SCISYS — Update 11 April 2016

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Space: revenues slipped 11% to £16.4m, while the contribution fell 18% to £3.3m (though it was steady at £4.0m on a constant currency basis), and the margin dipped 140bp to 20.0%. The division is most exposed to the movement of euro against sterling since almost all its revenues are euro denominated while the UK Space unit has costs in sterling. The division’s performance is underpinned by long-term programmes with customers including the European Space Agency (ESA) and the European satellite navigation system Galileo. Specific roles include at Galileo, where SCISYS’ Space division takes responsibility for a large proportion of the ground segment software, and at ESA where SCISYS experts are in charge of developing the rover visual localisation flight software for its rover mission to Mars. As in the past decades, operations support activities for ESA's Space Operations Centre in Darmstadt, Germany, have added a robust revenue stream. Working closely with its long-term partner Thales Alenia Space France, SCISYS recently secured another multi-year project worth more than €5m under a programme of the European Union to maintain and enhance the GMS, which is the heart of the Galileo satellite navigation system. SCISYS says that it is pursuing a variety of initiatives to complement its traditional revenue streams. The proprietary PLENITER product suite will serve the commercial space market better, and SCISYS's expertise in earth observation and robotics and autonomy will be taken to adjacent sectors. The unit benefits from healthy growth drivers underpinned by government funding, and has operations in Germany and the UK. The ESA’s budget rose from €3bn in 2008 to €5.3bn in 2016 for a CAGR of 7.3%, in spite of a challenging economic backdrop and tight public sector environments. Its 2016 budget has increased by an impressive 18% (see Exhibit 4) and the combined German and UK contribution rises by 7% to €1.2bn. This is good news for SCISYS, since ESA apportions work to its suppliers based on location, matching their country’s contribution to its overall budget.

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Enterprise Solutions & Defence (ESD): in FY13, the group’s three UK-based, non-space divisions (Environment, Government & Defence and Application Support) merged to form this enlarged division. In FY15, revenues fell 10% to £12.2m, while the contribution tumbled 46% to £1.7m, providing a contribution margin of 14.3%. The significant issues around the single failed project overshadowed the strong underlying performance of the division. Resources were committed to working on the problem project and could not therefore be utilised on other profit-making opportunities. During H2 many of the long-term sales efforts of ESD – particularly in the defence, security and maritime sectors – came to fruition. A major contract was won under the Imagery Exploitation Programme (IEP), providing improved situational awareness and analysis for enhanced intelligence-gathering capabilities across the nation's armed forces. The team won a multi-year research programme with the Defence Science and Technology Laboratory (DSTL) to investigate an optimised future operations room in support of the Maritime Air Defence Command. Another multi-million pound project was secured with the UK Ministry of Defence (MoD) to deliver software and services to support defence supply chain operations and movements for the design and delivery of the Customs Compliance Management Information System (CCMIS) application and the provision of ongoing hosting and support services. A large framework contract has been agreed in the security sector that started to bear fruit late in 2015.

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Media and broadcast: revenues dipped 21% (although just 9% in constant currencies) to £6.4m while the contribution fell by 19% to £2.0m, resulting in an 80bp higher margin. At constant currencies, the revenue decline was £0.9m in H1, but just £0.7m for the full year, suggesting that the division has turned the corner. To establish growth potential, sales activities progressed with the existing client base and potential customers in Germany, the UK and internationally. The award of the second exclusive, large-scale framework by the BBC was a major step in securing future revenues from its UK-based activities. The scope of SCISYS's dira! product was extended further, particularly around mobile computing capabilities and multimedia-based functionality. The Radio Digital Archive (RDA) project won under the BBC framework agreement partly relies on these new technologies and provides online search and retrieval functionality for archived content to journalists so that it can be reused quickly and easily in future programmes.

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Xibis: revenues were £0.9m in its first full period, although this was below our forecast of £1.2m. The founder directors left the business shortly after acquisition, ahead of their scheduled departure dates, and a £0.8m deferred payment was paid based on the audited 2014 results (the subsequent earnout for 2015/16 was surrendered). New management was appointed from the team and in H2 the new team stabilised the business and returned the financial performance to planned levels, securing landmark contracts with new customers, and worked successfully with the group’s ESD division to win joint projects.

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Cash flow: operating cash flow before taxes dipped by £3.2m to a £1.6m. We note that cash flow is subject to timing of cash receipts in the December/January period. After interest (£0.2m), tax (£0.6m) and capex (£0.6m), the free cash outflow was £0.2m. After acquisitions mainly relating to the final purchase price for Xibis (£0.9m) and dividend payments (£0.3m), the group swung from £0.3m net cash to a net debt position of £1.0m.

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Outlook: the group's year-end order book rose 23% to £37.2m from £30.3m a year earlier, and there is a healthy pipeline of new business. SCISYS says that the positive outlook is supported by “encouraging major wins during the second half of 2015 and we expect significant opportunities to materialise during the first half 2016 across all our divisions; some of which have already materialised”.

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Pricing and project management: management has increasingly been focused on ‘value pricing’ (charging for core software, pricing based on customer ROI, etc) and far greater project management skills within the organisation.

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‘Reusability’ of platform software: while core third-party software platforms are consistent across many projects (ie use of Oracle, Microsoft etc), nearly all customer solutions are bespoke to their requirements. However, in many cases in specialised industry verticals (eg media, military, trading exchanges), SCISYS has developed key software IP. Management has focused project teams not only on efficient ‘reuse’ of this IP, but also increasingly on charging customers for the value of using it (ie 100% gross margin licences).

