PSI — Update 22 November 2015

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. The company has three key divisions: Energy Management – the company’s systems are used to ensure a stable and dependable supply of electricity, gas, oil, heat or water; Production Management – solutions for optimising metal processing, automotive production, mechanical engineering and mining processes; and Infrastructure Management – highly resilient control systems for managing and monitoring road, rail and other public transport systems. 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.

The company’s recent trading and outlook suggests the business is now set on a recovery path, following a difficult period in 2013 and early 2014, where a weak domestic energy market and cost overruns severely compressed margins. Order intake over the nine months to September 2015 grew by 12% to €149m and sales by 7.4% to €137m, driven mainly by demand in Western markets, particularly in Energy and Production management. EBIT grew by 66% y-o-y to €7.3m due to recovery from the negative impact of cost overruns in early 2014 and operationally geared growth, although weak conditions in South-East Asia were a supressing factor. Our estimates have not changed materially other than a reduction in the dividend (20c to 15c for FY15, 30c to 20c for FY16) to reflect management’s 30% payout-ratio guidance. While we are mindful of the uncertain economic and geopolitical environment, and of the potential for German electrical grid investment to soften following the tariff setting year, we see good potential for PSI’s growth and margin expansion trajectory to continue. The strategic partnership with ThyssenKrupp should support growth in PSI metals, while new product releases in Automotive & Industry, Logistics and Energy Trading and a follow on order in Mining should support growth across a broad base of divisions. Reflecting the progressive impact of the software platform consolidation and shift to a product-led software model, we forecast EBIT margins expanding from 4.1% in FY14 to 8.5% in FY17. This drives a 44% EPS CAGR over this period. Looking longer term, we believe that the initiatives could drive margin expansion to the mid-teens level on a four- to-five year view versus 6.1% forecast for FY16.

Despite the recent recovery, PSI’s share price remains rated at recovery multiples, with a low EV/Sales (1.0x) but relatively high P/E (18.9x), although the latter is not out of kilter with the company’s broader peer group. On a fundamental basis, our DCF scenario analysis suggests that the current share price factors in low single-digit organic growth, with margins expanding to 10% by 2020. Expansion of operating margins to 15% would justify a share price above €20. We believe that evidence that the current growth and margin expansion trajectory is set to continue is likely to be the key catalyst for upside. In particular, management is guiding to a 10%+ growth in revenue and order intake into early FY16, which if sustained could drive upside to our estimates and potentially a moderate upwards rerating of the P/E as well.

PSI’s software solutions control, monitor and optimise complex, mission critical infrastructure for utility companies, industrial manufacturers and processors and the transport industry.

Control software is an essential component in the operation of advanced industrial or logistics processes enabling operators to improve operational efficiency, reduce the risk of potentially catastrophic failure, deploy infrastructure more efficiently, adapt to change or improve flexibility and reduce environmental impact.

The range of functionality covered by the company’s solutions varies by vertical market, but includes front-end user interfaces for control and monitoring, process-specific control algorithms, fault analysis and handling, simulation, reporting, maintenance, trading software and workforce management.

The company segments its business into three divisions: Energy Management, Production Management and Infrastructure Management, each addressing a broader collection of end markets. However, to better understand the dynamics of the business, it is important to note that each of these three divisions is made up of a number of more focused businesses, each offering optimised solutions and expertise to address more specific industry verticals, as shown in Exhibit 3. Consequently, each reporting segment consists of a number of businesses with differing maturities and margin profiles and each is exposed to different end-market and competitive dynamics. Looking at the business from this perspective, the five largest businesses in terms of revenue contribution are PSI Metals (25%), Electricity and Multi-Utility (19%), PSI Automotive & Industry (16%), Gas and Oil (13%) and PSI Incontrol (10%) (percentages are estimated on trading for the nine months to September).

Geographically, the company operates on a global basis, with just over half of revenues generated from Germany. Again, the profile differs very much by division, with the Electricity and Multi-Utility, PSI Penta and PSI Traffic divisions being largely domestic, whereas Metals and Gas and Oil are both international although the latter has significant exposure to Russia. PSI Incontrol operates in South-East Asia.

From its foundation in Berlin, in 1969, PSI was built up through organic development supplemented by a number of acquisitions, and as a result the company currently works with around 25 different specialist software platforms, each developed for specific vertical markets of applications. The requirement to enhance, maintain and support all of these platforms clearly results in very significant inefficiencies, suppressing margins and impairing competitiveness.

