Tungsten Corporation — Update 19 October 2016

Tungsten Corporation was established in 2012 and listed on AIM in 2013. At flotation it had agreed the acquisition of an e-invoicing business, OB10, itself founded in 2000, and a bank. The aim was to develop the established, multi-national e-invoicing business network and to offer additional services such as data analytics and, through the bank, invoice discounting to buyers or suppliers on the network. The business completed the acquisition of Tungsten Bank in 2014 and developed the Tungsten Network post-flotation, including the purchase of a business specialising in the automation of accounts payable (DocuSphere, now renamed Tungsten Workflow).

The core e-invoicing business provides a network service for buyers and their suppliers that generates electronic invoices enabling automated straight-through processing. This is not possible with an emailed pdf, for example, and fraud prevention is another important benefit of adoption. E-invoicing can reduce buyer invoice processing costs by as much as 60% (source: Tungsten), while suppliers also gain in terms of efficiency and improved visibility of the status of their invoices and the expected payment date. Tungsten Network generates its revenues through charging initial set-up fees, subscription fees and per transaction fees. The fixed element of fees accounts for 60-70% of revenue. At end April 2016 there were 175 public and private sector buyers (39% of revenue) and over 203,000 suppliers (60% of revenue) on the network.

As Tungsten moved beyond its start-up phase the board recognised the need to contain the rate of cash depletion and improve operational performance. To this end, Rick Hurwitz, previously head of Tungsten Network US, was appointed as chief executive (July 2015). Hurwitz undertook a strategic review to help address the mismatch between delivery and stock market expectations.

As part of the reappraisal, Tungsten decided to sell Tungsten Bank because its agreement with Insight Investment (part of Bank New York Mellon) provides sufficient funding for the invoice finance offering, so the cash tied up in the business and costs of running a regulated bank were not justified. The sale was agreed in December 2015 and is set to be completed shortly with c £30m of cash to be released, with an annual net cost saving of £2m also expected. Subsequently, the invoice financing offering (Tungsten Network Finance) has been revised under the leadership of Prabhat Vira, an experienced trade financing executive who joined Tungsten this year. The funding partnership with Insight Investment, initiated in 2014, has been reaffirmed and expanded while further partnerships will be considered where appropriate. Under the partnership agreement, Insight Investment provides funding for supplier finance, while Tungsten receives a share of the income generated.

Initiatives taken or underway at Tungsten Network include:

The technology change is a key component in the continuing measures to contain costs and achieve greater operational leverage. This can be illustrated in the process of supplier onboarding, where the use of artificial intelligence and introducing the capability for suppliers to sign themselves up can reduce errors and manual intervention substantially.

A summary of Tungsten full year results to end April this year is shown in Exhibit 1. Revenue was 16% above the previous year and, after adjusted costs (down 6%), the EBITDA loss was 26% lower at £18.7m. There was a non-cash £6.8m impairment item relating to Tungsten Bank, which was the main reason for a marginal increase in the loss at the operating and post-tax levels.

The movement in operating expenses (a c £3m reduction) included lower one-off costs at £4.4m versus £6m (mainly relating to Tungsten Network Finance) and cost savings/bad debt reduction of £1.9m. Against this there was also investment in increased staff, system and marketing costs, making up the balance.

Further detail on the performance of the main Tungsten Network business is shown in the next table. Buyer and supplier revenue were up 17% and 15% respectively compared with increases of 1% and 12% in the number of buyers and suppliers. While there were only two net additions to buyers there were 11 new companies added including Duracell and Sanofi. The nine buyers removed from the reported numbers included three with little invoice volume as Tungsten increased its focus on customers with growth potential, three as a result of mergers and three where local contracts were replaced by global contracts. The pick-up in revenue per buyer, supplier and per invoice can be attributed to a combination of mix, success in negotiating higher prices on contract renewals and the introduction of standardised supplier pricing.

Tungsten renewed 34 buyer contracts due for renewal during FY16 at a weighted average increase of 64% confirming the value of the service provided. At the time of the results, the company indicated that a further four buyers had renewed with similar increases and that a further 10 buyers extended their existing contracts but were in negotiation on new terms when they expire. At the AGM Tungsten confirmed that contract renewals at higher prices have continued and also that three new buyer contracts have been signed. Supplier additions are also reported as running at an encouraging pace, with suppliers signing up to use the integrated solution service (machine-to-machine processing versus manual web entry) running at twice the rate in the same period last year. Integrated solution suppliers account for the majority of supplier revenue.

During FY16 invoice financing of over £100m was arranged with an average duration of 34 days generating an average gross yield of 6.3%. Total financing fees (for the Tungsten Network Early Payment product) were £611,000 compared with £153,000 last year and this was allocated between Tungsten Network Finance (£14,000), Tungsten Bank (£180,000) and Insight Investment (£417,000). Given the prospective sale of the bank, Tungsten Network Finance and Tungsten Bank have been separated in the FY16 segmental presentation. The EBITDA loss for Tungsten Network Finance was reduced from £10.6m to £3.8m, reflecting lower one-off costs while the loss at Tungsten Bank was £2.6m versus £2.1m. Prospectively, following the sale of Tungsten Bank, Tungsten Network Finance is set to generate all or most of its income from fees arising from its partnership with Insight Investment.