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Workforce profile and rationalisation: in a consulting business like SCISYS, human resources will always be the major cost, typically expensive and difficult to manage in a flexible way (ie management teams in the sector often do not like to cut consultants in a quiet period as they can be very difficult to hire back when business picks up). However, there are a number of opportunities for SCISYS to restructure its workforce in the medium term, not only in terms of cultural focus on profitability, but also through the more efficient use of experienced consultants (eg high-level consulting and mentoring), while developing the junior cohort under them.

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Improved group structure and succession planning: in FY07 the group suffered from a lack of communication between project managers and management, and employees were often promoted without having the appropriate skills. Layers of management have been removed and the group has been investing in an improved career development strategy, as well as providing more appropriate succession planning. The senior management structure has been reorganised to operate through an executive board.

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Smarter bidding: because of the nature of the target markets, bids are lengthy and therefore costly. We conservatively estimate that ‘lost’ bids probably affect the P&L by c £0.2m a year. This is partly unavoidable. However, management is now far more selective about the bids for which it tenders (ie typically high-value, high chance of winning).

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Competition: in some areas of the business, such as media, the competitors are small and specialist (eg Dalet, GlobeCast, Jutel, David). However, many large enterprise and public sector projects require a wide range of hardware and software integration. Therefore, in many cases the major consultants are on the shortlist (Deloitte, Capgemini etc), as are the major electronics suppliers (IBM, Fujitsu etc). While these players have massive balance sheet strength and pricing power compared with SCISYS, they often lack the very specialist know-how and IP in specific industry verticals. Therefore, as customers recognise the need to outsource to an ‘IT expert’, we believe SCISYS can continue to take market share.

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Consultancy: this includes fairly traditional business case development, programme and project management, business process analysis, IT architecture review and strategy, procurement management, solution architecture, business change etc. The consultancy process focuses on maximising business benefits matched with value for money. This therefore means that when scoping a project specification, SCISYS will often recommend ‘off-the-shelf’ and ‘open source’ software alongside its own bespoke designs.

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Implementation: the challenge then is to seamlessly integrate the software into a platform solution for the customer. Many of the group’s complex projects take many months in the design stage and often even longer to implement on customer sites (as customers often ‘roll-out’ a new software platform in stages across multiple sites). Clearly, there is a significant overlap in personnel and in-house expertise on the consultancy and implementation teams. When pricing the implementation of projects, the group is moving towards a more total value-based approach. In some cases this involves charging customers (by the ‘user’) for software licences.

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Support: SCISYS has grown its ongoing support function quickly over the last few years. As well as SCISYS projects, the team increasingly supports third-party software sitting on customers’ premises (in many cases these are older software solutions where there is little support from the developer, but SCISYS has the in-house experience to help). There are a number of pricing models for the support function but, in line with typical IT services companies, we estimate this activity has the highest underlying gross margin.

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Revenues: we assume group revenues rise 5.3% to £38.0m in FY16, then rise by 4.9% to £39.9 in FY17. We assume ESD stabilises in FY15, as the recent problematic projects have now been resolved, and its higher-risk exposures to the UK public sector are now greatly reduced (eg the Environment Agency). We have assumed £1.2m of revenues from Xibis in FY16, representing 3% of total revenues. We note that revenues can be influenced significantly by low-margin hardware sales (as well as subcontracting in the Space division), which can be difficult to predict. However, management is de-emphasising these low-margin revenues.

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Operating costs/margins: roughly 60% of costs are staff costs, including c £4m of annual research and development, which is largely customer-financed, although there is some direct R&D in Media & Broadcast relating to dira!, as well as a small amount in the mobile apps business. We assume operating costs rise by 0.6% to £35.5m in FY16 and by 4.2% to £37.0m in FY17. Consequently, our operating margin forecasts are at 6.6% and 7.2% in FY16 and FY17.

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Investment: we forecast a capex/sales ratio of 2.0%, to support management’s plans to grow the business. We assume annual working capital outflows of 0.5% of sales.

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Tax: we have maintained our assumptions to 21% in FY16 and 22% thereafter. We understand SCISYS claims R&D tax credits of c £0.4-0.5m a year, which offsets UK taxable profits, while it pays c 30% on German profits. Further, it has c £4-5m of brought-forward UK tax losses.

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Traditional valuation measures: in traditional P/E valuation terms, the stock trades on 10.6x our forecasts in FY16, falling to 9.4x in FY17 and to 9.1x in FY18.

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Peer comparison: comparison with fellow IT services businesses is difficult, given the different business mixes, partly relating to low-margin reselling of hardware. However, the stock trades at a significant discount to the average of its UK peers in Exhibit 9 (noting considerable dispersion), as well as its North American and Europe-based large caps.

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Cash generation: the group generated free cash flow of £13.1m over the last 10 years. Based on our forecasts, the FCF yields for FY16-18 are c 9%, c 11% and c 11% respectively. We note the strong balance sheet (£4.4m cash and £5.3m debts, unutilised working capital facilities of £3.6m, while the Chippenham freehold and other smaller properties provide extra flexibility).

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Discounted cash flow valuation: based on our conservative forecasts (which include 3.0% compound annual revenue growth over the next 10 years, a 8% long-term margin target and 2% terminal growth rate) and a weighted average cost of capital (WACC) of 11%, our DCF model values the shares at 91p, or 38% above the current share price. Discounting back from our forecasts, the market is attributing a break-even WACC of 13.9% to the stock. The 11% WACC assumption is conservative in the current ultra-low interest rate environment, and we note a 1% cut to 10% would lift the valuation to 121p.