TXT e-solutions — Well funded for growth

TXT e-solutions is an Italy-headquartered software and services company. Having recently sold TXT Retail, its retail software business, TXT now operates solely through its TXT Next business. TXT Next is a software solutions and services business focused on the aerospace and aviation, and banking and finance segments, with roughly two-thirds of revenues generated in Italy. The group plans to drive growth through a combination of organic growth and targeted acquisitions, using some of the proceeds from the recent disposal of TXT Retail. The remainder of the proceeds are expected to be paid out as a special dividend in H118, after approval at the AGM in April.

This is the first set of results since the disposal of TXT Retail, which is now accounted for within discontinued operations. We have revised our forecasts according. We have nudged down our TXT Next forecasts to reflect the impact of higher commercial and G&A costs. We forecast net cash will increase to €86.9m by the end of FY17 and €87.2m by end FY18 (before accounting for the special dividend).

On an EV/Sales and EV/EBITDA basis, TXT trades at a premium to its peer group. Its EBITDA margins are currently below the peer group, although the company is targeting EBITDA margins of 12% in the medium term. With €85m in gross proceeds from the sale of TXT Retail in the bank, TXT is trading on an inflated P/E multiple. We would expect the share price to fall once the special dividend is paid out, reducing price multiples to more normal levels. Until the remainder of the cash is put to use on value-accretive acquisitions, we would expect the stock to trade at a premium to peers on a P/E basis. Our reverse DCF shows that the current share price is factoring in revenue CAGR of 4.2% from FY19-26 with an average EBITDA margin of 9.9% over that period. In our view, this appears conservative.

TXT e-solutions was formed in 1989 as a software and solutions vendor and listed on the STAR segment of the Borsa Italiana in 2000. Until recently, the company operated through two divisions: TXT Retail (52% of FY16 revenues) and TXT Next (48% of FY16 revenues). In October, the company sold TXT Retail for €85m to APTOS, a US retail software company. TXT Next is a services and software solutions business, focused on the aerospace and aviation, and banking and finance segments, primarily in Italy. In FY16, the aerospace and aviation business generated 56% of revenues in Italy and 44% from international customers. The banking and finance business generates all revenues in Italy. The business has grown organically and via the acquisition of PACE in 2016 and has increased its international exposure.

TXT Next has shown robust organic growth over recent years (CAGR 7.9% FY12-FY16) boosted by the acquisition of PACE in FY16, and EBITDA margins have expanded over this period. Now that it is a standalone business, its strategy is to grow through a mixture of organic growth and acquisitions in the aerospace and aviation markets.

In Exhibit 3 below, we show the group’s divisional growth targets and what this means for group revenue growth, as well as the group EBITDA margin target. In FY16, TXT Next achieved a higher EBITDA margin than this target, although it is running at a lower rate year-to-date.

Having received proceeds of €85m from the sale of TXT Retail, after paying a special dividend we expect the company to retain funds of at least €20-30m for acquisitions to bolster the growth of the aerospace & aviation business. In addition, the company has treasury shares worth €13m that could be used for acquisitions. The company is primarily targeting profitable businesses with annual revenues in the range €5-20m and an international profile. They would ideally be well-established in the industry, and have a solid customer base and committed management team. Target companies would offer access to at least one of the following: a broader technology offering, increased geographical presence, new customers, or better penetration within existing accounts or domains.

TXT is run by a long-established team: the chairman is the original founder of the company and the group CEO, Marco Guida, joined TXT in 1994. The CFO, Paolo Matarazzo, joined the company in 2007. Several key managers of the business have been with the company for many years in Italy (with TXT Next) and Germany (with PACE).

TXT Next is now the main business of TXT. TXT Next provides specialised software solutions and services through two divisions: aerospace and aviation (A&A), and banking & finance (B&F). In 2016, TXT Next acquired PACE, a German aerospace software business. Exhibit 4 below shows how two-thirds of group revenues are generated in Italy, with a growing proportion of sales generated elsewhere in Europe and to a lesser extent, the US and Asia Pacific. In the nine months to September 2017, TXT Next generated 91% of revenues from services and 9% from software licenses and maintenance (FY16: services 90%, software 10%).

This business, founded 30 years ago, makes up the largest proportion of TXT Next, generating pro-forma revenues of €26m in FY16 (76% of TXT Next pro-forma revenues) and an EBITDA margin of 10.9%. The division provides a mix of software and specialised engineering services, providing support to customers’ R&D, engineering and manufacturing operations. In FY16 revenues were generated from OEMs (68%), first tier suppliers (13%), airlines (7%) and automotive customers (8%). Until relatively recently, the business was mainly staffed out of Italy. Partly through a “follow-my-customer” strategy and partly as a concerted effort to expand internationally (organically and via the PACE acquisition), the division now has more than 330 consultants based in Italy, Germany, France, the UK, the Netherlands, Switzerland and the US. In FY16, the business generated 56% of revenues from Italy, 34% from other EMEA countries and 10% from the US and APAC. Exhibit 5 shows key customers and highlights the international nature of the customer base.

