SLI Systems — Quality over quantity

SLI Systems provides a suite of premium e-commerce optimisation products designed to increase online sales for its clients. This is achieved by search engine enhancement tools to maximise click-through rates (CTRs) to its clients’ websites from search engines, in addition to search and merchandising functionality on the clients’ websites to improve the conversion rate of site visitors to customers. SLI continuously adds to and develops its series of complementary products that enhance its core search functionality.

One of SLI’s key differentiators is that is has very low implementation costs for its clients, as it uses its own staff for installation and set-up at minimal additional cost to the client. While this helps to win business, it also results in a net cash outflow for each new client acquisition, with a typical payback period of two years. Despite this trade-off between growth and profitability, cash at 31 December 2016 remains high at NZ$6m, so we do not foresee the need to raise additional operational capital. Operating revenues fell by NZ$1.9m y-o-y, attributable to FX fluctuations and the three largely unavoidable client losses in Q416 (as a result of insolvencies and change of ownership). Net losses for the period grew to NZ$1.3m (H116: NZ$446,000).

We forecast a continuation of historic client retention levels of 87%, with a corresponding CAGR increase in ARR of 7.8% in FY16-19. We expect the company to exit FY17 at a cash flow-neutral run rate, with a return EBITDA profitability (NZ$928,000) in FY18 and EPS profitability the following year (NZ$0.26/share).

The retention rate is the key sensitivity for mid- to long-term profitability. SLI attempts to mitigate the risk of client churn by investing heavily in customer support and having automatic renewal with a 90-day notice period for most of its customers.. However, the industry is very competitive and therefore it is likely that SLI (and its peers) will need to invest continually in R&D just to keep up with the crowd. This makes a close customer relationship even more important since it provides SLI with insight that its more standardised peers will miss. The success and growth of the e-commerce platforms may also have a substantial effect on the company.

Assuming mid-term CAGR revenues of 7.3% and matured EBITDA margins of 20%, our core DCF scenario using a WACC of 12% and a terminal growth rate of 1.5% yields a valuation of NZ$0.77/share. At EV/Sales of 0.5x, SLI is trading at an acute recovery rating and a substantial discount to search/SaaS peers (typically 2x+). While the current price is a reflection of the company’s loss-making status and the reduction in ARR y-o-y, any recovery momentum should drive operationally geared growth in profitability and a re-rating upwards. We believe that early signs of such a recovery are already apparent, as demonstrated by the recent uptick in client retention rates, in addition to the H117 recovery of ARR.

H116 was a transitional period for SLI, with CEO Chris Brennan implementing a number of changes aimed at reinvigorating growth and cementing a scalable business model. Changes are being implemented at a number of different levels. Investment in R&D has been increased to accelerate the rate of product innovation with a particular view to enhancing competitiveness for larger enterprise accounts. The sales structure and incentives have been changed to focus on lifetime value rather than volume and the company has invested in CRM systems to enable better targeting and tracking of these higher-value accounts.

It is early days yet, but we believe there were enough encouraging signs in SLI’s H1 performance (such as recent high-profile US client wins) to suggest that a recovery in momentum may be due.

Management is seeking to improve its sales mix through improving its offering and sales approach to higher-value enterprise customers while moving out of bidding for smaller, less profitable accounts. Success should benefit the business in a number of ways including improving the scalability and margins of the business as larger accounts typically incur proportionately lower set-up costs and supporting the ability to drive sustainable growth as larger established customers tend to be less volatile and offer more scope for cross/up-selling.

There were signs of this strategy coming through in H1. While the company lost 69 customers and won 39 over the period, ARR remained flat, with the new customer average contract value (ACV) of NZ$40,000 (Exhibit 1) substantially higher than the ACV of NZ$31,000 for lost clients.

