TXT e-solutions — Putting cash to work

TXT e-solutions is an Italy-headquartered software and services company. Having sold TXT Retail, its retail software business, in 2017, TXT now operates solely through its TXT Next business. TXT is a software solutions and services business focused on the aerospace and aviation, and banking and finance segments, with roughly two-thirds of revenues generated in Italy. The group plans to drive growth through a combination of organic growth and targeted acquisitions, using some of the proceeds from the recent disposal of TXT Retail.

Q3 results confirmed strong organic revenue growth and a normalised EBIT margin of 5.8%. We forecast revenue growth of 11.0% in FY18 and 12.8% in FY19, with EBITDA margins expanding from 10.7% in FY18 to 13.0% in FY19. Reflecting higher opex and higher net finance costs year-to-date, we have reduced our EBIT, PBT and EPS forecasts for FY18. For FY19, with TXT Sense spun-off, we forecast a slightly lower cost base, resulting in improved profitability. We forecast net cash will increase to €69.6m by the end of FY18 and €71.3m by end FY19.

On an EV/sales and EV/EBITDA basis, TXT trades at a large discount to its peer group. With €65m of proceeds from the sale of TXT Retail still unspent, TXT is trading on an inflated P/E multiple. Until the remainder of the cash is put to use on value-accretive acquisitions, we would expect the stock to trade at a premium to peers on a P/E basis. Our reverse DCF shows that the current share price is factoring in revenue CAGR of 4.8% for FY20–27 with an average EBITDA margin of 12.3% over that period. In our view, this appears conservative.

TXT e-solutions was formed in 1989 as a software and solutions vendor and listed on the STAR segment of the Borsa Italiana in 2000. Until recently, the company operated through two divisions: TXT Retail (52% of FY16 revenues) and TXT Next (48% of FY16 revenues). In October 2017, the company sold TXT Retail for €85m to APTOS, a US retail software company. The remaining business provides services and software solutions business focused on the aerospace, aviation and automotive (AA&A), and banking and finance segments, primarily in Italy. In FY17, the AA&A business generated 55% of revenues in Italy and 45% from international customers. The banking and finance business generates all revenues in Italy. The business has grown organically and via the acquisition of PACE in 2016 and Cheleo in 2018.

TXT has shown robust organic revenue growth over recent years (CAGR 6.8% FY13-FY17) boosted by the acquisition of PACE in FY16, and EBITDA margins have expanded over this period. Now that it is a standalone business, its strategy is to grow through a mixture of organic growth and acquisitions in the aerospace and aviation and banking and finance markets.

In Exhibit 3 below, we show the group’s divisional growth targets (communicated in March 2018) and what this means for group revenue growth, as well as the group EBITDA margin target.

Having received proceeds of €85m from the sale of TXT Retail and after paying a special dividend of €11.7m in May, TXT was left with net proceeds of €73m to invest in the business. In June, TXT acquired Cheleo, an Italian-based developer of lifecycle management software for financing, for €10m (60/40% cash/equity). We expect the company to make further acquisitions in the aerospace and aviation and banking and finance businesses. In addition, the company has treasury shares worth €10m that could be used for acquisitions. The company is primarily targeting profitable businesses with annual revenues in the range of €5–20m and an international profile. They would ideally be well established in the industry and have a solid customer base and committed management team. Target companies would offer access to at least one of the following: a broader technology offering, increased geographical presence, new customers, or better penetration within existing accounts or domains.

TXT is run by a long-established team: the chairman is the original founder of the company and the group CEO, Marco Guida, joined TXT in 1994. The CFO, Paolo Matarazzo, joined the company in 2007. Several key managers of the business have been with the company for many years in Italy (with TXT) and Germany (with PACE).

TXT provides specialised software solutions and services through two divisions: AA&A, and B&F. In 2016, TXT acquired PACE, a German aerospace software business. Exhibit 4 below shows how two-thirds of group revenues are generated in Italy, with a growing proportion of sales generated elsewhere in Europe and to a lesser extent, the US. In the nine months to September 2018, TXT generated 87% of revenues from services and 13% from software licenses and maintenance (FY17: services 89%, software 11%).

