (12% including energycredit) and 5% in FY17. We expect adjusted operating profit to rise to £3.4m in FY16 and to £4.0m in FY17. Brady had net cash of £6.6m at the end of FY15 and we forecast this to increase to £7.0m at the end of FY16, after paying for energycredit, and to £8.5m a year later. The group has no financial liabilities.

Commodity markets are cyclical and subject to periods of extreme volatility. However, in our view, Brady’s greatest sensitivity, as with the typical enterprise software vendor, is the risk of IT department budget cuts in an economic downturn. The 2015 commodity selloff, which was related to the Chinese economic deceleration, was persistent and severe, and correlated across asset classes. The one E/CTRM asset class that performed relatively well in 2015, was petroleum, but Brady has no exposure in this space. The commodity selloff forced restructurings across the commodity trading sphere (c 50% of Brady’s customer base), as well as in the scrap metals space, and players deferred deals to conserve cash.

The stock trades on a P/E of 15.6x our FY16 earnings forecast, falling to 14.0x in FY17. On a cash-adjusted basis the numbers fall to c 13.7x and c 12.2x in the respective years. Our DCF model, assuming a weighted average cost of capital of 10%, values the shares at 100p, or c 84% above the current share price. This target is supported by current customer win rates, potential for cross-selling, and the scope to add further acquisitions to broaden the customer base into new geographies.

The final results were in line with our forecasts, which we last revised in December. While FY15 got off to a good start, the rout in commodity prices through H2 affected the group’s customer base. This was particularly prevalent across commodity trading houses, which represent c 50% of the customer base, as well as in the recycling space. Hence several deals that were anticipated in the second half were deferred, and the group announced a profits warning in late November. Nevertheless, 20 significant deals were signed in FY15, which was the same as FY14, while 27 contracts went live. Nine of the new deals were hosted in the cloud, up from six in 2014, providing the group with additional recurring revenues. Group revenues dipped 12% (or 7% at constant currencies) to £27.4m, while adjusted operating profit fell 82% to £0.9m. The group ended the period with £6.6m cash and no debt. Brady acquired ScrapRunner in September 2015 and energycredit in early January 2016. The annual dividend was passed in order to conserve cash. We believe this was primarily to ensure the group has adequate resources to make further acquisitions without having to raise additional funds from shareholders.

Brady, which has established itself as the largest European headquartered E/CTRM (energy/commodity trading, transaction and risk management) company, seeks to be the definitive provider of choice for natural resources software solutions. Brady is the largest player in metals globally, has the largest European energy installed base and is the biggest in US recycling. The group now has over 400 customers, including many blue-chip, household names, and a large part of new business, including the largest deals in FY15, are upsells to existing customers.

We highlight the following points on the group strategy.

The original Brady plc developed a strong position delivering trading and risk solutions to the metals markets and was floated on AIM in 2004. Gavin Lavelle, CEO, joined in 2007. Comsoft was acquired in 2009 to broaden the metals offering into concentrates. Viveo Switzerland was acquired in March 2010, establishing the group in the softs & agricultural space. Viz Risk Management was acquired in December 2010, establishing the group in the electricity and gas sector, which was boosted by the acquisitions of Navita and Syseca in 2012. SAI was acquired in 2014, immediately establishing the group as a major player in the recycling space, and further boosted by ScrapRunner in 2015.

Group contribution dipped 31% to £6.5m, as business deferrals in H2 resulted in FY15 numbers not meeting earlier expectations. Hence, Brady took £2.0m out of the business late in FY15 and these benefits are expected to flow through in FY16. These cost savings were spread across the group’s non-revenue generating activities. The performance was also affected by currency moves, which reduced revenues by £1.3m and contribution by £0.5m. This was due to the weak Norwegian krone, which has since staged a recovery, rallying by c 9% since year-end. An FY15 highlight was the improvement in profitability in the group’s Energy business unit, following the division’s restructurings, which involved it transitioning to a common go-forward platform.