TXT Next already had a significant aerospace-focused business, providing IT, consulting and R&D services to mainly Italy-based business such as Leonardo. The acquisition of PACE added specialist aerospace software as well as a larger international customer base. Customers include more than 50 companies covering aircraft and engine manufacturing, airlines, civil and defence operators, and maintenance, repair and overhaul (MRO), including Airbus, Air France & KLM Engineering, Boeing, COMAC, Delta Airlines, Embraer, GE Aviation, Lufthansa, Rolls-Royce, Safran Group and Sukhoi. Until the acquisition, TXT Next had predominantly generated revenues from services – PACE adds higher-margin software revenues, which over time should drive higher recurring revenues.

From PACE’s perspective, TXT Next has a large number of qualified consultants who are able to provide additional engineering software services to PACE’s client base. The business continues to trade under the PACE brand, with the three founders continuing as managing directors, focused on expanding the value and range of services offered around their engineering software products.

TXT paid €7.7m for 79% of PACE (including contingent consideration). It also accrued a potential payment of €1.4m for the put/call option for the remaining 21% stake (owned by the three founders) exercisable from 1 January 2020 to 31 December 2021. On acquisition, it consolidated €2.3m of net cash within the PACE business; total consideration for the business, net of cash acquired, was €6.8m.

Exhibit 6 shows the services and software the company offers across business processes.

The original TXT Next business offers specialist engineering services, and has developed a variety of industry-specific software libraries and toolboxes and reference applications. Examples of reference applications include TXT FAST 4.0 (for digital manufacturing), TXT SIMCARE (for flight simulators), TXT IoT Manufacturing Operation Management (for internet of things) and TXT WEAVR (for augmented reality and virtual reality training solutions). With the PACE acquisition, TXT has added fully packaged software and related services (see Exhibit 7).

The division now has a customer base of more than 70 companies. Although most of the work is project based and therefore not recurring in nature, TXT has a very loyal customer base that provides repeat work. Of revenues generated from services, roughly three-quarters are from turnkey service engagements, while the remainder are contracted on a time and materials basis.

The aerospace and aviation markets are characterised by global groups with large investment budgets – many groups have multiple subsidiaries that could each use TXT’s software engineering services. The rapid pace of innovation combined with increasing regulation drives growth in R&D. In its 2020 strategic plan, Altran estimates that the global engineering and R&D services market was worth c €130bn in 2015, and is forecast to grow at a CAGR of 9-11% to 2020. Within that, it forecasts growth in Europe of 5-7%.

One obvious source of growth for TXT is to increase its share of wallet with the existing customer base, selling to multiple divisions within each customer. The business is also targeting new international customers. While not strictly fitting within the definition of aerospace and aviation, the division also supplies automotive manufacturers and sees further potential growth from this market.

In terms of its product range, the company is considering offering managed services – this would increase the level of recurring business. It is also looking to extend the capabilities and range of its software assets. In addition to achieving this through internal R&D, the company is looking to acquire niche software providers and is selectively targeting highly specialised mid-sized companies.

The banking & finance business, which has been in operation for the last 15 years, provides software testing, verification and validation services to banks and insurance companies in Italy. Exhibit 8 shows the services offered across the software quality assurance lifecycle. Functional testing of software accounts for the majority of the division’s services. Testing services are performed both on-site and off-site, using the company’s Test Factory methodology.

The division targets the top 50 Italian banking institutions; customers include Azimut, Banco BPM, Banca Mediolanum, Banco Popolare di Sondrio, Ergo Assicurazioni, Gruppo ICBPI, Gruppo Bancario Credito Valtellinese, ING Bank, Intesa SanPaolo, SIA. Webank.it, and Widiba.

The business has 128 consultants, all based in Italy. In FY16, it generated revenues of €8.1m (24% of TXT Next pro-forma revenues) and an EBITDA margin of 8%.

The company believes it can continue to grow this business organically. Management plans to strengthen the services offered through a combination of deepening domain knowledge, developing standardised “testing bricks” (reusable software IP), and developing its test methodology to master a wide range of market-leading tools from third-party providers (eg IBM, HPE, open source) and a wider range of banking domains/processes.

Drivers of demand include increasingly strict regulation, emerging fintech software and services, and the rapidly evolving IT landscape. The company estimates that the market for quality assurance and testing services in the Italian banking sector is worth at least €100m per annum.