This growth in new client ACV was helped by winning two important US enterprise accounts over the period: Crate & Barrel, a housewares retailer with NZ$800m online sales and 8.8m monthly visits (Internet Retailer rated number 71) and Rocky Mountain ATV, the online auto parts retailer ranked in the top 50,000 global Alexa ranking. The Crate & Barrel client win is particularly encouraging in terms of demonstrating the company’s ability to compete in the enterprise space, given that it was won following a beauty parade against competitors including Endeca (owned by Oracle), which was the incumbent supplier. Both of these accounts will rank within SLI’s top 15% of contracts by ACV.

Customer retention over the H1 period was 87% on an annualised basis, compared to 84% for the 12-month period (Exhibit 3), which was affected by the largely unavoidable loss of three large customers late in FY16 (due to insolvencies or change of control). It is difficult to gauge how much this figure can be improved in the future. Whereas historically the company enjoyed higher retention rates (90%+ in 2013 and 2014), this churn was coming out of a substantially lower historic customer base. As churn typically happens when customers migrate to a new e-commerce or web platform, the customers decision to reassess their search provider is not necessarily a result of dissatisfaction, although a competitive offering is clearly key to retaining the business when these decisions are made.

The company has continued to invest in product innovation with R&D headcount increased by 25% over the period, despite costs reducing by c NZ$1m from H216 to H117 (reduction in sales expenditure and currency were the offsetting factors).

Key enhancements in H1 were the launch of SLI ESP (Enhanced Search Personalization), which improves real-time individualisation of the results returned on search and navigation pages using the SLI product, and a new tracking technology for JavaScript, which enables the provision of more comprehensive data for personalising the shopping experience.

Management aims to further the capabilities in H2 with the roll-out of support for HTTP/2 (faster page loads through improved data compression) and the addition of the SSL certification (cryptographic web server protection), which will deliver speed and performance improvements for retailers and improve security levels, respectively. These measures should improve SLI’s competitiveness, particularly when pitching for larger clients, as both these aspects are increasingly being seen as necessary requirements for mid- to large-cap companies.

Whereas SLI has to date followed a purely organic path, the announcement of a new corporate development function signals that the company is now looking at more expansive opportunities for growth. A range of opportunities will be considered here, including licensing or resale agreements (to strengthen the proposition and create cross-selling opportunities), partnerships or M&A. Should any substantial acquisitions take place, it is likely that management would need to raise additional capital. We see this scenario as unlikely, so do not build it into our forecasts.

Founded in 2001, SLI Systems provides a suite of premium e-commerce optimisation products designed to increase online sales for its clients. This is achieved by search engine enhancement tools to maximise CTRs to its clients’ websites from search engines, in addition to search and merchandising functionality on the clients’ websites to improve the conversion rate of site visitors to customers. Small increases to CTRs and conversion rates can have a significant accretive earnings impact for clients. SLI prioritises client services, which in our view is equally important to the technology solution due to the fragmentation of the market and the corresponding difficulty for companies operating in this space to be gauged against their peers.

SLI continuously adds to and develops its series of complementary products, which enhance its core search functionality. A complete list of SLI’s products and descriptions is shown in Exhibit 4.

SLI Systems typically charges customers monthly or quarterly in advance, with fees depending on their usage and the number of products they use. SLI differentiates itself by absorbing on-boarding costs for new clients by using its own staff to implement its systems on clients’ websites. This results in a net cash outflow for each new client acquisition, with a typical payback period of two years. However, the revenues are high margin, and are highly recurring due to both the efficacy of the technology offering and the company’s emphasis on customer service. A high retention rate is therefore critical to long-term profitability. The company generally pays its expenses in arrears (mostly salaries), thereby giving it a working capital-neutral model, with light capex requirements.

The addressable market for SLI’s solutions is unquestionably very large and growing fast. eMarketer estimates worldwide retail e-commerce sales will rise to US$3.6tn by 2019 from US$1.7tn in 2015 (16% CAGR), while it further projects that retail e-commerce will still only represent a mere 12.8% of all retail purchases. These statistics indicate the growth opportunity available to SLI as its technology will continue to aid its customers to maximise their online revenues.