This business, founded 30 years ago, makes up the largest proportion of TXT, generating revenues of €27.8m in FY17 (77% of TXT revenues) and an EBITDA margin of c 11%. The division provides a mix of software and specialised engineering services, providing support to customers’ R&D, engineering and manufacturing operations. In FY17 revenues were generated from OEMs (60%), first-tier suppliers (20%), airlines (10%) and automotive customers (10%). Until relatively recently, the business was mainly staffed out of Italy. Partly through a “follow-my-customer” strategy and partly as a concerted effort to expand internationally (organically and via the PACE acquisition), the division now has more than 370 consultants based in Italy, Germany, France, the UK, the Netherlands, Switzerland and the US. In FY17, the business generated 55% of revenues from Italy, 31% from other EMEA countries and 14% from the US and elsewhere. Exhibit 5 shows key customers and highlights the international nature of the customer base.

TXT already had a significant aerospace-focused business, providing IT, consulting and R&D services to mainly Italy-based business such as Leonardo. The acquisition of PACE added specialist aerospace software as well as a larger international customer base. Customers include more than 50 companies covering aircraft and engine manufacturing, airlines, civil and defence operators, and maintenance, repair and overhaul (MRO), including Airbus, Air France and KLM Engineering, Boeing, COMAC, Delta Airlines, Embraer, GE Aviation, Lufthansa, Rolls-Royce, Safran Group and Sukhoi. Until the acquisition, TXT had predominantly generated revenues from services – PACE adds higher-margin software revenues, which over time should drive higher recurring revenues.

From PACE’s perspective, TXT has a large number of qualified consultants who are able to provide additional engineering software services to PACE’s client base. The business continues to trade under the PACE brand, with the three founders continuing as managing directors, focused on expanding the value and range of services offered around their engineering software products.

TXT paid €7.7m for 79% of PACE (including contingent consideration). It also accrued a potential payment of €1.4m for the put/call option for the remaining 21% stake (owned by the three founders) exercisable from 1 January 2020 to 31 December 2021. Total consideration for the business, net of €2.3m cash acquired, was €6.8m.

Exhibit 6 shows the services and software the company offers across a range of business processes. The original TXT business offers specialist engineering services, and has developed a variety of industry-specific software libraries and toolboxes and reference applications. Examples of reference applications include TXT FAST 4.0 (for digital manufacturing), TXT SIMCARE (for flight simulators), TXT IoT Manufacturing Operation Management (for internet of things) and TXT WEAVR (for augmented reality and virtual reality training solutions). The PACE acquisition added fully packaged software and related services (see Exhibit 7).

The division now has a customer base of more than 70 companies. Although most of the work is project based and therefore not recurring, TXT has a very loyal customer base that provides repeat work. Of revenues generated from services, roughly three-quarters are from turnkey service engagements, while the remainder are contracted on a time and materials basis.

The company’s goal is for the division to become an international, specialised, multi-niche mid-sized (c €100m) provider of engineering solutions to the global aerospace and aviation industry.

The aerospace and aviation markets are characterised by global groups with large investment budgets – many groups have multiple subsidiaries that could each use TXT’s software engineering services. The rapid pace of innovation combined with increasing regulation drives growth in R&D. In its 2022 strategic plan, Altran estimates that the global engineering and R&D services market was worth c €155bn in 2017 and is forecast to grow at a CAGR of 9% to 2022. Within that, it forecasts growth in Europe of 4–6% pa and growth in the Americas of 8–10% pa.

One obvious source of growth for TXT is to increase its share of wallet with the existing customer base, selling to multiple divisions within each customer. The business is also targeting new international customers. In terms of its product range, the company has started offering managed services – this should increase the level of recurring business. It is also looking to extend the capabilities and range of its software assets. In addition to achieving this through internal R&D, the company is looking to acquire niche software providers and is selectively targeting highly specialised mid-sized companies.