TXT Next has been a beneficiary of the trend to outsource, which gives the customer greater flexibility on cost and better access to specialist skills. Once a customer has outsourced a specialist area of R&D or IT, it is usually very difficult to bring it back in house, as the in-house knowledge and expertise will have diminished. TXT Next has worked closely with the majority of its customer base for many years, creating a strong partnership and demonstrating its specialist expertise.

On the services side, the division’s competition is from customers’ in-house R&D and IT departments, as well outsourced engineering services providers and system integrators. The A&A business sees competition from large European engineering services businesses such as Akka Technologies, Altran, Alten and Assystem in France (all listed on Euronext), ESG Group in Germany (private) as well as smaller local providers such as Critical Software (private, based in Portugal), Teoresi (private, based in Italy), and Philotech (private, based in Germany ). Both the A&A and B&F businesses compete with the large offshore BPO providers such as HCL, Tech Mahindra and Tata, although TXT’s specialist knowledge and on-shore capabilities are often preferred for mission critical work that requires not only technical expertise, but also in-depth industry knowledge and proximity to customers. The B&F business also competes with specialist outsourced testing providers such as SQS (AIM-listed). On the software side, PACE operates in the market for aircraft design and engineering processes, typically served by the large PLM1 software vendors such as Dassault, PTC and Siemens. PACE offers niche solutions to address specific, critical tasks that complement and integrate with PLM software solutions.

The company announced in May that it had created a new division called TXT Sense (sitting within TXT Next). This division is focused on exploiting the opportunity presented by augmented reality (AR) and virtual reality (VR) technology. The aerospace market has made use of AR and VR for years in flight simulation and ground crew training. TXT is keen to apply the knowledge it has built up in this area to other verticals. The division, with eight employees, is exploring opportunities to use the technology in other sectors including media & advertising and discrete manufacturing.

Our forecasts and TXT’s share price will be sensitive to the following factors:

TXT Next saw minimal y-o-y revenue growth in Q317. Software license sales were marginally higher than a year ago although were 20% higher sequentially, and service revenues were flat y-o-y. This is a seasonally quiet period for TXT as it covers the summer holiday period in Italy. Higher R&D and commercial costs were only partially offset by lower G&A costs resulting in a decline in EBITDA and EBIT margins y-o-y.

We have revised our forecasts to reflect the disposal of TXT Retail. Exhibit 10 below shows the main changes to estimates. Now that the costs of being a public company are being fully borne by the remaining business, this weighs on profitability in Q417 and FY18. Margins should start to expand again from FY19. In our forecasts, we have not accounted for the special dividend – instead we have reduced our dividend assumption to reflect a similar pay-out ratio to prior to the disposal of TXT Retail. In reality, we expect the company to announce a special dividend worth c €50m at the AGM in April 2018 – this would equate to a dividend of €4.3 per share.

We have revised our peer group to reflect the focus of the remaining business. We have included European IT services and engineering services companies as well as software providers to a similar customer base. On an EV/Sales and EV/EBITDA basis, TXT trades at a discount to its peer group. Its EBITDA margins are currently below the peer group, although the company is targeting EBITDA margins of 12% in the medium term. With €85m in gross proceeds from the sale of TXT Retail in the bank, TXT is trading on inflated P/E multiples. We would expect the share price to fall once the special dividend is paid out, reducing price multiples to more normal levels. Until the remainder of the cash is put to use on value-accretive acquisitions, we would expect the stock to trade at a premium to peers on a P/E basis.

We have previously noted that TXT has been a beneficiary of the Italian PIR scheme. The January 2017 introduction of the PIR individual savings scheme in Italy, which allows mutual funds held for five years to earn returns tax free, has boosted investment in Italian small and mid-cap stocks.

We have estimated the potential impact of using a proportion of the proceeds to acquire businesses with similar financial characteristics to engineering service providers such as Altran. Using an EV/Sales multiple of c 1.1x for CY18, proceeds of €30m could be used to buy CY18 revenues of c €27m. On a 10% EBIT margin with a 30% tax rate, this would equate to incremental EPS of €0.16 in FY18. Using a total normalised EPS of €0.38 and a P/E multiple of 15.9x (the peer group average) would result in a share price of €6.0. Add to that c €4.3 for the special dividend and the share price would be c €10.3, 5% above the current share price.

We have performed a reverse 10-year DCF to calculate what we believe the market is factoring into the current share price. Using a WACC of 9%, long-term growth of 2%, working capital/sales of 2% and capex/sales of 1.2% (the company does not capitalise development costs), a revenue CAGR of 4.2% for FY19-26 and average EBITDA margins of 9.9% over FY19-26 are required to reach the current share price. Based on market growth and the company’s targets, this appears conservative.