Tungsten Corporation — Update 3 January 2016

Tungsten was founded in 2012 to use leads obtained from an e-invoicing business that Tungsten would acquire to break into the large, global and lucrative invoice financing market. A bank was acquired to facilitate funding. The e-invoicing business cost £101m, while the bank cost £30m, including £5m of goodwill. A further £5m of capital was injected into the bank on acquisition. Tungsten’s strategy has evolved to place more emphasis on transforming the profitability of its
e-invoicing business by increasing its scale, repricing and re-engineering its processes to enable it to achieve the operational gearing potentially inherent in the business. Given the slower than expected flow of invoice financing take-up in the short term, and alternative opportunities to fund the invoice financing, Tungsten has sold the bank with the transaction expected to be completed in six to 12 months for expected cash proceeds of c £30m. Management has suggested this will result in a net reduction to the cost base of £2m pa.

The sale of Tungsten bank should mean that the Tungsten has enough cash to fund the business through to EBITDA break-even.

Tungsten is difficult to value as it is at the early stage of evolution, with many uncertainties about the development of its business and is yet to make a profit. We estimate that the market is currently applying a cost of equity of 24% to Tungsten’s cash flows, far higher than the 9% that Bloomberg estimates is used for the FTSE100.

To achieve the turnaround in e-invoicing profitability, Tungsten will need to significantly reprice the services it offers buyers, increase the number of suppliers on its network and re-engineer its processes to achieve the operational gearing that is potentially inherent in its volume-based business. Failure to achieve any of these measures would jeopardise its ambition to achieve EBITDA break-even on a run-rate basis by the end of FY17.

In October 2013, Tungsten listed on AIM and raised £160m. It used £101m of this to acquire an established e-invoicer, OB10, which has since been renamed Tungsten Network. An e-invoice is one that is sent from a supplier to its customer in electronic format for automated, straight-through processing. Invoice financing is an activity that allows a supplier to obtain early payment of the invoice by selling it to an invoice financier and so improve cash flow. To provide funds for its invoice financing efforts, Tungsten bought a bank for c £30m with a UK banking licence, now called Tungsten Bank. Tungsten has not achieved the growth that it anticipated in invoice financing and announced the sale of the bank in December 2015, subject to regulatory agreement. It is considering other options to obtain funding for discounted invoices to add to the arrangement it already has with Insight. Tungsten has also acquired rights via a five-year rolling licence agreement in September 2013 to a spend analytics service, which allows buyers on the network to analyse their spending and make cost savings by selecting the cheapest supplier.

Tungsten has refreshed its strategy to focus on the profitable growth of its e-invoicing business. It seeks to expand the number of buyers and supplier users, re-engineer its processes to achieve the operational gearing that is potentially inherent in a scale business and reprice the services that it offers, especially to buyers.

Tungsten offers invoice financing in its product suite for those suppliers on its network who want early payment of their invoices. Following the sale of the bank this will be financed by Insight and other sources of finance are being pursued. By offering a seamless, transparent and good value service, it anticipates that it will win market share away from the incumbent operators.

We believe investors should consider the following:

To achieve this, the company needs to achieve the following:

Richard Hurwitz became CEO in July, having previously been in charge of Tungsten in the Americas and of global client development. Rick has 30 years' experience leading teams in financial services and information technology, as we describe on page 13. Since taking the helm, Rick has reconstituted the board to add germane expertise and be more independent. Two new independents have joined the board: David Benello (formerly at McKinsey) and Ian Wheeler (former senior marketing executive at Amadeus). He has also built a new executive team, adding executives who fill important skill gaps: CTO Brian Profitt, CMO Connie O'Brien, head of corporate development Guy Miller, and has hired a new head of Tungsten Network Finance, who will be announced in January. Other board members are Nick Parker, chairman (ex-PWC partner), Edi Truell, vice chairman (founder of Tungsten and ex-Duke Street Capital founder), Peter Kiernan (ex-Goldman Sachs) and Danny Truell (CIO at Wellcome Trust).

e-invoicing is a large and growing business. Billentis, an e-invoicing consultancy firm, estimates that globally, around 170bn invoices are sent by/to businesses and governments each year and of these around 28bn or 16%, are e-invoices and this figure is rising. Currently there is no official organisation collating the statistics in a standardised way.

Billentis estimates that e-invoices can save 60-80% of the cost of a paper invoice and quotes a Finnish state treasury estimate of a paper invoice costing €30-50 to process versus €1 for a fully automated one, and an Italian study by Politecnico di Milano quoting savings of €65 per invoice for a fully integrated process.

