GBST chief to retire

There have been some curious goings on at GBST since the company reported its final result five weeks ago. The presentation accompanying that result gave some confused signals about investment, talking variously of further 'investment to build international scale', research and development 'consistent with prior years', and 'investment … accelerating'.

In the conference call management put a little flesh on the bones, suggesting that research and development expenses would move from about 10% to closer to 12.5% of revenue. That sounds innocent enough, but on the expected $130m in revenue for 2016, it adds up to about $3.3m, equivalent to about 11% of operating profit and thereby taking a large chunk out of the expected growth of around 15%.

You might have thought that was important enough to mention in the materials released to the ASX. The sharemarket seemed to think so, with the stock turning an initial 9% rise following the announcement into an 8% loss by the close the following day.

The impression is of a company that is perhaps finding it difficult to decide on the right level of expenditure, and the plot has thickened with news today of the retirement of managing director Stephen Lake. The company will embark on a search for internal and external candidates before Lake hands over some time in 2016.

Lake is more associated with GBST's capital markets software: Shares, which was its main product when he came to the company in 2001, and now Syn~, which came with the acquisition of Coexis in 2008. Customers in Australia are being migrated from Shares to Syn~ and the company is investing to in the hope of building sales overseas, although the international capital markets business is currently losing around $4m a year.

The company's star performer is the Wealth business, whose prime product Composer is currently making great strides in the UK. With Lake leaving, it may mean that the group's focus shifts further in this direction. We'd like to see the company investing in Wealth and Capital Markets, even at the expense of profit growth over the next year or two. But, if pushed, you'd have to say that Composer is the key to GBST's success, so we don't necessarily see Lake's departure as a bad thing.

Expenses not created equal

So what of the increased development spending? Well the important thing to understand here is that not all expenses are created equal: some are necessary simply to maintain a company's existing level of sales, whereas some is intended to help the company grow.

Some of GBST's planned expenditure will no doubt be necessary to keep its software up to date and competitive, but it's at the forefront of a fast-growing industry and we have little doubt that investment in its products will also create additional sales – initially in the UK but eventually in other regions, with Asia being a major focus. Syn~ is something of a wild card: quite likely little will come of it internationally, but there is a small chance of spectacular success.

The reality is no doubt somewhere in the middle – the increased spending gives a small boost to expectations of future sales growth, but it'll likely be at slightly lower margins.

We'd note, however, that the margin assumptions in our initial upgrade (see GBST's Platform for Growth on 30 Mar 15 (Buy – $5.75)) don't look aggressive. Even in our 'optimistic' scenario for 2020 we have an operating margin of 30% for the international wealth business, while management has suggested that over time it should move towards the levels recorded in Australia, of 39% in 2015. So that still looks comfortable even if we knock off an extra 2.5% for the increased development costs.

2016 earnings flat

At the same time, our 'conservative' assumption for 2020 revenue of $143m is already looking seriously undercooked, and if the increased expenditure brings the optimistic assumption of $238m a bit closer, then we're very happy. As we wrote back in March, even the 'conservative' scenario in 2020 should deliver a 'decent result, implying earnings growth of 11% a year on top of the stock's current free cash flow yield of over 4%'.

The effect of the increased investment is to knock down the free cash flow by perhaps 10-15%, but we'd argue that the growth assumptions should rise by more, although they'll now need to be weighted more to later years. And of course the 15% share price fall since March (not to mention a better than expected result for 2015) has boosted the prospective free cash flow yield to more than 5%.

With a tax rate also expected to be slightly higher in 2016, underlying earnings per share are likely to be flat at around 28 cents, putting the stock on a forward multiple of about 17, which looks cheap given the cash flow and medium- to long-term growth prospects. We're cutting our Buy price from $6.50 to $6, to account for the fact that the growth is, at least, further away, but GBST remains a BUY.

Note: Our Growth and Income portfolios own shares in GBST.

Disclosure: The author owns shares in GBST.