The company introduced a new platform in July 2010, based on the Eclipse Java based architecture and has invested well over €10m in the development to-date. The group is now around a third of the way through a programme to progressively migrate its operations onto this architecture, which should ultimately improve the efficiency of R&D and support and enhance competitiveness. It is also a key enabler of the company’s strategic transition from its previous position as an IT solutions provider to a more product-driven software licensing model.

The key benefits of this migration to the company’s margin profile are as follows:

Ultimately, the potential for this platform consolidation to proportionately reduce R&D costs and raise margins could be significant. In the transition period however, margins are being compressed by an element of double costs being incurred, as the company still supports a number of disparate legacy solutions, while it further develops the platform.

The migration process is also very much a long-term project, with the divisional schedule based on both commercial need and degree of complexity. Consequently the release of efficiency benefits will be very progressive.

However, we believe that the recent strategic deal with ThyssenKrupp for PSI Metals, which is now largely based on the new platform, does give investors an indication of the type of commercial benefits which will be made possible. As part of the deal, PSI become the standard software provider for ThyssenKrupp’s European steel business, and over a period of years all of ThyssenKrupp’s 15-20 European plants, (which currently use a variety of different solutions) will migrate to the PSI platform. We highly doubt that such a deal would be possible using a legacy solution.

Historically, PSI operated a solutions-based model, whereby the licensing component of a customer engagement was relatively low, with revenues weighted towards the implementation project, which involved customising and then integrating the solution, often on a fixed-price basis. Facilitated by the move towards a standard software platform, the company is now shifting its model, whereby the licensing component (for a more modern, flexible product) will be higher, while the implementation work will be carried out on a time and materials basis, and should proportionately reduce with the improved configurability of the new platform. The standardisation of the platform should also support growth in maintenance and upgrade revenues, through enhancing the company’s ability to sell standard software upgrades and security patches, often bundled into a full upgrade and maintenance contract. Historically, the typical value of a standard maintenance contract was 15-16% of sales, whereas under the new model a full upgrade and maintenance contract may be worth as much as 20-25% of the initial licence fee.

Ultimately, this shift in the model should help drive up margins and improve earnings predictability. The shift should drive growth in licensing (high margin but volatile) and maintenance and upgrade revenue (high margin and recurring), while software development and integration revenues are likely to decline, although the shift towards time and materials contracts should reduce exposure to cost overruns. Hardware revenues, a significant proportion of which are generated by Incontrol, are unpredictable and low margin. The shift will also suppress growth in the order book in the near term as multi-year fixed price implementation projects, (where the whole value would be recognised in the order book) give way to time and materials, upgrade and maintenance revenues, which enter the order book more progressively.

The company has also taken further steps over the course of the past year to consolidate the business, building on its key strengths in vertical markets, where the company has a strong competitive position, while rationalising weaker operations.

The acquisition of Broner, a direct competitor to PSI metals in Q414, showed PSI’s ambition to build upon its core strengths, consolidating the market to improve pricing power and grow the company’s customer and geographic footprint. Equally, the headcount at PSI Incontrol has been reduced by 40 to adjust to the difficult economic environment in South-East Asia.

The production segment consists of two of PSI’s larger businesses, PSI Metals and PSI Automotive & Industry (previously called Penta), with two smaller divisions, Logistics and PSI Mining. In the nine months to September, revenues grew by 8% to €65.6m with EBIT increasing 167% to €4.5m. While the Q414 Broner acquisition will have accounted for the bulk of this increase, we see good scope for robust organic growth going forward, driven by the ThyssenKrupp deal in Metals, new product launches in Automotive & Industrial and Logistics and follow-up orders from initial trials in mining.

Challenging conditions faced by the global steel industry over the past year have had an impact on what had previously been one PSI’s strongest performing divisions. However, the deal with ThyssenKrupp should provide support for the steel business for a number of years, while investment in the aluminium production industry also provides growth opportunities. The contribution from Broner is difficult to gauge, as other than certain key modules, the Broner products are being phased out to be replaced by the PSI ones. We have yet to see any evidence that Broner is helping drive new business wins in geographies where PSI was historically weak, such as the UK, India and Brazil, but given the industry’s long sales cycles and conditions in the global steel industry this is not surprising, although the consolidation of a competitor may have simplified the bidding process for the ThyssenKrupp deal.

PSI Automotive & Industry (previously PSI Penta) stands somewhat apart from the rest of the group in that it supplies enterprise resource planning (ERP) and manufacturing execution systems (MES) rather than control software. Operating primarily in Germany, the division supplies into two key verticals: the automotive manufacturing supply chain; and German Mittelstand manufacturers. The economics of this business are hampered by the fragmentation of the customer base (over 400 customers) and competition with SAP. However, a major new product update, due for launch in H116, which will bring the solution onto PSI’s core platform, should both enhance competitiveness and replacement sales, although the knock-on effect from the Volkswagen scandal clearly adds an element of risk.