According to data collected by Billentis, most European e-invoicers just about break even in their
e-invoicing activities, as most of the cost savings made by using e-invoicing accrue to users rather than system providers such as Tungsten Network. Billentis also estimates that over 70% of the companies offering e-invoicing in Europe were part of companies that were profitable overall thanks to their other activities, which allow them to finance expansion of their e-invoicing activities. Billentis believes that e-invoicers seek market share and scale and hope to eventually make profits from providing add-on products such as spend analytics and invoice financing. Two leading e-invoicers, Ariba and Basware also offer these add-on services.

Tungsten’s management has an ambitious plan to achieve profitability through repricing and adding many more suppliers and buyers. Tungsten offers invoice financing which, following the sale of the bank, will be financed via the arrangement with Insight. Other funding sources are being pursued. In September 2013, Tungsten acquired the rights via a licence arrangement (terms not disclosed) to a spend analytics business. Tungsten Network has a trading history of over 10 years and around £50m has been invested in the development of the network. The business has never made a profit and, as we show in the table below, the EBITDA/revenue ratio has been negative by 10% to 18% over the last few years.

At end H116, Tungsten had 178 buyers on its network and 194,500 suppliers. The former earned 39% of revenues in that period and the latter 61%. Supplier revenue amounted to around £84 each in H116 and included annual licence and transactions fees. Only around 20% of suppliers pay fees to Tungsten, as Tungsten does not charge them for the first 52 invoices that are processed. Revenue from buyers was around £58,000 each and was mainly from licence/transaction fees but also included some set-up fees. The buyers on the network are mainly large, often well-known multinationals or large government agencies. On average, each buyer has over 1,000 suppliers who are frequently SMEs. Tungsten operates a closed network, which requires that buyers on its network invite their suppliers to join them on the network.

Exhibit 2 shows what needs to be achieved by e-invoicing according to management guidance for the group to break even in FY17.

In H116, Tungsten Network added another six buyers, having added a similar number in FY15 (excluding the 43 from the acquisition of DocuSphere) and two in FY14. This results in a total number of 178 buyers (two buyers merged in H116). Tungsten’s efforts to increase buyer numbers do seem to be bearing fruit; we have assumed nine more buyers in H216 and 15 per year in FY17 to FY20. Tungsten Network added 13,500 suppliers in H116, slightly ahead of the FY15 figure, but less than it planned. Tungsten has said that there are many suppliers in the pipeline waiting to join the network, but it is taking longer than expected to on-board them. Tungsten is taking steps to speed up the process, for instance by taking what was a mainly manual upload process carried out by Tungsten to a digital process performed over the internet and supported by the buyers who nominate the suppliers. We have assumed a similar level of suppliers is on-boarded in H216 and thereafter the number increases by a few thousand each year to reach 35,000 new suppliers added in FY20.

Tungsten intends to persuade its buyers that they should pay more for the service by convincing them of the following:

As a buyer can take up to 18 months to connect its IT system to Tungsten Network’s and on-board its suppliers, there is likely to be considerable inertia and reluctance among the buyers to move to another e-invoicer, so Tungsten Network does have some pricing power. It now proposes to use that power. Tungsten Network’s contracts with buyers normally last three years, so that every year around one-third come up for renewal. In H116, Tungsten renegotiated renewals with 14 buyers at price increases averaging 70%. A further 35 buyers have contracts coming up for renewal in H216. In our forecasts we have assumed that Tungsten achieves a similar level of price renewal over the next two and a half years so that the average price increases are around 12% in FY16, 21% in FY17 and 26% in FY18. It should be noted that H116 revenue per buyer was slightly lower than it was in FY15 because the majority of new buyers were signed at the end of the period, so that little revenue was earned by them in the period and there were fewer, large one-off buyer set-up fees in H116 compared with the previous year. In our forecasts we have assumed that revenue per supplier remains around £75 in H216 and from FY17 to FY20. Tungsten expects supplier revenues to increase as a result of the Network effect – in particular, as new buyers are added Tungsten expects to earn additional revenue from connecting current suppliers to them.

In H116 administrative expenses were £15.7m, with just £0.4m of one-offs. Tungsten Network is proposing to keep administrative costs in H216 at a similar level to those in H116, making a total of £31.7m for the year. Thereafter it proposes to keep costs flat. Tungsten says that it has re-engineered its processes in Tungsten Network to reduce reliance on manual intervention and increase the amount of automation and tasks carried out by buyers and suppliers and this and similar measures will enable it to control costs. We have little visibility over the measures that have been taken and their likelihood of success so the cost control ambitions remain subject to considerable uncertainty.

