SCISYS — Space division is flying in spite of Brexit

SCISYS is a specialist IT services provider that builds and operates bespoke and product-based mission-critical IT systems for customers across a range of sectors including media & broadcast, space, government, and defence & commercial sectors. The group has blue-chip clients, and industry expertise with strong and growing revenue visibility. Supported by this backdrop, management's strategic objective is to grow revenues, operating profit and operating margin to deliver sustainable long-term value to shareholders. The media & broadcast operations were boosted by the acquisition of ANNOVA at end-FY16 while the Space division is performing strongest with 20% H1 revenue growth and a significant new business win.

The highlights in FY17 were the strong organic growth from the Space division (20% in H117 supported by the coveted contract with OHB in H2) and the attainment of the BBC milestone by ANNOVA. We estimated that FY17 operating cash flow before taxes was £7.8m and free cash flow was £5.8m. We forecast operating cash flow to dip to £5.7m in FY17 and rise to £6.3m in FY18, and for net debt to remain broadly unchanged at end-FY18 after an earnout payment for ANNOVA.

The UK government’s commitment to reduce public sector spending put pressure on some of the group’s public sector 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. Following the Brexit vote, there is uncertainty around the group’s ongoing work on the EU’s Galileo satellite navigation system, but we note that SCISYS has the ability to bid for work through either its UK or German offices. There is a risk of cost overruns on fixed-price projects. In all, we view SCISYS as a relatively robust business with a low-risk customer base, and we note that the group has no bad debtors and 55% of revenues are outside the UK.

The stock trades on 11.6x our earnings forecasts in FY17, falling to 11.0x in FY18 and to 9.9x in FY19. In our view, this is attractive given the positive momentum, with the significant new contracts in Space and the ANNOVA acquisition integration progressing well. Based on our forecasts and a conservative weighted average cost of capital (WACC) of 10%, and a long-term margin target of 10.7%, our DCF model values the shares at 160p, or 23% above the current share price. In our view, this valuation is supported by the group’s strong record of cash generation, margin growth potential, a healthy balance sheet, the increasingly diverse customer base and the potential for further value-enhancing acquisitions.

SCISYS group is a leading UK-German developer of information and communications technology services, e-business, web and mobile applications, editorial newsroom and advanced technology solutions. The company operates in a broad spectrum of market sectors, including media & broadcast, space, government, defence & commerce sectors. In the UK the group operates through SCISYS UK (with offices in Bristol, Chippenham, Reading and Leicester and c 250 employees). In Germany (with offices in Bochum, Dortmund, Darmstadt and Munich and c 270 employees) it operates through its wholly owned subsidiary SCISYS Deutschland GmbH.

SCISYS has a long history, having formed in 1980 and floated on AIM in 1997. The company acquired CODA, an accounting software business, in 2000. CODA was spun off in 2006 and subsequently acquired by Unit 4 Agresso in 2008. At the time of the CODA demerger in 2000, SCISYS sold its Chippenham head office for £9m, but it repurchased the property in 2011 for £5m. The group’s German business was acquired in 2007 with the acquisition of VCS for €16.7m. After a five-year break from acquisitions, it acquired MakaluMedia in 2012 for c €2m, which doubled the size of the group’s Darmstadt-based space consultancy business. Xibis was a small acquisition made in late 2014 that extended the group’s offerings into web and mobile apps. The Xibis deal enabled SCISYS to add breadth to its offerings when its bids for new business. At the end of 2016, SCISYS acquired ANNOVA (for an initial €11.35m along with an earnout spread over three years), beefing up the group’s media & broadcast operations and extending its capabilities into television.

SCISYS’s clients are predominantly blue-chip and public sector organisations and include the Ministry of Defence, Environment Agency, Airbus Defence & Space, Arqiva, Vodafone, the European Space Agency, EUMETSAT, the BBC, RNLI, Interflora and the National Trust.

