CREALOGIX Holding — Update 8 November 2016

CREALOGIX 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, and R&D slipped to 13.4% of sales in FY16. The aim now is to seek the benefits from scaling the platform across a much larger international base, with the main focus on Germany, the UK and Austria. Also, management believes there are 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 in January 2015 provided the group with strong experience in wealth management and added c 30 clients using hosting in the 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, announced in October 2015.

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:

FY16 revenue jumped 28% to CHF63.3m, as growth accelerated to 40% in H2 from 16% in H1. The H2 performance benefited from the inclusion of ELAXY. CREALOGIX acquired 80% of ELAXY Financial Software & Solution (a complementary front-end banking software business) for CHF7.2m (net of cash) and 20% of ELAXY Business Solution & Services (a hosting business specialised in the banking area with its own data centre) for CHF2.2m and these businesses contributed to the results from 1 January 2016. Total software revenues jumped by 34% to CHF34.4m, which included a 210% jump in hosted SaaS revenues to CHF4.5m and a 30% rise in licensing fees to CHF29.9m (we estimate c 5% is from maintenance fees). Services grew by 21%, while goods slipped by 8%. Recurring revenues (maintenance and hosted SaaS) rose by 45% to CHF23.8m, representing 38% of total revenues.

EBITDA swung to CHF3.7m from a CHF10.6m loss in the prior period, which reflects management’s planned actions to boost revenues while reducing costs. Full-time equivalent employees, including freelancers, rose by 17% to 414, including the impact of ELAXY Financial Software & Solutions (ELAXY FS&S), which added c 100 employees. Research and development spend was CHF8.5m, representing 13.4% of sales, down from 21.5% in FY15, and all R&D was expensed. Cost growth has also been tempered by the reduction in freelancers and the shift of some support and development functions to nearshore facilities.

45% of FY16 revenues were generated from outside Switzerland, up from 32% in FY15 and 27% in FY14. The FY16 international revenues were boosted by the inclusion of ELAXY, which has made Germany the group’s second largest market.

The acquisition of ELAXY enabled CREALOGIX to expand its client base in Germany by around 380 Volksbanken and Raiffeisen banks. In addition to Volksbanken and Raiffeisen banks, CREALOGIX also gained the following customers through ELAXY: Landesbank Baden-Württemberg (LBBW), Deutsche Apotheker- und Ärztebank (Apobank), Bankhaus August Lenz, Finanz Informatik (the IT services provider of the Sparkassen-Finanzgruppe) and Oldenburgische Landesbank. New customers not linked to ELAXY included the German financial service provider MLP, Medbank in the UK (the first combined offering of the former MBA and CREALOGIX products) and Australian asset manager Crestone. Successful implementation of the new CREALOGIX flagship product − The Digital Banking Hub – at Crestone took just three months. CREALOGIX carried out the project together with Tech Mahindra, its implementation partner for the Asia-Pacific region. In Switzerland, projects for next-generation mobile solutions began under the heading ‘Banking to go’. Customers include Aargauische Kantonalbank, Basler Kantonalbank and the Coop Bank, St. Galler Kantonalbank, Thurgauer Kantonalbank and Bank Julius Bär.

Income from associates swung from a loss to CHF517k, reflecting the group’s 37% interest in Qontis, due to one-off effects that accrued in H1 and we do not expect this level of profitability to continue. It also included the group’s 20% interest in ELAXY BS&S from 1 January 2016. The H2 income from associates was a small loss.

Cash outflow from operations after interest (zero) and tax (CHF0.1m) was CHF1.1m, and hence there was a CHF1.2m inflow from operations in H2. After net capex of CHF0.5m, free cash flow was CHF0.7m. After payment for 20% of ELAXY BS&S of CHF2.2m and 80% of ELAXY Financial Software & Solution of CHF7.2m, and gains from other financial assets (CHF2.2m), the cash out flow was CHF6.8m. After the net purchase of treasury shares (CHF2.0m), convertible bond sale (CHF24.4m) and a small exchange movement (CHF0.2m), the total cash position rose by CHF16.7m from CHF10.8m at 30 June 2015 to CHF27.5m as at 30 June 2016. The debt component of the convertible bond is CHF24.1m, leaving net cash of CHF3.4m.

