Today, we want to introduce a company we found trough a stock screening process and which we found very interesting: The Vitec Software Group AB (STO:VIT-B) is a Swedish software designer specialized in comprehensive property and energy management systems for buildings, forecasting for energy companies (electricity, district heating and wind power), management systems for realtors and media distribution. Merely a warning in advance: historical annual reports are published exclusively in Swedish language, but the company has started to publish reports in English as well. That might also be the reason international investors start paying attention. We were already able to realize modest gains (we invested at about 135 SEK) but think there is still an upside. Some of you might remember that we pitched the idea in February at the EBS talk. Here is the full story.
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Data: Bloomberg and own calculations, Website: http://www.vitecsoftware.com/en/
Live Stock Chart:
This is an overview of the corporate segments as offered by the company:
We have also put together the revenue split by region and product. Clearly, the property management and real estate agent software make up the largest portion. It is also clear that Scandinavia is and will be the main market. The exception would be the energy business which is quite generic and is therefore, at the time, used in all parts of Europe. Again, this only accounts for less than one percent of overall revenue.
1985 – The company is founded by Olov Sandberg and Lars Stenlund when they were researchers at the University of Umeå and is run as a sideline project.
1989 – Both founders leave the university to focus on the business. Operations are scaled up and external members join the board.
1992 – Revenues start to grow by 30% per year, part of the company is issued publicly at 10 million SEK.
1997 – Growth reaches 50, 57 and finally 86% in the year 2000.
2002 – The company is able to maintain its turnover and still improves results during the IT bubble burst. The first dividend is payed out.
2003 – Vitec makes larger acquisitions and is still able to grow 25% per year with an operating margin of 12%.
2009 – Operating margin increases to 15%. More prominent acquisitions are made in Scandinavia.
2011 – Vitec is listed on the Nordic Stock Exchange NASDAQ OMX.
2012 – 3L Systems is purchased entirely.
2013 – Acute FDS OY is taken over.
2014 – Autodata Norge AS and Aloc A/S are bought.
2015 – Vitec announces the acquisition of Fox Publish and Adservice AB.
Vitec’s business is based on developing and acquiring absolute niche market companies. The strategy is in most cases building up market share in areas that larger players are not willing to attack because of the limitations of the markets (few hundred to a couple thousand customers). Still, Vitec’s market share is estimated to be between 50% and 75%, except for the media business. Not only is it trying to fully penetrate the markets it operates in, its acquisition philosophy is also focused on spotting strong customer bases for new products. When it comes to technical shifts, it is obvious that there needs to be constant development in order to maintain the advantage of the reputation.
Vitec operates in a B2B market. Its customer base includes large banks as Nordea and Swedbank, but also small businesses with only a few employees. In most cases, the products are complex and its functionality is critical for the customers. On the other hand, the licenses do not make up more than 1% of the total cost in many cases. Switching would be very costly and complicated. Furthermore, the management told us that competition in the very segments would often lack structured processes, thereby failing to build sophisticated products, while large software companies would have no incentive to attack the small markets. ‘Stickiness’ is created by the ‘little price big pain’ feature that we have often talked about before. New customers are often acquired when they decide to switch from an old system and are looking for a new solution. Vitec is at least known as a (if not THE) brand in all the segments it operates in in the Scandinavian room. It avoids experiments when looking at new targets, but seeks to build on and improve successful structures.
The company officially declares a huge share of about 75% of overall sales to be recurring revenues. Although that would be an intuitive way to look at it, it could be easily misleading. As matter of a fact, one of the most significant assets of the company is the customer base. That is also what the company strategically looks for when making acquisition decisions. But it would be careless to assume that these customers will always stick with the product, as they would to their favourite ketchup brand. While the products of Vitec do in fact bear high switching costs, they also have to be redeveloped continuously. This means that the business is not as simple as handing out new licenses every year. Effectively, they develop new software for an existing (and growing) customer base every few years. Not a single product is older than five years which seems realistic due to technical shifts. (Ten years ago, two years before the first iPhone, nobody would have assumed that real estate brokers would be able to manage their business on a small screen of a phone or a tablet on the go.) This also means the risk of failure to adapt to new platforms and operating systems as technical shifts occur.
During the acquisition process, Vitec needs to find a way to evaluate potential targets. This is done by integrating own employees into the routine of target companies and demanding custom continuous performance reports. The general policy is to acquire at 5 to 7 times EV/EBITDA and at margins of 8-12%. Over the course of 3 to 5 years, this is brought down to 2 to 3 times EV/EBITDA. Usually the target staff is kept and in the case the management is leaving, it is replaced with insiders from Vitec. Then operations are refined and strategic focus is established. In part, there are increased short term costs during restructuring, but in the long term, EBIT margins in the range of 30% can be expected. Vitec is mainly looking at targets in the Nordic countries that have usually been on the market for 15 to 20 years and have a customer base. Building new software from scratch is considered too expensive.
Competition and Moat
Vitec’s competitors are either small, less organized specialists or large software firms that would have sufficient financial fire power but that are not interested in entering small markets. In the real estate sector, the Norwegian Webtop is a competitor. In the real estate business, Momentum Software AB operates building maintenance, building management and enery management services. In the financial sector, there are no real threats from competitors. In the health sector, there is also fairly small competition in the sector, since it does not include the big hospitals; it is rather a small service industry. The business of Vitec-acquired AutoData includes selling car parts from large shops and repair stations; many car part producers use their own web space. In Norway, AutoData operates as a much more centralized shop than in other countries. For energy, which is at the time the only Europe-wide sold product, there are many small competitors. Software giants as SAP have not shown interest in entering the competition due to the reasons mentioned before.
Key Industry Drivers, Economics
The industry is fuelled by continuing digitalisation of all sectors of private and public life, especially the need for mobile accessibility (broker, real estate) and the technological arms race in trading (energy). The demand for mobile solutions in the Nordic countries should grow at least moderately. We see a positive trend for demand for all sectors of the company. One could assume the brokerage and property systems are subject to the housing market. Even during the subprime crisis Vitec’s license business has proven to be very stable. Energy trading could be affected by a general trend towards more sustainable energy production, thereby boosting sales for the energy solution. The ‘comparatively little cost’, ‘high switching cost’ and ‘cruciality’ features protect the software business from market downturns.
Cyclicality, Exposure to Recession
Macro-economically, Vitec operates in a really stable environment. Sweden and Norway rely on the Swedish Crown and Norwegian Crown, respectively and only Finland is a Euro-zone member (5% of Vitec’s business). So we are optimistic in that aspect. You also have to consider how elegantly Vitec has survived the IT bubble burst and the financial crisis. Here, you can see how the company profits from high switching costs that bind customers even in economically difficult situations, as they are so reliant on the product.
Management and Governance
The founders that have led the company through all the years are still in charge of the company. The CEO Lars Stenlund owns 7.30% of capital and 28.30% of voting rights. Olov Sandberg, the Vice President and IRO owns 6.70% of capital and 28.10% of voting rights. We are highly in favour of the participation of the founders. To us, they made a very positive impression. The ownership structure looks like this (röster are voting rights, kapital is the capital share):
Vitec acquired Infoeasy AS in Norway (21.8 m NOK sales), an industry-specific software company for the automotive industry, Datamann A/S (29.5 m DKK sales), a Danish software maker for the car industry, after signing a 250 m SEK revolving credit facility for acquisitions from the bank Nordea over four years. Thereby the company has bought additional sales of about 60 m SEK. In February, they had bought Fox Publish, a Norwegian software maker with a Swedish sister, Adservice AB (28 m SEK sales total). Overallj, the company has more that met our growth expectations for this year.
Let’s start with the overall profitability measures:
It is easily observable that the full year results were great news also for shareholders as the stock price jumped from 134 SEK to about 205 SEK. For FY2014, we end up with a record 10% net profit margin and a 20% return on tangible capital employed based on NOPAT. The crucial question is whether Vitec will be able to continue performance on this level in the long term, i.e. whether it will find suitable targets. At the time, we are as optimistic as the management that this will be the case. In Q1 it has proven its ability to find attractive targets and we think it will continue to do so. These are the segment profitability numbers:
The trailing 10 year average growth for Vitec is about 25.2%. To account for the business model of constant re-development of software, we try to implement the usual cycle by estimating 20% continued growth for four years and a somewhat conservative 15% from thereon, which takes us to expected earnings of about 590 mSEK for 2015 (computing with recent acquisitions, it has proven to be a quite realistic estimate). We look at a 12.9% historical EBITA-of-Sales. However, last years EBITA was 18.4% and according to our estimates a sustainable 25% ratio is more than reasonable. In our approach we use the Earnings Power Value net of financial debt, which we derive with the help of discount rate of 11%. Using these numbers we arrive at a value well above the current share price. As we said, we made our buy decision at a much lower price, but given the moat of the company, it still seems very attractive to us.
In our view, Vitec Software Group AB is a wonderful company at a more than fair price. We were able to realize some significant gains already, but think there is some upside left. The company learned to invest in absolute niche companies with great skill and successfully improves long-term efficiency. It uses economies of scope and high switching costs. The current developments indicate they will succeed our sales expectations for 2015. We think that the management should be able to continue its success in the coming years and we are not skeptical about a long-term investment.
Disclosure: LONG Vitec Software Group AB