Commodities (c 45% of FY15 group revenues)

Brady merged its UK-based Metals business unit with its Geneva-based Physicals business unit in 2013 to form an enlarged Commodities division. Brady is the world’s leading provider of trading and risk management software for the global metals markets, and is installed with producers, fabricators, merchants, banks and brokers around the globe. Also, it has leadership in the LME market (over 50% of LME Cat 1 members use Brady software, which is mainly for back and middle office processes). The Physicals business was acquired in late 2010, then known as Viveo Switzerland. It focuses on commodities for physical delivery, operating across soft commodities, metals and oil & gas.

The division’s revenues dropped 14% (15% on constant currency basis) to £12.2m. The contribution dipped by 37% to £3.7m, to give a contribution margin of 29% (FY14: 41%). This division was heavily affected by the contagion in the commodity markets, particularly in relation to the major global commodity traders, several of which underwent restructurings. Sales highlights included major contracts signed with one of the world's largest commodity companies and the brokerage division of a large Japanese multinational, covering base and precious metals and agricultural commodities. Another highlight was the signing of four new start-up commodity trading companies, which selected cloud-based solutions for cotton, metals and concentrates trading and risk management. There has been a trend in the spinoff of trading units from major traders, and it is encouraging to see Brady picking up this new business.

Energy (c 39% of group revenues)

Brady has the largest installed base of ETRM (energy trading, transaction and risk management) solutions in Europe. The division was formed via the acquisitions of Viz Risk Management in 2010 and Navita in 2012, both of which are based in Norway, and Switzerland-based syseca in 2012. Brady provides solutions that support electricity and gas trading, covering trading and risk management, logistics, data management and settlement. Most solutions are sold on a recurring rental basis and c 75% of the division’s revenues are recurring. The group does not offer specialised solutions for the petroleum market.

FY15 revenues slipped 15% to £10.7m while the contribution fell 1% as the margin recovered to 26%. On a constant currency basis, revenues fell 1% while the contribution rose 18%. Eight new significant contracts were secure, including four new clients. There were 10 go-lives, including five contracts that were signed earlier in the year and two implementations of the first release of Brady's integrated pan-European power scheduling and balancing solution. In 2016, the division stands to benefit from the creation of a common settlement system for the Nordic markets, replacing the existing country-based systems, and Brady has 24 customers participating in a beta solution.

Recycling (c 16% of group revenues)

Brady is the largest supplier of software solutions to the recycling industry in the US, where six of the 10 largest recycling companies are customers, and 50% of ferrous scrap is processed with Brady’s software. The division was formed with the acquisition of SAI, based in Maumee, Ohio, in 2012. The business unit develops and licenses highly specialised software that scrap metal businesses use to manage their business processes. The core solution, CRES, offers a complete end-to-end solution from scrap yard to accounting for the supply-chain management, profit margin analysis and forecasting for recycling organisations in the ferrous, non-ferrous, paper and steel sectors. Around 1,000 scrap yards use Brady’s software in the US.

The division’s revenues rose 5%, but were flat on a constant currency basis, to £4.0m, while the contribution dropped 91% to £0.1m. The division’s customer base was affected by sliding scrap metals prices, which were largely related to the weak Chinese market. Nevertheless, Brady was selected by Sims Metal Management (ASX: SGM), the world's largest recycling company, to implement Brady’s software in all its facilities in Australia, New Zealand and New Guinea. We would expect this rollout to extend to Europe in due course, as it is part of Sims’ larger plan to standardise all its global operations.

R&D expenditure dipped 8% to £6.7m, representing 24.5% of revenues in FY15, compared with 23.5% in FY14. The group has c 140 technology staff, up from 25 six years ago, including 40 in Bangalore, which joined as part of the energycredit acquisition post-period end. Brady believes it can make significant cost savings to its R&D programme by leveraging its facility in Bangalore.

The group’s pension deficit increased from £1.9m to £2.2m. However, we note that Brady has no defined benefit schemes (where the company takes on the investment risk). The deficit relates to two Swiss defined contribution pension schemes, which it is required under IFRS to account for as if they are defined benefit schemes because Brady guarantees them. However, they are insured with Zurich Insurance. Hence we have not included the deficit in our adjusted debt numbers.