Our forecasts anticipate that network revenue will increase 19% in FY16 and 22% in FY17, and generate a 14% CAGR from FY17-20. These calculations are at best tentative and rely heavily on Tungsten Network’s sales efforts being successful. We have assumed that administrative costs are £32m pa from 2017-20. On the basis that Tungsten does control its costs as it intends, we calculate that Tungsten Network may achieve an EBITDA of £1.5m in FY17, EBITDA of £9.7m in FY18 and an EBITDA margin of 36% in FY20.

While Tungsten seeks to earn profit from e-invoicing, it aims to enhance its returns by cross-selling the invoice financing product to the suppliers on its network. Invoice financing enables suppliers to obtain cash earlier than they would do otherwise and so improve their cash flow. A supplier sells an invoice that they have raised to a buyer of their product or service at less than face value to an invoice financier, frequently a subsidiary of a well-established bank. The invoice financier should then receive full payment on the invoice a little later and earn the difference between the amount received and the amount paid. Tungsten seeks to use the supplier relationships that it has acquired from its e-invoicing activities to build an invoice financing business. It proposes to make its method of giving credit, called Tungsten Early Payment (TEP), superior to the incumbent operators. The delivery mechanism will be fully integrated with the e-invoicing activities and once set up, will require an authorised individual to click a box on a list of invoices available for early payment.

TEP intends to offer a low cost and transparent pricing structure, in contrast to many existing operators who currently have a complicated fee structure and charge relatively higher prices.

Initially funding was to be provided by Tungsten Bank. However, the lower than expected take-up of its invoice financing offer, together with the availability of finance from others has led Tungsten to conclude that shareholders’ interests would be better served by selling the bank. An agreement to sell it for £30m, NAV (ex-intangibles) plus c £4m-5m premium depending on when the transaction closes, was announced with the H116 results and the transaction is expected to be completed within six to 12 months.

In December 2014, Tungsten announced that it had entered into an agreement with Insight Investment Management, under which Insight agreed to acquire invoices from Tungsten. Insight is a global investment manager owned by BNY Mellon, with over £300bn of assets under management. In addition to Insight there are many other potential acquirers of discounted invoices, including alternative finance providers and some of the recently listed investment companies investing in SME loans. Details of Insight’s revenue sharing arrangements with Tungsten are not in the public domain. We expect that Insight’s funds will bear any credit loss from the lending and Tungsten will take a share of the interest received from the lending, which it will record in its accounts as a fee. The lending will not be recorded on Tungsten’s balance sheet (nor that of Tungsten Bank) so there will be no requirement for capital backing for the lending to comply with Bank of England PRA capital requirements. The anticipated lending rates depend on the size of the supplier, with SMEs estimated to pay up to 12% per year and large companies around 3% to 5% per year.

Tungsten launched its invoice financing service in November 2014. As evident in the H116 results, the take-up has been slower than hoped for. For a supplier to discount an invoice it is necessary that Invoice Status Service (ISS) is enabled for buyers. It is also necessary for suppliers to register for the service. At the end of H116, 294 suppliers had registered (with 108 using the service), up from 38 at end FY15, but this is a small fraction of the number of suppliers on the network. The value financed was £43m, from £32m at end FY15. Most of these invoices were of short duration, 40 days in H116, such that the average amount of outstanding finance in H116 was £12.8m. While this is a meaningful increase on the £6.5m in H215, it is a small fraction of the amount that its suppliers likely financed during the period, which we estimate was probably around £1bn.2 The average gross yield on the financing was 6.17%.

The potential to sell invoice financing to suppliers on its network remains, and indeed other e-invoicers are also offering suppliers invoice financing such as Basware and Ariba, a large e-invoicer owned by SAP. Tungsten faces competition for invoice financing not just from the traditional suppliers but also other e-invoicing organisations.

Tungsten has identified two main causes for the slow take-up of this product to date:

Additionally Tungsten needs to work hard to establish its brand and reputation as a provider of finance.