The B&F business, which has been in operation for more than 15 years, provides software testing, verification and validation services to banks and insurance companies in Italy. Exhibit 8 shows the services offered across the software quality assurance lifecycle. Functional testing of software accounts for the majority of the division’s services. Testing services are performed both on-site and off-site, using the company’s Test Factory methodology.

The division targets the top 50 Italian banking institutions; customers include Azimut, Banco BPM, Banca Mediolanum, Banco Popolare di Sondrio, Ergo Assicurazioni, Gruppo Bancario Credito Valtellinese, ING Bank, Intesa SanPaolo, Nexi, SIA, Webank.it and Widiba.

The business has 118 consultants, all based in Italy. In FY17, it generated revenues of €8.1m (23% of TXT revenues) and an EBITDA margin of 8%.

Drivers of demand include increasingly strict regulation, emerging fintech software and services, and the rapidly evolving IT landscape. The company estimates that the market for quality assurance and testing services in the Italian banking sector is worth at least €100m per annum.

The company believes it can continue to grow this business organically. Management plans to strengthen the services offered through a combination of deepening domain knowledge, developing standardised ‘testing bricks’ (reusable software IP), and developing its test methodology to master a wide range of market-leading tools from third-party providers (eg IBM, HPE, open source) and a wider range of banking domains and processes. The business is keen to develop more automated services and is exploring the use of robotic process automation.

TXT is also keen to offer new high value fintech software solutions of relevance in the European market. The recent acquisition of Cheleo and T3M mark the first steps into this area.

On 31 July, TXT acquired 51% of Cheleo, an Italian developer of lifecycle management software for financing.1 Cheleo’s portfolio includes software to manage the entire process (initial application, credit management and collection, disposal of loan books) for leasing, mortgages, personal loans, salary-based loans, factoring and non-performing loans. Customers are Italian specialist financial companies. TXT has a put/call option in place to acquire the remaining 49% over the period 1 January to 31 January 2019. Cheleo was majority-owned by Laserline, the business owned by Enrico Magni, TXT’s largest shareholder and a TXT board director. Cheleo reported 2017 revenues of €2.8m and EBITDA of €0.95m (34% margin).

The price of the deal was set at a total consideration of €10m, based on an enterprise value of €7.6m plus c €2.5m of net cash. TXT is paying 60% in cash and 40% in treasury shares. It has issued 354,202 shares at an implied price of €11.293/share to the founders of the business (value €4.0m) and paid €1.1m in cash to Laserline. TXT will pay the remaining €4.9m in cash when it exercises its option to acquire the remaining 49% of the business. We have fully consolidated Cheleo with the amount due for the 49% stake treated as debt.

While Cheleo will continue to operate on a standalone basis within the B&F division, we expect a focus on cross-selling opportunities across the combined Italian client base. The two founders, Bruno Roma and Flavio Minari, will remain on the Cheleo board and will be entitled to a future cash payment based on the 2019 performance of Cheleo.

In November, TXT made a small acquisition to add risk assessment software to its B&F offering. It acquired 51% of T3M Innovation for €0.3m and has a put/call option in place to buy the remaining 49% at a price based on the performance of T3M in FY20. T3M has developed risk assessment solutions based on predictive, probabilistic models using machine learning and IA techniques. Its cloud-based FARADAY platform is used by customers to carry out checks on potential clients to prevent involvement with money laundering, corruption and terrorist financing. T3M is substantially at break-even.

TXT has been a beneficiary of the trend to outsource, which gives the customer greater flexibility on cost and better access to specialist skills. Once a customer has outsourced a specialist area of R&D or IT, it is usually very difficult to bring it back in house, as the in-house knowledge and expertise will have diminished. TXT has worked closely with the majority of its customer base for many years, creating a strong partnership and demonstrating its specialist expertise.

