PSI — Update 15 April 2016

PSI (Gesellschaft Fuer Produkte und Systeme der Informationstechnologie) develops, sells and integrates software for controlling complex systems, networks and infrastructures. Its systems are crucial components within these systems, enabling them to run efficiently, improving flexibility and avoiding failure.

For reporting purposes, the company has three key segments:

Each of these segments is made up of a number of more focused businesses, each offering optimised solutions and expertise to address more specific industry verticals. These divisions are shown in Exhibit 3, which highlights the divisions that are most influential to the overall group result: PSI Metals, Electricity and Multi-Utility, Automotive and Industry, Oil and Gas and Incontrol.

The company transacts business across the globe, with Germany accounting for circa 51% of sales as a result of a strong domestic position in Electrical and Multi-Utility Energy, Logistics and Automotive & Industrial divisions.

Two key initiatives are being implemented to add resilience to earnings and put the business back on a margin expansion trajectory. Firstly, the shift towards a product-led vs project-based model should reduce exposure to cost overruns and improve the working capital profile. Secondly, the progressive migration of customers and products onto a unified technology platform should help improve development and implementation efficiency and reduce overheads.

Segment revenues increased by 4.8% to €67.2m, with operating profit improving from €4.8m to €5.3m.

This segment’s growth was driven primarily by the energy management segment (c 21% of group sales), which supplies solutions for managing electrical power generation and distribution systems in the German and neighbouring markets. Robust demand is being driven by structural investment in PSI’s solutions, which enable the grid to adapt to more volatile, renewables-based supply and the cyclical demand upswing related to Germany’s energy tariff setting cycle. The division typically experiences a three-year demand upswing in the years preceding during the “photo year” in which tariffs are set, which is 2016 for electricity and 2015 for gas (although the former is much more significant for PSI). Consequently, the company expects robust demand from electricity to continue in FY16, but is more cautious on the near-term outlook for gas. The reduction of the tariff setting cycle from five years currently to four should help smooth the division’s demand profile moving forward.

Demand from Oil and Gas (c 12% of revenue) remained stable over the period. At the revenue level, the company expects to broadly offset weakness in the upstream business (with a significant customer base in Russia, so also exposed to currency headwinds) with the development of its downstream business in western markets. Profits are expected to be negatively affected however, due to the higher than average margins of the upstream business, where the company works with integration partners and the licensing component of revenue is higher.

Revenues in the Production Management segment grew by 8.5% to €86.4m, with operating profit expanding significantly to €6.2m from €2.2m in 2014. The revenue growth was largely due to the full year contribution from Broner (acquired in November 2014), although the exact contribution is not disclosed, and the Broner product is being discontinued (the acquisition was largely made to acquire customer relationships), making the exact contribution difficult to isolate. The significant expansion in profitability is mainly due to the robust recovery of the logistics division from significant execution issues and cost overruns in FY14.

Given the weakness in the global steel industry, PSI Metals, the largest division within the segment (c 23% of group sales) performed solidly, maintaining margins at around the 10% level. Interestingly, the company is now seeing some signs that the demand cycle in steel is improving, with investment in software being key to enabling the industry to adapt to the changed supply demand dynamic. (For example the potential conversion of the Newport UK steel mill from raw material processing to recycling.) This may be somewhat offset by a slowdown in aluminium processing, although the company’s exposure to this industry is substantially lower.

PSI Automotive and Industry (c 16% of group sales) supplies enterprise resource planning (ERP) and manufacturing execution systems (MES) primarily into the German industrial market. The division’s performance has been lacklustre for a number years, due in part to the difficulties of competing with SAP in the German mid-market. Operating margins were below 5% in 2015. However, the outlook now appears to be more positive. The initial feedback on the new client-side software platform due for launch in H1 is said to be positive. The company’s investment in playing a leading role in Industry 4.0 research could be set to pay dividends, with a number of projects looking set to move from the research phase to production deployment.