In H116 revenue from TEP was £84,000 and consisted of the revenue on invoice receivables financed by Tungsten Bank. No revenue was recognised on invoice receivables financed by Insight as Tungsten could not provide invoices that met with Insight’s requirements

Our tentative forecasts for Tungsten Network Finance are shown in Exhibit 3 below. For H216 and H117 we have assumed a similar level of revenue and profits as H116, but for H217 and onwards we have assumed the sale of the bank has completed and all revenues will be earned by passing the invoices to Insight or another funding provider. We have assumed that Tungsten Network earns fees of c 1% of the value of these invoices. This fee is towards the lower end of fees earned by other providers. GLI Finance, a company that owns 19 alternative finance platforms arranging loans for SMEs, earns fees of c 1-4% for loans arranged. Given Tungsten’s desire to build this business, we have assumed, conservatively, that it charges fees at the bottom of this range. We have anticipated that invoices discounted in H216 are 15% higher than in H1 and that from FY17-20 they grow at a rate of 20% pa. In H116, an impairment charge of £6.3m was incurred as a result of the propose sale of the bank, which should be partially recovered in FY17 as a gain of £2.2m should be earned on completion of the proposed disposal. We have assumed that the cost base falls by £1m in FY17 as a result of the sale of the bank and by £2m per year thereafter, as indicated by management. These forecasts anticipate that EBITDA losses fall from £5.4m in FY17 to £2.5 in 2020. We have taken a cautious view of Tungsten Network Finance forecasts given the lack of visibility on its likely volume growth or its pricing structure. We expect that Tungsten will persist with the activity given the potential size of the market and the likely reduction in losses.

The following table is a summation of the forecasts for Tungsten Network and Tungsten Network Finance discussed previously, together with the corporate centre. These forecasts have been based on management guidance of EBITDA break-even on a run-rate basis by the end of FY17 for the group and indicate what needs to be done to achieve this goal. Our revenue and EBITDA forecasts for FY16 are in line with management’s guidance of revenue of at least £27.5m and an EBITDA loss of no more than £19m.

At the end of H116, Tungsten had £39.7m of cash and equivalents, of which £23.9m was held in Tungsten Bank, leaving £15.9m available for the rest of the group. By the end of FY16 we anticipate that the cash will have fallen to £33.2m and, assuming a similar amount is held within the bank, this would leave £9.3m for the rest of the group. With cash outflows continuing in FY17, we anticipate that the cash and equivalents balance would fall to £29.0m by end FY17, but with the sale of the bank completed by then and the cash at the bank becoming cash available to Tungsten, all of this balance will be available for the group. In FY18, we anticipate that the group will generate positive cash flow from its operations, so cash and equivalents could rise to approaching £30m at the end of FY18, and to around £45m at the end of FY20.

The valuation of Tungsten is highly subjective given the company’s early stage of development and the many uncertainties associated with its expansion in e-invoicing and invoice financing. Our main approach is to use reverse discounted cash flow analysis to estimate what the current market capitalisation of the company implies for Tungsten’s cost of equity, assuming management achieves its break-even forecast for 2017. We also attempt to place the valuation of Tungsten in the context of other companies with e-invoicing activities.

The market capitalisation of Tungsten’s ordinary shares is currently around £47m and with c £40m of cash and equivalents on its balance sheet that implies that the market is currently valuing the operating entities at £9m. The free cash flows that we have used in our DCF valuation are shown in Exhibit 5 below and are based on management’s expectation that it will achieve EBITDA break-even on a run-rate basis at the end of FY17 and the specific assumptions we have articulated earlier in the report.

On the basis that the terminal growth rate of Tungsten’s cash flows after 2020 is 3% per year, we estimate that the market is currently applying a 24% cost of equity to Tungsten’s cash flows.3 This rate is considerable higher than Bloomberg’s estimate of the cost of equity for the FTSE100 and reflects the uncertain developmental stage of Tungsten’s activities.

Most e-invoicing companies are either privately owned or part of larger organisations, notably the global leader Ariba, owned by the giant German software company SAP, which makes peer comparisons of limited value. The most frequently cited comparable to Tungsten is Basware, but just under a third of its revenue is derived from e-invoicing operations, the remainder is from providing software solutions.

However, there has been some takeover activity in the e-invoicing industry, which offers some valuation comparison. Exhibit 6 summarises the largest e-invoicing M&A transaction, SAP’s purchase of US company Ariba, and three of Basware’s recent larger transactions. The weighted average EV/Sales of Basware’s deals is 3.7x. Tungsten paid £101m (gross) for Tungsten Network in 2013, a multiple of 5x sales. This multiple reflected management’s hope that it could monetise the e-invoicing relationships, although this has proved challenging.

Using the EV/sales multiples in Exhibit 6 above and taking FY15 achieved sales, it is possible to compute a sum-of-the-parts (SOTP) valuation for Tungsten of 91p, as shown in Exhibit 7 below.