The longer term and more significant growth opportunity within this vertical will come from PSI’s ability to capitalise on the anticipated upheaval in manufacturing processes and supply chains brought about by the implementation of Industry 4.0 or smart factory concepts. The basic principal of Industry 4.0 is that by connecting machines, work pieces and systems, businesses are creating intelligent networks along the entire value chain that can control each other autonomously. While the pace of change and therefore the extent of the revenue opportunity for PSI is difficult to estimate, management reports a rapid acceleration in interest from customers. The company has also been a prominent evangelist of Industry 4.0’s potential and has been involved in multiple research projects regarding its implementation in practice.

PSI Mining is an early-stage business, which has been implementing control room software at two lead customers, both in China. The company is now in discussions with one of these customers for a follow-up order, which should be more profitable than the initial trial implementation, as well as adding further referencability to PSI’s solutions in this field .The overall market opportunity looks significant. PSI’s solutions help improve efficiency, so we see ample opportunity for the division to grow from its small base, despite the weak commodities market.

The logistics division is now well placed to grow again following the costly project overruns, which significantly hurt group earnings in 2013 and ran into H114. The launch of a new warehouse management system has been successfully deployed at lead customers and a broader sales and marketing campaign is set to commence in H116, once the consolidation of the product into the group platform is fully complete.

The Energy Management segment comprises three divisions: Electricity and Multi-Utility, Gas and Oil, and Energy Trade and Sales. Overall revenues for the segment grew 7% to €49.1m year-on-year in the nine months to September 15, compared to €31.8m in H1. While nine months EBIT increased by 29% to €3.5m, reflecting both operational gearing and lower development costs. We believe that a requirement for increasingly complex control solutions and new product launches to meet this demand should create a robust demand environment for this segment over the medium term, although we need to be mindful of a potential near-term moderation in demand in electrical energy related to the German electricity tariff setting and investment cycle.

The German electrical energy business was, as expected, a key driver of growth for the segment and the group as a whole. This is in part cyclical, with demand being buoyed by investment ahead of the German tariff-setting ‘photo year’ (the five year cycle when feed-in tariffs are decided) in FY16. (Around two-thirds of the division’s revenues come from the domestic market.) More structurally, the shift towards decentralised energy supply, more volatile renewable energies and intelligent grids should drive demand for complex control software and PSI has invested in solutions to meet these requirements. The use of more sophisticated control software can for example help reduce the overall investment required in the distribution network to adapt to the changing energy supply dynamics. The shift to a decentralised supply should also reduce the exposure to the centralised tariff setting cycle. For example, the company started a pilot project for a “multi-client capability control system for municipal utility co-operations” in Q215.

Enabled by the new software, the company is also looking to structure its deals towards a more recurring maintenance/update-weighted format. Looking further out, the cyclicality of the sector could be further reduced if German government plans to exclude software investment from the tariff-setting cycle are ratified.

The balance between cyclical and structural demand within Electrical Energy is difficult to gauge at this stage. However, while it is prudent to assume some degree of drop-off in 2016/17 following the tariff setting cycle, the overall demand environment looks set to remain substantially stronger than the 2012/13 period, when the German government’s policy to eliminate nuclear power generation and to migrate from conventional to renewable energy sources starved PSI’s core customer base of cash.

The company’s Gas and Oil business supplies control software primarily for gas distribution grids (mainly domestic) and pipelines (mainly overseas). Given the overseas businesses exposure to Russia and the weak oil price, demand appears to have held up surprisingly well, although the company is expanding its position in the Scandinavian market, which should help diversify exposure.

This is a small division, which supplies software for enterprises working in the liberalised energy market to allow them to manage all sales- and trade-related processes. This is another division where the development of new products and reimplementation of existing products on the group platform should support growth prospects. For example the division has won further contracts this year for its gas and electricity solutions, which are both on the new platform. A trial project to implement the first virtual power plant for decentrally-generated energies and industrial energies also commenced in Q315.

Infrastructure is PSI’s smallest division covering three relatively small business, none of which we would consider core. Sales grew 6% to €21.9m in the nine months to September but EBIT of -€20k (versus a €900k profit last year) was affected by continued weakness in South-East Asia and restructuring costs.

PSI Incontrol – differs from the rest of the group, in that it was PSI’s implementation partner in South-East Asia, which the company acquired in 2009. As such, its revenues are more project than product based and it also has a more significant hardware component to its revenue mix than the rest of the group. The weak economic and turbulent geopolitical environment in South-East Asia has afffected progress, prompting the company to reduce headcount this year by 40.

