The 2016 financial year was one that GBST would prefer to forget. After upgrading the stock to Buy just a few months before it began, we’d happily join them.
It began with the revelation in the 2015 results conference call that research and development (R&D) spending would increase from 10% of revenue to about 12.5%. The market saw that glass as half-empty, marked down its forecasts and knocked the shares down by about 15% in three weeks.
2016 result hit by project delays, Brexit
Cash flow improved in H2
Good news from Aegon partnership
Then (after a brief share price recovery) there were some large share sales by outgoing chief executive Stephen Lake, followed by a warning that project delays would hit earnings and, a few days later, Lake’s prompt departure. We’d have preferred all this to have happened in reverse order.
To cap it all, we had Brexit. As management explained in Monday’s conference call, the impact of this began a couple of months ahead of the actual vote. This has then been followed by a period ‘when Cameron was on the way out [when] the Government was almost frozen’ and then by the UK’s traditional holiday season. ‘It couldn’t have come at a worse time, basically,’ explained chief executive Rob De Dominicis.
|Year to June ($m)||2016||2015|| /(–)
|Adj. net profit||13.4||19.2||(30)|
|*Fully franked final dividend of 5.5c (unchanged),
ex date 29 Sep
Although no current projects have actually been delayed as a result, activity (and therefore licence revenue) has been affected, and the fall in sterling will reduce the Aussie dollar value of UK profits. Sterling is now down 12% against the Aussie dollar since the vote and 20% since this time a year ago.
Since 40–45% of GBST’s profits came from the UK in 2016, this alone is enough to knock group profits down by around 10%. Indeed management even claimed, rather limply, that despite the achieved earnings before interest, tax, deprecation and amortisation (EBITDA) of $20.0m (before $2.8m of restructuring charges) missing the bottom of its guidance range of $20.5m–$22.5m, it would have been close to the middle of the range in constant currency terms.
But, for all these problems, the underlying investment case for GBST remains intact. Indeed it could even be getting better. In spite of Brexit, the UK platform market is still expected to continue its rapid growth. Indeed, De Dominicis was hopeful that, with so much else on the UK Government’s plate, they might see a relatively stable period with less regulatory change.
And GBST’s share of this market is increasing. Recently that’s been thanks to the acquisitive nature of its cornerstone UK client, Aegon (with whom GBST recently signed a new five-year agreement), but it’s none the worse for that. Aegon's recent acquisition of Cofunds makes it the largest platform operator in the UK and – if all Cofunds assets move across to Aegon’s platform – it will more than double GBST’s share of the UK platform market to 35%.
Although the details of the arrangements are confidential, Aegon’s wording around the Cofunds deal provides some optimism. For example, Aegon ‘expects to generate £60m of annualised cost synergies by moving the Cofunds business onto the state-of-the-art Aegon technology’ [provided by GBST]. The company estimates the cost of the move to be £80m, to be spent over the course of 2016 and 2017.
Some of this will be coming GBST’s way, although it’s next to impossible to say how much. A little more patience will be required, as well, because the move isn’t expected to ramp up until the second half of this financial year.
Management is also hopeful of extending the international success of its wealth business, picking out South Africa, in particular, as a source of opportunity. One customer has apparently completed (and paid) for scoping work for a GBST platform deployment and the company is in discussions with a couple of others.
So, while the 29% fall in wealth management EBITDA was disappointing, there are signs that things should start to improve in the second half of the current financial year.
There were also some positive signs in the result, although they mostly have a bittersweet element.
The first of these is that losses in the international capital markets business shrank to just $0.9m in the second half, from $3.6m in the first, due to cost-cutting and refocusing of this business following the change in management. The Australian capital markets business also enjoyed a strong result, with EBITDA rising 51% to $5.9m, thanks to higher than expected retail equity trading and a pick-up in project activity.
The relative lack of services revenue during the year (due to the project delays) also means that recurring revenue increased to 65% of the total, up from about 58% in 2015 (see Chart 1). We’ll be hoping that percentage goes down again, and it almost certainly will when the Cofunds move gets into full swing, but in the meantime it does emphasise the company’s solid base of recurring revenue.
After the suggestion that R&D spending would move to around 12.5% compared to 10% in 2015, it in fact came to 15% in 2016 because the company took the opportunity to shift available capacity into this type of work. Again, we’ll be hoping this number drops as services work increases again. However, it’s valuable work (we trust) and good to take the opportunity to do it.
Also of note was the cash performance. The project delays caused a spike in work-in-progress and debtors in the first half. This duly unwound in the second half to provide free cash flow of around 80% of EBITDA, compared to just 8% in the first half. As a result, net cash rose to $9.0m, from $4.5m in December, despite the payment of $3.7m in dividends in the second half.
Software can be a lumpy business and you have to take the rough with the smooth. The past year for GBST has certainly been pretty rough, but there is light at the end of the tunnel.
Adjusted earnings per share, after adding back amortisation charges, came to 19.9 cents in 2016. For the 2017 financial year we’d expect a gentle improvement (perhaps growth of 3–10%), loaded to the second half, with more rapid growth after that. Against that outlook, the stock’s multiple of 20 times 2016 looks attractive. BUY.
Disclosure: The author owns shares in GBST.