Last year’s profits warning related to a lengthening of sales cycles, due to a deterioration of market conditions in the commodity sector. However, Brady says the deals have been deferred rather than cancelled. As a consequence of the deferrals, the company reduced costs by c £2m, which will help to underpin FY16 profitability and cash flow.

While the overall market outlook remains uncertain, Brady is confident that it will continue to take market share demonstrated by its ability to sign and deliver increasingly large contracts with global leaders and its strong list of referenceable customers who already rely on Brady systems to run their businesses. Brady has visibility over c 65% of FY16 revenues.

Despite the uncertain market conditions, Brady benefits from healthy underlying business drivers, including a market underinvested in IT, along with regulation, compliance and risk-related factors. Brady operates in a large, global market: everybody on the planet is reliant on commodities and energy; the recycling market is growing strongly; and Brady continues to be well placed for profitable growth.

In early January Brady announced the acquisition of energycredit, a provider of credit risk management solutions for the energy and commodity markets, from Temenos for an undisclosed sum. Brady has had energycredit on the radar for a number of years and we believe it is an interesting time to buy a credit risk management solutions business given the current turmoil in the commodity markets and there is an opportunity to extend the solution to other asset classes.

Founded in 1995, energycredit is headquartered in London, with c 55 employees. It also has a commercial office in Houston, Texas, and a development centre in Bangalore, India, where it has 40+ employees. energycredit offers a traditional licence business model, with professional services and support and maintenance. A typical licence is in the £0.5m to £1.5m range, including delivery and customisation. Nearly all of its customers are in the energy sector, including household names such as Royal Dutch Shell, Statoil, RWE and Chevron. Nevertheless, the product itself is sector agnostic and Brady plans to extend it across new verticals by targeting its existing customer base. Brady also plans to leverage the Bangalore development centre across its other asset classes, which should help to put downward pressure on R&D costs.

Our forecasts are broadly maintained, albeit for the inclusion of energycredit, which was acquired in early January. We forecast energycredit to generate £1.5m of revenues in FY16 (nearly 12 months) along with c 10% operating margins. In all, we forecast revenues to rise 12% in FY16 (6% excluding energycredit) and 5% in FY17. We assume R&D eases to £6.6m in FY16 (21.5% of sales), noting that cost reductions have not yet had much impact, of which 25% are capitalised. We assume that energycredit cost £0.5m. We expect the group to be cash generative from FY16, with net cash rising to £7.0m as at the end of FY16 and increasing to £8.5m a year later.

We assume dividends resume this year at a 50% payout ratio, noting FY16 EPS is still at a depressed level, and move progressively higher thereafter.

We believe our forecasts are conservative, based on a subdued economic backdrop and there are a number of reasons why the risks are now shifting to the upside.

Commodity markets are cyclical and subject to periods of extreme volatility. However, while falling commodities prices hurt producers, they are beneficial to traders and manufacturers, who also purchase the group’s software. Further, falling commodities can force producers to drive through efficiencies, which can involve them upgrading or replacing their in-house software with Brady’s software. The 2015 commodity selloff, which was related to the Chinese economic deceleration, was persistent and severe, and correlated across asset classes. This forced restructurings across the commodity trading sphere, with players deferring deals to conserve cash. Nevertheless, target commodity customers (producers, fabricators, traders, etc) are generally well capitalised, dealing with high volumes, yet are significantly under-invested in IT trading platforms. Strong regulatory and compliance drivers are also pushing demand for improved IT systems.

We highlight the following sensitivities:

Brady has been signing and delivering significantly larger licence agreements and expanding its customer base of high-quality, blue-chip names. This provides strong references, and creates the momentum for further deals.

The major commodity software sector deals executed at high EV/sales multiples in late 2011 and mid-2013. These deals highlight the popularity of the commodity software space, particularly from private equity, and Brady remains the only quoted asset in the sector. This gives Brady a significant advantage over major peers, which have been losing market share, as the business is more transparent as a quoted company.

We note that since the trading news, Kestrel Partners, Brady’s largest shareholder, has used the weakness in the share price to accumulate a 23% shareholding.

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