Competition for site search comes from three main sources. Alternative providers of dedicated site search solutions include Cetona, Nextopia, Adobe with Target and a number of others. In addition, there are suppliers of e-commerce platforms that include search functionality. This category includes companies such as Magento, WooCommerce, Shopify and PrestaShop. Finally, in-house platforms – often built on open-source building blocks – are still used by (typically larger) e-commerce sites (Exhibit 5).

We believe that a crucial factor in the company’s success will be to sell into customers who currently that third-party e-commerce platforms. At present, many retailers use third-party platforms, which include all the web-based functionality retailers need to operate an online store, including product search. In our opinion, online search and merchandising will become more of a speciality because of its importance to revenue and we therefore believe SLI’s main competition in the long term will be direct independent search providers.

SLI Systems achieved a return to growth in its annual recurring revenue of 0.3% for the six months ending 31 December 2016 compared to the previous six-month period on a constant currency basis, as seen in Exhibit 6. Operating revenues fell by NZ$1.9m y-o-y, although approximately half of this fall was related to currency fluctuations, particularly in the recent weakness of sterling. Net losses for the period grew to NZ$1.3m (H116: NZ$446,000). Gross margins fell slightly to 74.4% for the six-month period, although this remains in line with the long term average.

Exhibit 7 shows net cash outflows of NZ$753,000 for the period, primarily driven by the reduction in operating revenues attributable to currency fluctuations, in addition to continued investment for growth. Net cash at the end of the period remains strong at NZ$6m, and management remains committed to continued operations without a further capital raise, as significant cost reductions could be made, if required, by the reduction of investment for growth. SLI’s model allows for a relatively smooth cash flow as inflows are generally billed in advance while outflows are paid in arrears.

Exhibits 8 and 9 show how North America remains the critical market for SLI. On both constant currency and reported currency bases, the North American market represents just under 60% of total annual recurring revenues. The degree of sales success and client retention rates in this market will hence go a long way to deciding the long term growth profile of SLI. The recent high profile client acquisitions of Crate & Barrel and Rocky Mountain ATV provide assurance that management is prioritising this highly important market. UK growth was strong, with ARR on a constant currency basis up 10% y-o-y, much of which was offset by currency. The effects of the loss of three major clients in South America in Q416 can also be seen, with a reduction in ARR of 45% on a constant currency basis y-o-y.

We reinitiate our forecasts, having suspended them in August. Data points are still limited, but on the basis of an improving contract base and new product enhancements being brought to market there are grounds to support a return to growth in ARR in H2 and continuing into FY18 and FY19. Our estimates assume that the client retention rate remains steady at the 87% H217 level, while the level of new business won steadily recovers (Exhibit 10). While we expect some increased investment to support growth, we forecast that operational gearing returns the business to EBITDA profitability in FY18 and EPS profitability in FY19.

The company has a broadly neutral working capital model and we do not expect the business to pay tax in our forecast period, so the P&L profile should be broadly mirrored in the company’s cash performance. On the basis of our forecasts, cash should trough at c NZ$5m at end FY18.

At EV/Sales of 0.5x, SLI is trading at an acute recovery rating and a substantial discount to search/SaaS peers (typically 2x+). Revenues are highly recurring and we do not believe that this aspect is currently priced in by the market. This is understandable given the company’s recent flat ARR and loss-making status. However, any recovery momentum should drive operationally geared growth in profitability and a re-rating upwards. We believe that early signs of such a recovery are already apparent, as demonstrated by the recent uptick in client retention rates, in addition to the H117 recovery of ARR.

Our core DCF analysis uses a WACC of 12% and a terminal growth rate of 1.5%, resulting in a DCF valuation of NZ$0.77. It further assumes a CAGR of revenues of 7.3% from 2017-23, and a matured EBITDA margin of 20% (Exhibit 12).

Our DCF scenario analysis (Exhibit 13) suggests that achieving and sustaining 5% growth in the mid-term should generate upside, while a DCF valuation equal to a doubling of the current share price is very achievable (7.5% mid-term growth and 20% EBITDA margins). This compares favourably with historical CAGR of revenues of 17.7% in 2012-16.