PSI Transcom – provides software for controlling public transport infrastructure: metro, buses, trams, regional trains, etc, and also has a depot management system in German-speaking countries. Despite operating in a competitive market, particularly for public transport infrastructure systems, where the company competes with INIT and IVU Traffic Technologies, divisional sales and earnings have grown this year. However, given the relative lack of scale, the division’s long-term fit with the rest of PSI’s business looks unclear.

PSI Poland – is a small division in terms of revenue contribution, providing PSI’s solutions into the Polish market. However, is also an important R&D centre for the group, with over 200 software developers, leading the development of the group platform.

Results for the nine months to October growing were generally encouraging, with order intake growing by 12% to $149m, sales by 7.4% to €137m and EBIT by 66% to €7.3m, driven mainly by demand in Western markets, particularly in Energy and Production Management. EBIT margins for the first nine months expanded from 3.4% in FY14 to 5.3% in FY15, reflecting the lingering impact of cost overruns in Logistics which suppressed the prior year and operationally geared margin expansion in Energy Management, boosted by robust demand from the German electricity market.

The company’s outlook statement was also encouraging, with management reconfirming its full year €11m EBIT target (we estimate €11.1m), while order intake and revenues are expected to grow at a double-digit rate into the early part of 2016.

At group level, our estimates have not changed materially for FY15 and FY16, although we have adjusted the divisional breakdown, moderating the sales performance for Production Management in FY15 but assuming a robust recovery in growth in FY16 driven by the ThyssenKrupp deal and opportunities in Automotive & Industrial, Logistics and Mining. We have also reduced our dividend forecasts from 20c to 15c for FY15 and from 30c to 20c for FY16 to reflect management’s 30% payout-ratio guidance. Our FY17 estimates are new.

At the group level, we believe our revenue growth forecasts are conservatively set at a mid-single digit level for both FY16 and FY17. While management’s expectation is of both order book and revenues growing at a double-digit rate in the early part of FY16, our prudent stance stems from the uncertain global economic and geopolitical climate and that investment from the German electricity sector may drop off following the tariff-setting year.

Reflecting the progressive impact of the software platform consolidation and shift to a product-led software model, we forecast EBIT margins expanding from 4.1% in FY14 to 8.5% in FY17. This drives a 44% EPS CAGR over this period (or 27% from 2015 to 2017).

Looking longer term, we believe that these initiatives could drive margin expansion to the mid-teens, on a three- to five-year view.

Looking at PSI’s peer group in Exhibit 8, successful companies with pure software models and a (more or less) consolidated software platform can generate operating margins well north of 20%. Achieving such margins would take time and/or more aggressive restructuring, but is not outside the realms of possibility.

The company had cash of €29.4m at end Q314 with financial liabilities of €5.8m, which was broadly unchanged year-on-year and a €46.7m pension provision.

The business does have a considerable amount of cash tied up in working capital (average 36% of sales over the past two years), mainly in receivables and accrued income, although this appears relatively stable. There should be room to reduce these levels as the company migrates to a software-vendor model, with a typically shorter payment cycle versus the project-based model, where significant capital can be tied up in projects. Expanding margins should also help cash conversion. Consequently, we expect positive free cash generation over our forecast period. Having not paid a dividend in FY13 and FY14, the board has communicated its intention to reinstate a dividend with a payout ratio of around 30% this year. Our forecasts for FY16 and FY17 are also based on a 30% payout ratio.

Despite the recent share price recovery, PSI remains rated at typical recovery multiples, with a low EV/Sales ratio but a relatively high P/E, although the P/E is actually not out of line with the broader peer group. However, PSI’s margins are substantially below the majority of its peers, which reflects the fragmentation of the current product set and project-based business model.

While the very high margins enjoyed by the likes of AVEVA and Dassault are likely to be out of reach, with some rationalisation, broader rollout of the Eclipse 4 software platform and a successful shift to a standard software model, we believe that expansion to the mid-teens level should be achievable with a five-year view. This would open up the potential for sustained double-digit earnings growth, which we do not believe is priced in.

A discounted cash flow analysis suggests that the current valuation is pricing in a low single-digit growth with operating margins expanding – and plateauing – at 10%. In Exhibit 9, we show a DCF sensitivity analysis assuming that the company reaches different operating margins by the year 2020 and differing organic growth rates between now and 2020. The analysis suggests that a share price of €20+ should be justifiable assuming growth rates above 4% and if operating margins can be expanded to 14% and €15+ if margins reach 12%. It is worth noting that the DCF-derived valuation is much less sensitive to variations in growth rate than margins.