SCISYS’s business model has predominantly been fixed-price and managed budget projects with a reasonable proportion of time and materials work. The group is increasingly able to price on a ‘value proposition’ basis (charging for its IP and software), as well as improving the focus on contract project management. Every project is different and the group therefore has the expertise (and the cost and project management required) to customise its approach for each customer assignment. SCISYS’s offering can be broadly split into three stages:

Management's focus remains on generating revenue growth and margin improvement. The objective to generate £60m in annual revenues and double-digit operating margins in the medium term was suspended following the untypical problem project of FY15 that put an increased emphasis on the management and control of risk. However, this objective was reintroduced in the 2016 annual report. Management plans to continue a progressive dividend policy. We note that the company will transition to the new revenue recognition accounting standard IFRS 15 in 2018. While there is not expected to be any discernible shift in bottom line figures as a results of IFRS 15, revenues could drop by c £2m from FY18 as a result of some pass-through activity being classified as “agent revenue” where the new standard only allows recognition of SCISYS’s margin on the deal being reflected in revenue. This will have the impact of increasing the margin as profits do not change while revenues drop.

We note that SCISYS has established strong operational and cost disciplines, which is reflected in the margin progression over the period of FY07-14, along with strong cash generation. The problem project of FY15 was likely a one-off. Management’s aim is to grow revenues both organically and through selective acquisitions. A major focus in FY17 has been to integrate ANNOVA, acquired at end-FY16, which has already passed a key milestone. Overall, management seeks to expand the business into adjacent sectors and new regions, with a focus on Northern Europe. The acquisition strategy is led by Dr Klaus Meng, who has a 9.7% shareholding in SCISYS, and Steve Brignall, technical director. Cyber security is an area of potential interest as it could have synergies with the defence segment (within ESD). Opportunities to grow organically exist in potentially transferring its public sector domain knowledge and IP (eg environmental regulations to private sector utilities, media to commercial radio and space and electronic architecture to the commercial sector).

SCISYS reports its business in five divisions – Space, Enterprise Solutions and Defence, Xibis, Media & Broadcast and ANNOVA Systems. Along with Space and Media & Broadcast, the group has a strong presence in the following sectors through its ESD division: defence, security & maritime; government and emergency services; and commercial. The group’s customers are large, competitors can be sizeable and the software requirements are often complex and expensive. Therefore, winning business is a challenge (on average, sales cycles are six to 18 months), but equally, once the customers have signed up, there are often significant opportunities to win additional projects. Typically, the offering is bespoke, tailored to the specific requirements of a customer. We estimate that across the group over 80% of revenues come from existing customers which, together with the long-term contract profile of many of the deals, highlights the ‘visibility’ in the business.

SCISYS Space, the largest division, is currently experiencing the strongest growth among the group’s divisions, benefiting from work on Galileo, several programmes for the European Space Agency (ESA) and delivering the initial sale of the PLENITER software suite. It is the group’s oldest division, having operated for nearly 30 years, and has grown into a significant player in the space industry. The unit has become a long-term supplier to large space industry prime contractors, as well as operating as a prime contractor itself. It works in partnership with large system integrators, satellite operators and European space institutions such as the ESA, EUMETSAT, the UK Space Agency (UKSA) and the German Space Agency (DLR). SCISYS Space bids for framework contracts with these customers for regular work and consequently fosters long-term relationships with them. The division’s performance is underpinned by long-term programmes with customers including the ESA, where SCISYS experts are in charge of developing the rover visual localisation flight software for its rover mission to Mars, and the European satellite navigation system, Galileo, where SCISYS Space takes responsibility for a large proportion of the ground segment software. SCISYS Space employs c 170 staff – c 70 in the UK (Bristol) and c 100 in Germany (Bochum and Darmstadt). Projects are delivered out of Bristol and Bochum, while spacecraft operations support activities, including for ESA's Space Operations Centre, are handled from Darmstadt.

SCISYS Space’s solutions include high-integrity, onboard flight software, data systems, and ground control solutions and engineering services. Coverage includes human space flight, navigation, telecommunications, earth observation and exploration missions, including robotics as well as related ground system infrastructures. The unit offers consulting work for space institutions and off-the-shelf software, as well as bespoke software solutions to commercial space operations. Software platforms include PLENITER (planning, implementation and operation of complete satellite missions), 2met! (multi-mission concept for real-time data acquisition, processing, visualisation and distribution of earth observation satellite data) and egmc² (provides a complete system for supporting platform operator and space ground interoperability in robotics). The plan is to expand away from the public space, eg PLENITER serves the commercial space market, while the group’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. The ESA’s budget rose from €3bn in 2008 to €5.6bn in 2016 for a CAGR of 6.4%, in spite of a challenging economic backdrop and tight public sector environments. We note that ESA apportions work to its suppliers based on location, matching their country’s contribution to its overall budget, and SCISYS has operations in Germany and the UK. ESA’s combined German and UK contribution rose to €1.26bn in 2017, representing 22% of its total budget. The UK Space Agency has said it will contribute €1.4bn over the next five years to ESA programmes, or c €280m per annum, which indicates a small decline from 2017 levels. However, the division could benefit from the UK Space Agency’s objective to help UK industry capture 10% of the global space market, or £40bn, by 2030.

The division is highly exposed to the movement of the euro against sterling since almost all its revenues are euro denominated, while the UK Space unit has costs in sterling.

In late 2017, SCISYS was awarded a coveted €18m contract by OHB System covering the ground segment of the German national satellite communications mission, Heinrich Hertz. As prime contractor, SCISYS will design and implement the complete ground segment of the Heinrich Hertz mission including the preparation of the mission operations concept. This is the first time that SCISYS has won a role as prime contractor for the entire ground infrastructure of a mission. Heinrich Hertz is an experimental satellite mission aimed at conducting scientific and technical studies and tests of new communication technologies in space. In addition, the satellite will carry an independent telecommunication payload (MilSatcom) that will be used by the German Federal Ministry of Defence. It is scheduled for launch in 2021.

The contract utilises SCISYS’s proprietary PLENITER software suite and this will be the second major installation of PLENITER, following the win with OneWeb satellite constellation in 2016. Both these deals reflect the drive from SCISYS to extend the group’s activities beyond the public sector.

The contract is valued at €18m, of which around half will be pass-through revenue, which is mainly ground station infrastructure along with subcontractors. The PLENITER software platform is bundled in the contract and there will be ongoing software support revenue. As prime contractor for the Heinrich Hertz ground segment, SCISYS is responsible for the complete satellite ground segment, ranging from the technology to the implementation of the operations concept. Nevertheless, other companies including OHB will be involved in this segment. OHB required SCISYS’s skills for the ground segment, because it is primarily focused on the space segment. The companies have worked together over 10 years. Recent major contributions working on the Control Centres of the Columbus module onboard the International Space Station and the European satellite navigation system, Galileo, helped SCISYS win the business. The contract will be managed by SCISYS out of its Bochum offices in Germany. OHB awarded the contract originated by the German Aerospace Center (DLR) for the implementation of Phase C/D plus launch of the mission. As the overall industrial prime contractor, OHB takes responsibility for the realisation of the entire mission, including satellite, launch and ground infrastructure.

PLENITER, launched in 2016, is a modular software suite for the planning, implementation and operation of complete satellite missions. It collates many years of experience at SCISYS, incorporating a number of tools that were created from customer-funded development, along with a small amount of internal development. Consequently, its initial investment is complete, while there will be some additional improvement and ongoing maintenance going forward. SCISYS says that PLENITER matches the latest technology in the sector.

The use of automated functions significantly reduces the number of manual operating steps and hence enables space and satellite operators to reduce their total cost of ownership.

PLENITER competes with GMV, a private Spanish company, and the US company, Kratos (NASDAQ:KTOS).

Most of SCISYS Space’s business has traditionally been as subsystem supplier. Hence, this deal, as prime contractor for the ground segment, is a major breakthrough, reflecting the group’s decades of experience and strong reputation in the space sector. SCISYS is confident it can move downstream in future, ie expanding from satellite control into flight dynamics and mission planning. Indeed, SCISYS believes it has a chance to move downstream on Heinrich Hertz and get more involved in the mission, with the next phase starting after the 2021 launch. The contract is an additional product reference for SCISYS, and a major reference for further commercial work. SCISYS believes it is well positioned to benefit from the ongoing need for innovation in satellite operations and sees significant opportunities ranging from aviation manufacturers to telecoms companies. SCISYS says customers often get fed up with fixed suppliers and believes there is an increasing need for an open system. It believes automation will become increasingly important.

Late last year SCISYS was awarded a contract by Sky and Space Global (UK) (ASX:SAS) to deliver the network management simulator for SAS’s Pearls constellation of nanosatellites. SCISYS Space will utilise its state-of-the-art software solutions and specialist know-how to deliver the Pearls Constellation Simulator within a 12-month period. The simulator will provide a representation of the constellation, its communication infrastructure, customer activity and mission operations. The simulator will also integrate the network management and fuel consumption optimisation algorithms, hence providing SAS with an essential operational analysis tool.

The Sky and Space Global Pearls constellation mission will operate c 200 narrowband communication nanosatellites in carefully selected orbits by 2020, giving equatorial coverage of the earth. This constellation of nanosatellites will create an affordable global communication network for voice, data and instant messaging for over three billion people currently without any mobile coverage.

In FY13, the group’s three UK-based, non-space divisions (Environment, Government & Defence and Application Support) merged to form this enlarged division. ESD supplies mission-critical software systems across its three business groups (Defence, Security & Maritime; Government and Emergency Services; and Commercial). It enjoys a strong reputation and is known in a number of microsegments of larger markets. While the division has the capability to integrate existing commercial, off-the-shelf (COTS) solutions, its niche specialisms are in creating high-value, bespoke software solutions using the ability to draw on reusable intellectual property. The defence sector is key to ESD, where it is regarded as a specialist in a number of subsectors. In particular, ESD has a strong presence as a software solution provider to military vehicles (the MOD’s Warrior upgrade programme) and naval command rooms (RNLI). Additionally, the division is a respected supplier to blue-chip commercial customers, where it has continued to foster longstanding relationships. It is also a recognised supplier to local government customers.

Going forward, we anticipate further expansion in defence, with growth coming from transitioning the group’s reusable IP into adjacent areas.

SCISYS’s Media & Broadcast division has been established in the sector for over 20 years, primarily serving the institutional public broadcast market across Europe. It is a leading provider of premium radio broadcasting solutions known globally as the dira! software solutions suite. dira! is a suite of television, radio, newsroom and new media production and playout applications, supporting core workflow at broadcasting companies. SCISYS has supplied the BBC since 2001 and today provides radio audio editing and production systems for all of the broadcaster’s radio channels, paving the way for leading-edge integrated radio audio production systems. The unit’s competitors are small players including Euronext Paris-listed Dalet (EPA:DLT) and private companies, GlobeCast, Jutel and David.

Going forward, the focus will be on exploiting the relationship with ANNOVA in new business pitches and expanding more deeply into the private sector.

In late 2016, SCISYS acquired ANNOVA Systems for up to €27.8m, doubling the revenues of SCISYS’s media and broadcast operations and taking it up to a similar level to the group’s other two major divisions. Given that there is a three-year earnout, the unit continues to act on a standalone basis. However, it operates closely with M&B.

ANNOVA is a leading supplier of software-based editorial solutions for the media sector. With c 70 employees, it is based in Munich, Germany and has smaller offices in Paris, to service its significant French customer base, and London, to service the landmark 12-year contract with the BBC it won in 2015. Its OpenMedia product is used by broadcast journalists to manage all their workflows – planning, creating content and filing their stories. OpenMedia is a mature product that is in use by more than 50,000 journalists, including those with major European broadcasters such as RTL, Deutsche Welle, WDR and Radio France. OpenMedia does not compete with M&B’s dira! In fact, the two products complement each other in the radio space and interface in a number of installations, including at German state radio broadcasters NDR, WDR and Deutsche Welle, and OpenMedia and Dira are already interfacing on live systems in BBC Salford and West Midlands.

The BBC deal boosted ANNOVA’s December 2015 order book to €35m, although this is spread out to 2027. This order book included a £4m payment from the BBC contract for consultancy services for the proof of the pilot stage, including configuration work, which was due on reaching a milestone and which was passed in August 2017. Consequently the roll-out of OpenMedia software across the BBC has begun and licences are payable as part of the post-milestone regular monthly invoicing as the BBC rolls out the system across its estate. The services element of the BBC contract involves significant customer-funded R&D work, worth up to £8m, as the BBC wanted to ensure that the product would be developed and enhanced.

ANNOVA operates a traditional enterprise software business model (a perpetual licence sale with an implementation/customisation project and ongoing support and maintenance at c 15% of the licence value). Recurring support and maintenance typically represents 25% of total revenues, while ANNOVA also has significant repeat services revenues from some key accounts.

This unit, which provides web and mobile app solutions largely to the retail sector, was acquired in 2014. Based in Leicester, it operates independently, hence is shown as a separate division despite its small size. The unit often works closely with the ESD division, working on joint projects and jointly bidding for new business. This improves ESD’s negotiating position when pitching for new business.

FY17 pre-close trading update

SCISYS says that its “trading results will comfortably meet current market guidance, both in respect of revenues and adjusted operating profit.” The order book is at record levels, boosted by the OHB contract, while additional contract wins across the group in Q417 mean that SCISYS is “entering 2018 with positive momentum across all divisions” hence the strong organic growth enjoyed at the end of 2017 is continuing into 2018. FY17 cash flow was “particularly healthy”, with year-end net cash £0.6m better than we forecast at £5.9m.

The integration with ANNOVA is progressing steadily. 2018 is the final ring-fencing year with ANNOVA and SCISYS has already commenced a programme to align ANNOVA's internal processes with SCISYS's high standards. The company highlights cross selling and synergies between ANNOVA and the Media & Broadcast division continue with contract wins at both MDR and RTL, respectively. MDR is a German public broadcaster and has been a customer for M&B since 1994; RTL France has been a long-standing customer with ANNOVA and is a large commercial customer for M&B and their first in France.

Interim results: Space division revenues grew by 20%

Revenues jumped 23% to £27.2m, including 6% organic growth and an initial £3.6m from ANNOVA, which was consolidated from 1 January 2017. The Space division drove the organic growth, with revenues rising by 20% to £11.6m and contribution gaining 23% to £2.4m. The other three divisions all posted small revenues declines. Net debt shrank by £1.2m over the six months to £9.0m. The order book stood at £64m, up from £35m a year earlier, and c £69m at the start of the year. The order book position includes revenues from ANNOVA‘s BBC contract which are scheduled to run over another c 11 years.

H1 operating cash flow after taxes rose by 21% to £2.7m, aided by a £0.3m tax credit after a £0.3m payment in the prior period. After interest (£0.4m) and capex (£0.8m), free cash flow was £1.5m. We note that the group’s annual cash flow is highly sensitive to the timing of cash receipts in the December/January period.

The interim dividend was increased by 11% to 0.59p.

The group operates a currency hedging programme, whereby it hedges its euro contribution exposure over the rolling following18 months. Both realised and unrealised gains and losses are reflected in adjusted operating profit. Hence, if excluded, the FY16 operating margin was 200bp higher at 9.0%. In its FY17 pre-close trading update, SCISYS said it does not anticipate any major impact from exchange-rate movements in 2018.

Trading updates were buoyant through FY17 and management says that momentum has continued in FY18. We have edged up our revenue forecasts, due to higher pass-through revenues in FY17, and the strong Space division. However, we anticipate that c £2m of pass-through revenues will disappear from FY18, due to the implementation of IFRS 15. We have reduced our end-FY17 net debt forecast by £0.6m, in line with the update, with subsequent years falling accordingly. Otherwise, our forecasts remain unchanged. Our forecasts are underpinned by the record orderbook, and we believe there is potential for upgrades as the year progresses. With the integration of ANNOVA progressing well and in the advanced stages we believe there is increasing potential for acquisitions. Management has said it is looking for appropriate acquisitions “where there is a good market, product and cultural fit”.

Our key forecast assumptions are as follows:

We highlight the following sensitivities:

the group’s capability to meet contractual requirements and damage its reputation.

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 continue to expand margins, including the reuse of bespoke software platforms, better project management and a continuing de-emphasis on third-party software and hardware resales. Further, albeit for the impact of the problem project of FY15, the management has built an excellent track record in driving margins higher and has an objective to return margins to 8% within five years. 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 16x year two earnings with operating margins at around 12%.

We believe there are several factors that will contribute to our current assumption of operating margin recovery to 9.6% by FY19, and potentially towards double digits in the longer term. This includes the development of specialist software platforms that can be sold across multiple customers, a focus on ‘value pricing’ (charging for core software, pricing based on customer ROI), smarter bidding and more effective management of the workforce.

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