The final element in the group EBITDA loss of £18.7m as shown in Exhibit 1 was the central item where the corporate EBITDA loss was £6.6m, slightly below the £6.8m for FY15.

In addition to the indications of continued momentum in buyer and supplier sign-ups, Tungsten’s AGM statement confirmed a positive start to FY17 with cost-saving measures, the sale of Tungsten Bank and progress towards performance objectives (see next section) all on track. The company also noted the recent launch of an international payment product to be offered to selected suppliers. Even though revenues are likely to be relatively small in FY17 the service, provided with a partner company, should help strengthen supplier relationships and represents a template for future add-on services.

The potential for strong growth in the e-invoicing market remains in place (see our initiation note published in January), reflecting rising penetration of invoice processing spurred by the significant cost-savings and fraud mitigation available by switching from paper or email-based systems. In addition to realising operational leverage as e-invoicing revenues rise, Tungsten aims to derive growing income from invoice financing, procurement spending analysis and by offering additional adjacent products to network subscribers.

In the nearer term Tungsten has provided guidance that includes expectations for revenue, costs and EBITDA for FY17.

Our estimates are framed to be consistent with this guidance, with an overview of group expectations shown in the financial summary (Exhibit 8) and key elements of the forecasts for Tungsten Network set out in the next table. Among the points to note here are the assumption of continued growth of over 10% in suppliers and the arguably conservative growth in the number of net new buyers prospectively (7% and 8% in FY17 and FY18 respectively). The significant percentage increase in revenue per buyer reflects the progressive impact of repricing as contracts come up for renewal. So far the signs on this are encouraging but this is among the key sensitivities of the revenue estimate and hence profitability. While costs appear to be held steady in FY17, we assume there is an underlying cost reduction with some one-off expenses that fall away during FY18. The estimated growth of 10-12% in invoices processed reflects a combination of growth in the existing user base and the addition of new buyers and suppliers while revenue per invoice is also set to benefit from the repricing of contracts.

Exhibit 4 sets out the potential growth in Tungsten Network Finance revenue and assumptions on the level of invoice financing that lies behind this. Extending the trends we have shown would point to a move into EBITDA profitability in 2020, but the expansion of the funding agreement with Insight Investment, and changes in the sales team and in the product to widen the number of suppliers that can use it, means it could generate more rapid growth than we have assumed.

At end FY16 Tungsten had net cash of £27.0m (£32.6m end FY15), which included £17.8m of cash at Tungsten Bank that is set to be released on completion of the disposal. A further £12.2m will be released on the sale from financial receivables and goodwill. A £10m revolving facility has been agreed to provide additional flexibility in the event the sale is delayed. As shown in Exhibit 5 our forecasts point to cash of c £20m for FY17 and FY18. The FY17 figure is consistent with Tungsten’s own objective while, as the table shows, the FY18 estimate hinges on a substantial improvement in operating cash flow as the various strategic initiatives in place become evident in revenues and costs.

Exhibit 6 provides a brief summary of changes in our estimates since publication of the FY16 results. While there are large percentage changes, these should be viewed in light of the developmental status of the business with significant change and growth taking place giving the potential for a swing into positive cash flow and profitability over the next two or three years.

As in our January 2016 initiation note, we have used a DCF valuation model to gain a sense of the discount rate that is implied by the current share price, given our cash flow assumptions. Since early January the share price has increased by over 60% to the current level of c 60p. Our cash flow estimates have also changed with a larger initial outflow as Tungsten continues its cash-consuming investment phase. On the other hand, we have higher cash inflows in the final two years of our explicit forecast period (FY19 and FY20). We have increased our long-term growth assumption from 3% to 4% to make some allowance for potentially substantial growth in Tungsten Network Finance that is not captured in our forecast period. Even after the substantial share price appreciation our model still suggests an implicit discount rate of 18% compared with 24% in January.

Exhibit 7 sets out the valuation output of our model using different discount and long-term growth assumptions centred around the current share price. The substantial variability of outcome for different projected cash flows means that this table only partly captures the range of values that can be reasonably justified. As a further example, if we were to apply a 5% growth rate within our model (consistent with a possible acceleration in 2018-23 growth) and a 10% discount rate, this would give a valuation of c £200m (157p per share) and an EV/revenue multiple of c 5x.

To put this EV/revenue multiple in context, we note that one peer, Basware, trades on nearly 4x annualised H116 revenues, while another, Coupa Software, was recently listed on Nasdaq and trades on a revenue multiple of c 9x, again based on annualised H1 revenues. In addition, given the nature of the e-invoicing business, where network benefits and scale are important, consolidation may be expected as the market becomes more mature and we have previously cited enterprise value to revenue multiples of 2.7x to 7.6x for transactions involving Basware and SAP.

By comparison, Tungsten trades on below 2x based on the current market cap, together with year-end cash and projected revenues for FY17. Completion of the bank disposal and further progress in the execution of the strategy of focus and increased operational efficiency should help underpin the value indicated, either from the DCF model (through a moderation of the required discount rate) or the simple EV/revenue measure (less risk for an acquirer, for example).