On the services side, the division’s competition is from customers’ in-house R&D and IT departments, as well outsourced engineering services providers and system integrators. The A&A business sees competition from large European engineering services businesses such as Akka Technologies, Altran, Alten and Assystem in France (all listed on Euronext), ESG Group in Germany (private) as well as smaller local providers such as Critical Software (private, based in Portugal), Teoresi (private, based in Italy), and Philotech (private, based in Germany). Both the A&A and B&F businesses compete with the large offshore BPO providers such as HCL, Tech Mahindra and Tata, although TXT’s specialist knowledge and on-shore capabilities are often preferred for mission-critical work that requires not only technical expertise, but also in-depth industry knowledge and proximity to customers. The B&F business also competes with specialist outsourced testing providers such as SQS (recently acquired by Assystem Technologies). On the software side, PACE operates in the market for aircraft design and engineering processes, typically served by the large PLM2 software vendors such as Dassault, PTC and Siemens. PACE offers niche solutions to address specific, critical tasks that complement and integrate with PLM software solutions.

In 2017, the company created a new division called TXT Sense focused on exploiting the opportunity presented by augmented reality (AR) and virtual reality (VR) technology. The aerospace market has made use of AR and VR for years in flight simulation and ground-crew training. TXT was keen to apply the knowledge it has built up in this area to other verticals. On 11 October, the company spun this division off, with the chairman Alvise Braga Illa becoming the majority shareholder. TXT invested €48k to retain a 24% stake in the business and is transferring 10 staff members across. The business is now called Sense immaterial Reality and will pay TXT €70k for the project work achieved to date and €40k per year for support services. The business will explore opportunities to use the technology in other sectors including media and advertising and discrete manufacturing.

Our forecasts and TXT’s share price will be sensitive to the following factors:

TXT reported revenue growth of 18.6% y-o-y for Q318; excluding Cheleo (consolidated from 1 August), revenues grew 12.8% y-o-y. Cheleo contributed revenues of €0.5m during the quarter. With a higher proportion of software revenue versus a year ago (Q318 14%; Q317 11%), the gross margin improved by 320bp y-o-y. We have treated €0.2m of costs relating to the acquisition of Cheleo as exceptional, resulting in a normalised EBITDA margin of 10.0% for Q318, up from 9.2% a year ago. Now that operating leases have been capitalised according to IFRS 16, the normalised EBIT margin has declined to 5.8% from 8.2% a year ago. Net finance cost of €0.1m and a tax rate of 23.7% resulted in reported net income of €0.1m for Q318.

During Q3, the company took advantage of attractively priced debt to take out a five-year, fixed rate loan for €41.7m. This pays interest at 0.5–0.7% pa. The table below shows the break-down of the company’s net cash position. The company has shifted a large proportion of its cash balance into partial return multi-segment insurance funds and bond and absolute return funds with a medium to low risk profile to improve returns.

We have revised our forecasts to reflect Q3 results, the spin-off of the TXT Sense business, share buybacks and the new debt taken on during Q3.

Our peer group includes European IT services and engineering services companies as well as software providers to a similar customer base. On an EV/sales and EV/EBITDA basis, TXT trades at a discount to its peer group. Its EBITDA margins are forecast to be just below the peer group in FY18 but slightly ahead in FY19. With €65m net cash remaining from the proceeds of the sale of TXT Retail, TXT is trading on inflated P/E multiples. Until the remainder of the cash is put to use on value-accretive acquisitions, we would expect the stock to trade at a premium to peers on a P/E basis.

We have estimated the potential impact of using a proportion of the proceeds to acquire businesses with similar financial characteristics to engineering service providers. Using an EV/sales multiple of 1.0x for CY19 (based on peer group average), proceeds of €60m could be used to buy CY19 revenues of €60m. On a 10% EBIT margin (based on peer group average) with a 30% tax rate, this would equate to incremental EPS of €0.35 in FY19. Using a total normalised EPS of €0.63 (current estimate of €0.28 plus €0.35 increment) and a P/E multiple of 13.6x (the peer group average) would result in a share price of €8.57, 4% above the current share price.

We have performed a reverse 10-year DCF to calculate what we believe the market is factoring into the current share price. Using a calculated WACC of 9%, long-term growth of 2%, working capital/sales of 2% and capex/sales of 1.5% (the company does not capitalise development costs), a revenue CAGR of 4.8% for FY20–27 and average EBITDA margins of 12.3% over FY20–27 are required to reach the current share price. Based on market growth and the company’s targets, this appears conservative.