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. The deal involved CREALOGIX acquiring 80% of ELAXY Financial Software & Solutions (ELAXY FS&S) and 20% of ELAXY Business Solution & Services (ELAXY BS&S) from Fiducia & GAD. While the pricing was not disclosed, the accounts reveal that ELAXY FS&S (along with two related entities) was acquired for CHF7.2m (net of cash acquired) while the 20% ELAXY BS&Ss stake was purchased for CHF2.2m. The two acquisitions were effective from 1 January 2016 and there are call and put options over the remaining 20% of ELAXY FS&S (put option to be exercised by June 2020 and call option to be exercised by June 2021). CREALOGIX has a call option to acquire the remaining 80% of ELAXY BS&S, to be announced by June 2018.

The acquisition of ELAXY has broadened 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.

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. Following this year’s rally, the shares now trade above the conversion price. The bonds are convertible anytime at the holder’s option and the first conversion (CHF25,000 nominal in bonds) has already taken place.

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 pro forma numbers, that would return the group to c CHF22.7m net cash while nearly doubling net assets to c CHF48m. In achieving this number, we have assumed a deferred payment of CHF2.4m for the 20% of ELAXY FS&S that the group does not own. However, we have ignored the 80% of ELAXY BS&S, as this is growing slowly and a purchase decision is at CREALOGIX’s option. CREALOGIX does not record either of these potential ELAXY acquisition costs as liabilities in its accounts as it is not required to do so under Swiss GAAP.

Management said it was somewhat cautious about FY17 due to uncertainties in the current market environment in Europe (eg, Brexit, Middle East, interest rates, monetary policy), which could delay decisions by customers. Nevertheless, management says it continues to expect double-digit growth in sales in FY17. Further, it expects to generate higher EBITDA in FY17, in spite of the continuing high level of investment in new product development, harmonisation of the product range and the opening up of new markets.

Management has maintained its medium-term targets, with CREALOGIX expecting growth rates of at least 20% and a minimum EBITDA margin of 10%, as annual averages. The international side of the business should contribute at least 50% to total sales and the target for the proportion of sales attributable to products is at least 70%. Short-term international growth is largely from Germany, with some growth also expected in the UK, while the group’s position in Asia remains nascent.

We have cut our forecasts for SaaS revenues, reflecting the decline in sterling following the Brexit vote in late June, which has reduced the value of the group’s existing SaaS recurring revenue book by c 18%. CREALOGIX has c 30 internet brokerage customers, which generate predominantly SaaS revenues. However, the costs of this business are also predominantly in sterling. Additionally, the Brexit vote has created a more uncertain outlook in the UK.

However, this is balanced by an increase in services, reflecting growth in the newly acquired German business (ELAXY), where services revenues are typically higher than in other regions. While CREALOGIX does offer products on a SaaS basis in regions outside the UK, there remains a strong preference for the traditional model from its customers. Further, a SaaS installation typically involves less services revenue as it normally involves some customisation but not integration work.

We continue to forecast strong growth in software revenues (including Hosting and SaaS) of 21% in FY17, 18% in FY18 and 16% in FY19. In all, we forecast revenues to rise 13% to CHF71.6m in FY17, which includes a full annual contribution from ELAXY FSS (six months in FY16), rising by 10% to CHF78.7m in FY18 and by 10% to CHF86.2 in FY18. We forecast CHF4.0m EBITDA in FY17, rising to CHF7.4m in FY18 and to CHF9.5m in FY19.

We forecast operating costs (including depreciation) to rise 8% to CHF56.9m, reflecting a full period from ELAXY in FY17. We note that CREALOGIX expenses all its R&D costs. This leaves the group with an adjusted operating margin of 4.0% in FY17. While noting that margins are difficult to forecast, we are forecasting operating margins to rise to 8.0% in FY17 and to 10.0% in FY18 as the group scales up its international revenues.

Associates represent Qontis, which is very difficult to forecast, and 20% of ELAXY BS&S (the ELAXY hosting business), which we expect to generate c CHF0.2m on a full-year basis.

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 CHF1.7m in FY17 (against CHF2.6m in FY16), falling to CHF1.4m in FY18. The decline is due to goodwill from previous acquisitions having been fully amortised.

We forecast a tax rate of 27% on normalised profits in FY17, easing to 26% in FY18 and to 25% in FY19.

The minority interest represents the 20% outstanding in ELAXY FS&S, which we anticipate will be acquired by CREALOGIX at the beginning of FY21.

We are forecasting capital investment of 1.5% of sales. 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 in the forecast period, as the company has not given any guidance on future dividend policy. This reflects the current priority on investment in technology, sales and internationalising the business.

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 highlight the following points on the group’s valuation: