SCISYS — Update 3 October 2016

SCISYS is a specialist systems house operating across a broad spectrum of market sectors including media & broadcast, space, government, defence and commercial sectors. The group has blue-chip clients, industry expertise and growing revenue visibility. The challenge is translating this opportunity into profitable growth.

The group’s main revenue models are a mixture of fixed-price contracts, time and materials (consultancy and professional services), along with services and support contracts. There is also some software licensing of SCISYS’s IP, as well as hardware procurement and integration and pass through third-party software licences. In recent years the focus has been on driving efficiencies through the business. In June 2015, SCISYS was hit by a profits warning relating to cost overruns at a fixed-priced project (since resolved) and it was also hit by the strength of sterling against the euro. Annual cash flow is influenced by the timing of payments around the year end. In H116 operating cash flow before taxes was £2.5m, and free cash flow was £1.9m. While we note that cash flow can be volatile around the year end, we forecast operating cash flow of £4.7m in FY16 and £3.7m in FY17, and for net cash to rise to £1.7m at end-FY16 and to £3.5m a year later.

The UK government’s commitment to reduce public sector spending put pressure on some customers (eg c 25% of FY11 group profits were from Environment Agency contracts). Following the Brexit vote and subsequent changes in the UK government, the focus on cost-cutting in the public sector has abated. However, this is balanced by the uncertain economic outlook. There is a risk of cost overruns on fixed-price projects, as we saw in 2015, but SCISYS has put in place rigorous risk monitoring and control procedures and, following the FY15 problem project, it has tightened the criteria for which bids need the board’s sign-off. In all, we view SCISYS as a relatively robust business with a low-risk customer base, and we note the group has no bad debtors.

The stock trades on 12.5x our earnings forecasts in FY16, falling to 11.7x in FY17 and to 11.0x in FY18. Based on our forecasts, a conservative WACC of 11% and a long-term margin target of 8.5%, our DCF model values the shares at 117p, or 23% above the current share price. In our view, this valuation is supported by the group’s strong record of cash generation, margin recovery potential, a healthy balance sheet, an increasingly diverse customer base and the potential for further value-enhancing acquisitions.

SCISYS reported a strong H1, with revenues up 35% to a record £22.2m and adjusted operating profit swinging around by £2.2m to a £1.1m profit, despite being held back by £0.5m due to currency hedging resulting from the slide in the pound sterling against the euro late in the period. The loss from hedging is reflected in central overheads, which rose by 52% to £4.3m. However, we estimate the underlying increase in central overheads was relatively small. This is due to three factors: 1) the decline in the pound against the euro (the average H1 €/£ exchange rate moved from 1.38 to 1.28) lifted central overheads in the group’s German operations by 8%; 2) crystallised FX gains on hedging contracts in the prior H115 period; and 3) crystallised FX losses of £0.2m on hedging contracts in H116 and a further £0.5m mark-to-market revaluation of hedging contracts that will not crystallise until H216 or FY17.

The strong performance partly reflects the impact of a problem project in H115, which required additional headcount to complete and therefore led to deferrals in other business from FY15 into H116. In June 2015, SCISYS revealed that it was hit by cost overruns at a fixed-price development project, which was the group’s first significant problem project since FY07. In order to complete the project, SCISYS had to redeploy headcount, and the project was satisfactorily concluded in late 2015. The reduction in H115 revenue and impact of the deferrals were reflected in the ESD division’s 79% revenue growth. Nevertheless, the group has been winning new business across all its divisions and had a strong closing order book at £35m, which is up from £28m a year earlier, but slightly below £37.2m at start of year. Cash flow was very strong, with the group returning to a net cash position of £1.4m, from £1.0m net debt at end-December. The interim dividend is reinstated at 0.53p (the dividend was passed in H115, although, given that the problem project was resolved, this was more than compensated for in the final dividend that was paid in July).

Space. Revenues rose by 22% to £9.6m, with the contribution rising 58% to £1.9m. The division secured over £3.2m of new contracts in H1, mainly from existing programmes; these include the European satellite-navigation system, Galileo, and the European Space Agency’s (ESA) rover mission to Mars, ExoMars. With the launch of the first of two ExoMars missions, Europe is now on the way to Mars. This historic step was also supported by SCISYS Flight Dynamics experts working in the Flight Control Team of ExoMars at ESOC in Darmstadt.

SCISYS says there are considerable bid opportunities with ESA, Eumetsat and also from German national and bilateral programmes that, if won, would secure revenues for the Space division for several years. Significant progress has been made with SCISYS’s proprietary PLENITER product, which provides reusable functional modules to operate complete satellite missions. In a post period event OneWeb, a new internet telecommunications enterprise that is preparing to build, deploy and operate the world’s biggest satellite constellation to provide global internet access for all, has chosen PLENITER to plan its mission of several hundred satellites. As an ongoing commitment to innovation in space, SCISYS and PLENITER have become partners of the PTScientists and their “Mission to the Moon” in the frame of the Google Lunar-X-Prize competition.

Enterprise Solutions & Defence (ESD). Revenues rose by 79% to £8.6m, with the division recovering strongly to a £2.5m profit from a £0.4m loss. The strong performance came on the back of a very strong opening order book along with significant recurring revenues from well-established customers. SCISYS reports that current projects are all in a healthy state, on plan in terms of cost and time to deliver, and have helped to achieve a very good contribution margin of 29%.

The 105 national power-cut phone line service provided by Vodafone for the Energy Networks Association (ENA) went live in April. SCISYS delivered the call routing component of the service, similar to the 101 and 111 systems previously supplied by SCISYS. Callers dialling the 105 number are put through to their local electricity network operator to report or receive information about power cuts and to report damage to electricity power lines and substations.

In September another significant contract was secured with the UK Ministry of Defence (MOD) to deliver further research and software development services to the Defence Science and Technology Laboratory (Dstl). The project extends SCISYS’s reach into the area of tactical combat systems in surface warships as it will create and demonstrate a new decision support system for use by the Royal Navy.

Media & Broadcast. Revenues rose by 12% to £3.5m, while the contribution edged up 1% to £1.0m. The performance was slightly disappointing, though the margin decline partly reflects the high level of costs in euros, while there are also significant revenues in sterling. Two significant contracts were won in the period: a £2m contract with a major UK radio broadcaster won in February and a €2m contract with South African Broadcasting Corp (SABC) in April. These contracts were won well into H1; the first has some impact on H1 while SABC had very little impact. SCISYS says the outlook is supported by a strengthened order book position.

Xibis. This unit provides web and mobile app solutions largely to the retail sector. This business unit was acquired in December 2014 and is reported separately from ESD, despite being small, since it is managed separately and has a different business model. Revenue slipped by 10% to £0.4m; however, it broke even after posting a £0.1m loss in the prior period. The unit has been affected by the founders’ decision to leave the company. However, management anticipates a significantly stronger H2 due to recent business wins and quality prospects. The division has done some project work in combination with the ESD division, and won business with the UK Hydrographic Office in a joint bid with ESD.

Outlook. Management provided an increasingly positive outlook statement, reporting that all divisions are performing to or are exceeding budget. Revenue momentum is expected to continue over the remainder of the year, given the near-record closing order book and strong short-term pipeline, and the business is traditionally H2 weighted. Management reports that there are strong prospects for future contract wins in all divisions during the second half, some of which have materialised already.

There will also be positive impacts on profitability from the weaker pound if it remains at current levels against the euro, as the hedging contracts, which were entered into at higher levels, expire.

Management says it does not expect any adverse operational consequences as a result of June’s EU referendum outcome. We note that ESD and Xibis are domestic focused, while Media & Broadcast is an international “best of breed” solution. The Space division’s largest customer, ESA, apportions work to its suppliers based on location, matching their country’s contribution to its overall budget. We note that while ESA is an intergovernmental organisation, it is separate from the EU and its contributors include Canada, as well as European countries and the EU directly.

SCISYS continues to look for opportunities to acquire companies where there is a good market, product and cultural fit. Potential areas of interest include cyber security or strengthening the group’s Media & Broadcast offering. SCISYS says it has very stringent criteria for acquisitions.

We have upgraded our revenue forecasts by 9% in FY16 to £41.5m, by 8% in FY17 to £43.0m and by 8% FY18 to £44.4m. We note the revenue outcome depends on the level of low-margin “pass-through” revenues, which in H1 mainly related to sub-contractors in Space and ESD, but at times can also involve hardware and software re-sales on some projects.

Our adjusted operating profit forecasts rise by 12% in FY16 to £2.8m, by 8% in FY17 to £3.1m and by 14% in FY18 to £3.4m. We have also reduced the tax charge (to 15% in FY16 from 21% previously, rising to 20% from FY18 from 22% previously) and hence EPS rises by 22% in FY16 to 7.0p, 15% in FY17 to 8.1p and 19% in FY18 to 8.6p. The group benefits significantly from R&D tax credits in the UK, while paying c 33% tax on its Germany-based operations. We now forecast the group to end FY16 with net cash of £1.7m (previously forecast at £0.3m), rising to £3.5m a year later.

The associates line represents the group’s 33.3% interest in ToMM Apps, based in Duisburg, Germany, which SCISYS acquired in September 2015. SCISYS has a call option to acquire the remaining 66.7% of ToMM Apps’ shares from 1 January 2018.

SCISYS has developed a strong niche as an expert player in highly specialised IT markets. As these markets continue to gain in complexity, SCISYS should, in our view, benefit from an improving negotiating position. Several factors should help the group to continue to expand margins, including the re-use of bespoke software platforms, better project management, and a continuing de-emphasis on third-party software and hardware re-sales. Further, the management has built an excellent track record in driving margins higher. The peer group’s mid-cycle margins have traditionally been in the 8-10%+ range, while its larger IT services competitors typically trade on around 12x year two earnings with operating margins at around 9%.

We highlight the following points on the group’s valuation: