Description

Overview

Alfa Financial is a May-2017 Fintech IPO on the LSE. The market cap is £495m but the Chairman and CEO own 66% and ADV is <£1m. The valuation at current levels provides some downside protection but there is high customer concentration and an implicit dependence on top-line growth to generate a return. For these reasons Alfa may be best suited as a PA idea.

The company makes Alfa Systems, an end-to-end asset finance platform serving the automotive and equipment financing companies. Alfa replaces either internal solutions or ERP modules and offers comprehensive software for point-of-sale, origination, contract management, wholesaling and servicing across global geographies.

Alfa has existed for 28 years but its current offering was developed in 2008. Over the last decade it has targeted the ~150 Tier I-II companies that manage >2/3 of global asset financing, and today has 32 customers in 26 countries. These include traditional financing companies (BoA, Barclays, SocGen, etc.), OEM lenders (Mercedes-Benz, Toyota, Siemens, etc.), and specialist independents (Motability, Uber’s former leasing subsidiary, etc.). These are long-term relationships. The company claims to have only lost customers who exited the industry.

Recent news has caused concern that revenue growth is at risk, triggering a derating as some FY18 revenue was pushed into FY19. While not objectively cheap, trading at 10x 2020 EBIT and a 7.5% FCF yield, the shares appear undervalued. Alfa has a net cash balance sheet, >40% EBIT margins and a normalized 100% cash conversion. Top-line growth is strong but from a small base, and customer concentration makes future profit warnings a real risk. This problem shrinks with time, however, and the product appears to be best-in-class, serving a structurally attractive market. At 20x EBIT the shares would trade 70% higher but remain below Alfa’s peak multiples and current comp valuations.

The Situation

Shares in Alfa are -62% from its IPO and -70% from its Dec-17 peak. This is primarily due to a profit warning issued on June 1st. In it, management reduced FY18 revenue guidance from £92m to £71-75m. Three causes for this revision were disclosed:

1. A major customer delayed their mid-progress implementation after finding issues in their legacy systems that forced a delay. Alfa staff on the project went from 40 to 2 and the project is expected to resume sometime in 2019.
2. A pipeline customer positively received a proof-of-concept proposal from Alfa and subsequently asked the scope be expanded into 2 additional geographies. This makes it a larger project but delays the launch date.
3. An existing customer with one European implementation that began in March-18 has delayed the US implementation into 2019.

Of these three issues, the first appears to truly be a customer problem unrelated to Alfa. The customer has already spent >$50m on the Alfa implementation and the legacy issues only further validate the need for this upgrade. The second is good news but causes delays, and the third is frustrating but again appears to be just a delay. Obviously in each case there remains a risk that the customer could cancel entirely, but this appears unlikely. These issues speak to the bigger risk at Alfa of customer concentration. Alfa needs 2-3 new implementations annually to maintain growth. Even a single large project delay is enough to cause a profit warning.

Business Overview

In 2017 Alfa generated £88m in revenue and £34m in operating profit (38% margin). The firm has consistently earned >45% EBIT margins, although 2018 will likely be lower due to the three delayed implementation projects. Note that 2016-17 saw large one-time IPO-related expenses (stock comp and listing fees) that account for the adjusted figures.

Alfa generates revenue in the three ways you’d expect from an ERP company: implementation, maintenance and ongoing development.

Implementation is 51% of revenue. This will decline over time but not quickly. Projects take 1-5 years to implement and typically generate £18m in revenue over 3 years, with the biggest generating >£50m over 5 years. I’ve asked and still don’t entirely understand why implementation is so time consuming. The explanation is basically that (a) legacy systems are extremely complicated and (b) as a mission-critical platform the transition must be seamless. Licenses are charged based on geography and # of seats. Implementation is charged as an average £1,350 day-rate per staff. Projects have 5-10 or up to 50 people staffed at a time. Alfa’s total headcount is 330 and up until the recent profit warning management were talking about hiring an addition 100 people. Payroll is their biggest expense and maintaining staff utilization for this day-rate model is critical. The operating leverage here isn’t great. In the future the potential for partnering with implementors like Capgemini exists, but this isn’t currently used.

Maintenance is 24% of revenue. It is contractually required and includes annual price increases that are typically CPI + 2%. Over time maintenance revenue should grow to >50% of total revenue.

Finally 25% of revenue is from Ongoing Development & Services (ODS). This includes post-implementation feature-enhancements. Large clients will have Alfa staff full-time on site providing not only maintenance but also a constant stream of ODS projects. As Alfa strategically focuses on smaller Tier III-IV clients the role of ODS is expected to grow as more customers buy an off-the-shelf software package and then tweak it later.

The product is currently sold as a license but the potential for SaaS sales exists. The product is entirely web-delivered (Java product built from the ground-up in 2008-10) and can be hosted on-site or in the cloud. As Alfa starts to target Tier III-IV customers it’s likely that a lite version of the platform will be offered as a cloud-hosted SaaS solution. Mgmt point to TCV (Total Contracted Value) to try and highlight the high proportion of “recurring” revenue, but this figure is slightly misleading due to initial 3-year maintenance contracts. On an annual basis Maintenance is only ~25% of income.

In 2017 the top customer was 23% of revenue and the top 3 customers were 43% (vs. 52% in 2016). There are 150 Tier I-II asset finance companies globally that Alfa has historically targeted. Customer concentration will decline over time as one to three new Tier I-II customers are added annually and as Alfa expands its product offering to Tier III-IV customers. This won’t happen overnight, and meanwhile customer concentration means that a single big customer delay can cause a profit warning, as occurred in June.

End-markets served by Alfa are 50% passenger cars, 30% commercial vehicles, 15% heavy equipment and 15% IT infrastructure (data centers, satellites, etc.). This is in-line with the global $1trn/yr asset finance industry.

As you’d expect the business is capital light. Capex is 0.5% of sales and working capital is ~3% of sales. Growth of maintenance and any SaaS revenue will further improve NWC. Implementation revenue is collected up-front and recognized during the course of the project, as per IFRS 15.

The competitive landscape includes IDS (International Decision Systems), White Clarke Group, First Derivatives, Temenos, and Fiserv. IDS is the largest US player and was taken private by mgmt in 2003. The table below from Alfa summarizes their view of competitor offerings:

Alfa earns a higher margin than peers. It is considered a premium product with a premium price. Management say they are typically a final 2 candidate for any RFP and when they lose it is on price, which they are comfortable with. Many competitors are region-specific and/or provide only select functionality. Alfa operates globally and provides comprehensive functionality.

Valuation

Shares are not obviously cheap, but I’d argue are sufficiently de-risked to offer an attractive risk/reward profile. Looking out two years and assuming the three delayed implementations get done, 2020 EBIT will return to 2017 levels. On these figures shares currently trade at 15x P/E, 10x EBIT and 4.5x sales, with a 7.5% FCF yield. This does not take into account any new client wins.

As a high growth company with >40% EBIT margins and a best-in-class product serving a structurally attractive end-market (asset financing), 20x EBIT is plausible. If Alfa traded at 20x then it is worth 280p/share, a 70% return from current levels. A 20x EBIT multiple translates into a 28x P/E, 8x revenue and ~3% FCF yield. This is below Alfa’s 2017 peak, which I won’t defend, but is in-line or a discount to specialist software comps. Given Alfa’s customer concentration a discount appears warranted. Again this ignores new customer wins, which are likely.

The best pure-play comps are White Clarke and IDS, both private. Other comps tend to be larger businesses with divisions that overlap with Alfa. Fiserv, a major US player in this space, trades at 20x EBIT but is much more exposed to the payments space. Temenos trades at 50x P/E, 40x EBIT and 15x sales with a lsd FCF yield.

Acknowledging that >50% of Alfa’s revenue comes from implementation, arguably software implementers are a viable comp. Capgemini trades at 18x P/E, 13x EBIT with lsd revenue growth, ~10% EBIT margins, msd single digit FCF yields and a small net debt balance.

The path to 280p/share for Alfa seems straightforward. There is an implicit assumption that this “perfect storm” of 3 project delays was a one-time event. Any progress on these 3 delays and/or new contract wins will support the long-term thesis. Alfa is a business with the potential for >10% topline growth that earns >40% EBIT margins and can convert all of those earnings into FCF. It has a net cash balance sheet that will grow to 20% of the market cap over the next two years, with the potential for special dividends (buybacks unlikely due to the limited float). It has a customer concentration problem that goes away slowly with time and it has a plausible strategic goal of expanding the TAM to serve smaller clients with higher-margin SaaS solutions. It doesn’t hurt that the founder/chairman + CEO own 66% of the shares and are highly incented to improve the valuation.

Risks

Risks include additional implementation delays or outright customer cancellations, both of which are symptoms of Alfa’s high customer concentration. Also the global automotive cycle is closer to the top than the bottom and this would indirectly hurt Alfa. Revenue is unrelated to leasing volumes but implementing Alfa is a large capex investment by customers and if their sales are depressed they may delay this sort of spending. Competition is always a threat but again Alfa appears well positioned with a best-in-class product that benefits from the accumulated “IP” gained from every implementation they conduct. New entrants would need to acquire their way into this space. As a global company with HQ costs in GBP and implementation costs mostly in local currencies, Alfa benefits from a weak sterling.

At 160p and 10x EBIT the downside seems limited and the upside potential is clear. On a 2 year timeline Alfa will need to continue winning 1-2 new customers annually to reduce customer concentration and grow the maintenance revenue. While lumpy, their past performance shows it is possible.

Alfa reports interim results on September 4th. I’m not suggesting timing the stock, but would expect a no-news update to be received positively. I’d view negative news such as additional delays or guidance reduction as a buying opportunity.

Catalyst

- any positive news relating to 3 delayed implementation projects

- any new customer wins

- a special dividend announcement