GBST gaining momentum
Recommendation
In the past couple of years Larry Ellison, founder and chief of US-listed software company Oracle, reportedly dropped US$400m on his own Hawaiian island and another US$300m on Oracle Racing, the super-yachting team that ultimately won the America's Cup.
Ellison's $48bn fortune came from selling Oracle database systems, which can cost tens of millions of dollars. Replacing them has been compared to having an organ transplant, so customers are very sticky despite paying around a quarter of the cost of the databases annually for software updates and customer service.
Key Points
- GBST finally hitting its straps
- International expansion poses risks
- Initiating coverage with Hold
If you don't pay, you risk losing customers if your system crashes, and Oracle will penalise you when you return to the fold. It's the sort of high recurring revenue, high free cash flow, high return on equity business that investors dream of.
GBST's current market value of $214m is the equivalent of one and a half days' sales for Oracle, despite sharing a similar business model. But unlike Oracle, which faces relatively pedestrian earnings growth because of its US$173bn market value, GBST's earnings are growing quickly (see Table 1).
Year to 30 June | 2010 | 2011 | 2012 | 2013 | 2014F |
---|---|---|---|---|---|
Revenue ($m) | 68 | 68 | 76 | 82 | 94 |
EBIT ($m) | 8.5 | 6.4 | 6.5 | 9.3 | 17.0 |
U'lying net profit ($m) | (2.4) | 1.4 | 3.3 | 6.0 | 11.0 |
U'lying EPS (c) | (4) | 2 | 5 | 9 | 17 |
PER (x) | n/a | 162 | 65 | 36 | 19 |
DPS | 2 | 4 | 5 | 7 | 9 |
Dividend Yield | 1 | 1 | 2 | 2 | 3 |
Franking | 100 | 100 | 100 | 100 | 100 |
GBST develops IT systems for the financial services industry. We'll focus on its Capital Markets and Wealth Management divisions, as the Financial Services division isn't material (see Chart 1).
Capital Markets Division
The company's flagship product in the Capital Markets division is GBST Shares in Australia, and GBST Syn~ abroad. They both automate 'back office' functions, such as reporting, shifting cash from one account to another and reconciling accounts, cash flows and trades. The more seamless the system, the fewer staff are needed, and the more brokers can cut costs.
Two-thirds of the Australian broking market uses a GBST system, but GBST's biggest competitor is not Computershare or Iress, for example. It's the systems that companies develop and maintain in house. GBST earns 20-30% margins from installing new systems, which can take a year or two. So just like Oracle's databases, once a GBST system is installed it's unlikely to be replaced.
As Ellison knows well, the cream lies in high-margin, long-term licences (Chart 2 shows the split between licence and services revenue). A typical GBST contract runs for four to five years and may contain clauses for usage and CPI increases. While large customers might pay a fixed fee – which helps support GBST's revenue in a downturn – as financial markets improve and financial activity increases smaller clients will pay more, potentially putting a rocket under the company's earnings. It's a bit like Westfield charging specialty retailers six times more rent per square metre than anchor tenants.
Renaissance
Like many other companies in the financial industry, GBST was no fairytale for investors between 2007 and 2012. In November 2008, GBST used a combination of newly minted shares and debt to acquire UK company Coexis to help modernise its products and expand overseas.
A variety of problems ensued, which we won't go into here, but as the GFC worsened GBST's share price eventually fell from a high of $4.10 in August 2007 to just $0.58 in March 2009. The company has spent millions resolving the issues, and finally has the modern suite of products it always wanted for its overseas expansion. Since 2009, its share price has increased almost sixfold.
Unlike GBST Shares, which only works in Australia, GBST Syn~ is attracting customers in Asia. GBST is also confident that the recent signing of a 'cornerstone' client in the US will provide a springboard for wider adoption in the world's largest financial market.
Wealth Management Division
GBST Composer - GBST's flagship product for the wealth management industry - is an administration system that must deal with myriad asset classes, taxation rules and regulations, clients and investment options. GBST Composer has around a third of the Australian market (though the true size of the market is difficult to estimate) and is aiming to replicate its success in the UK.
GBST's UK sales increased 17% in the six months to 31 December 2013, albeit from a low base. The UK suffers from a lack of investment in IT systems, has a complex tax code, a mature pension sector and a huge range of investment options. It also offers profit margins two to three times higher than in Australia, so it makes sense for GBST to keep investing over there.
Weighing it all up
It's taken seven years but GBST is now highly profitable, debt has fallen dramatically, the company's products have never been better, and its losses overseas in the Capital Markets division are declining as new installations are completed and its network of contacts and potential clients expands (see Chart 3).
After largely stagnating between 2008 and 2011, GBST's revenues have been gathering momentum over the past two years. A $2m loss in 2010 is expected to be replaced by an underlying net profit of about $11m this year, equivalent to earnings per share of 17 cents. That would put the company on a price-earnings ratio of 19, which seems fair for a small business with sticky clients, strong cash flows and reputable products that are being well received abroad. That view appears to be shared by the company's directors, who still own over 20% of the shares despite sales late last year at prices around $3.50, and Perpetual, whose funds own 10%.
The number one risk would be another downturn in financial markets, reducing customers and their usage of GBST's systems. Sales and margins could also be hit in the unlikely event that major new competitors disrupted the Australian market, while losses could continue abroad if GBST is unable to win new customers. If earnings don't continue to grow quickly, investors would likely assign a much lower multiple to GBST's profits than the current forecast multiple of 19.
The range of potential outcomes for GBST is wide, as much depends on how successful it is overseas. That's reflected in the recommendation guide and we'd consider upgrading below $3, which we estimate would be around 15 times 2015 earnings, provided the global economy holds together. We're initiating coverage with HOLD.