Revenues from the Infrastructure Management segment fell to €30.1m from €31.6m in FY14, with operating profit falling to €0.7m from €2.2m in FY14 (and €3.3m in FY13).

The weak performance was primarily due to the ongoing difficulties at PSI Incontrol (c 10% of sales), the company’s South-East Asian operation, which has been affected by the weak economic and turbulent geopolitical environment in the region. The division was restructured during 2015 and returned to a profit in H2, but made a loss over the full year. A better year is hoped for in FY16, although the long-term fit with the rest of the group remains questionable given its systems integrator/reseller model versus PSI’s proprietary product lead strategy.

Following a restructuring and new product launch, prospects for the logistics division (where losses due to execution issues and project overruns in FY13 and FY14 severely damaged the overall group result) now look positive. Margins have returned to over 10%, and demand in the logistics market is being boosted by a new product offering and the rise in e-commerce.

Reflecting the shifting cyclical and economic landscape, growth in order intake was driven primarily by Germany, where new orders increased 14% y-o-y to €111.5m, with more modest growth across Western Europe, the Americas and China, offset by declines in Russia and Eastern Europe and the Middle East. Overall book to bill was 1.06x, driven by the strong progress in Germany (1.2x), offset by negative figures in the other regions.

Full year results were as expected and in line with guidance set at the beginning of the year at the P&L level. EBIT margins expanded by 190bp to 6.3%, driven primarily by Production Management (recovery in logistics following cost overruns in FY14) and Energy Management (Electricity), offset by weakness in Infrastructure Management (Incontrol).

Cash performance was stronger than forecast, with year-end net cash standing at £35.4m versus £27.8m forecast, reflecting lower than expected receivables and capex. A dividend of 21 cents has been declared. The pension liability stands at €47m, unchanged from last year.

However, while order intake grew by 6% y-o-y to €195m and by a robust 9% to €51m in Q4, this was slightly short of guidance for double-digit growth in orders exiting 2015 into early 2016.

The shift in mix from high-margin upstream to lower-margin downstream business in oil and gas contributes to our revenue forecast actually moving up slightly. More recent economic and geopolitical uncertainty together with currency headwinds prompted management’s guidance of
0-17% growth in operating profit (€11-13m), versus Edison’s previous €14.5m (31% growth) estimate. This prompts cuts of 17% and 10% to our FY16 and FY17 EPS estimates, respectively. The conversion of a significant deal for the Electricity and Multi-Utility division in Iran could be the swing factor between financial performance being at the lower end or the upper end of guidance.

Looking longer term, we still believe that the company’s shift towards a software vendor model and the consolidation of products onto a common platform have the potential to drive margins to the mid-teens level, although a five- to seven-year view now looks more realistic, versus our three- to five-year estimate previously.

Looking at PSI’s peer group in Exhibit 7, successful companies with pure software models and a (more or less) consolidated software platform can generate operating margins well north of 20%. While the very high margins enjoyed by the likes of AVEVA and Dassault are likely to be out of reach, we believe that with some rationalisation, broader roll-out of the new software platform and a successful shift to a standard software model, expansion to the mid-teens level should be achievable, albeit on a somewhat longer timescale than previously thought.

Following the downgrades, PSI’s P/E rating of 21.3x 2016e earnings, dropping to 16.8x for 2017e is towards the lower end of the company’s broader peer group. The company’s substantially lower EV/sales ratio and current operating margins highlight the potential if PSI can bring its margins closer to the level of its software vendor peers.

A discounted cash flow analysis suggests that the current valuation is pricing in a low single-digit organic growth with operating margins expanding – and plateauing – at 10% by 2022. In most circumstances, expansion of operating margins to 12.5% would justify a share price above €17. Operating margin expansion to 15% would in the same timescale justify a valuation well above €20.

In Exhibit 8, we show a DCF sensitivity analysis assuming that the company reaches different operating margins by the year 2022 and differing organic growth rates between now and 2022. Given the moderation in margin expansion expectations for 2016, we have lengthened the time to reach target margin by two years, from 2020 to 2022 versus previously published valuations.