Monday, October 21, 2013

Lombard Risk Management - Enterprise Software

Lombard Risk Management (“LRM”) develops risk management and regulatory compliance software and licenses this software to financial institutions. 




Risk Management

The risk management business is long established and consists mainly of COLLINE, a collateral management product, and OBERON, an institutional trading software product. 

When banks and businesses lend to each other some kind of collateral is often required in order to reduce counter-party risk exposure. The types and varieties of collateral have become ever more complex over time. “COLLINE”, Lombard Risk’s 10 year old collateral management product, helps lenders keep track of these. COLLINE is licensed to about 50 financial institutions – including Northern Trust and Société Générale – and is probably the leading product in its niche. 

OBERON is software for processing, valuation and risk management of trades involving interest rate and inflation derivatives, currencies, and money market and fixed income securities. Its pedigree is longer than COLLINE's and dates back to 1996, is accordingly well-established. Mature enterprise software products tend to be characterized by stable revenue streams and high margins, and management reports that OBERON enjoys just that.

In any case, the Risk Management segment looks like this:




Regulatory Compliance

Regulatory Compliance is the segment that presents LRM with strong, sustained growth opportunities as the regulatory directives such as COREP & FINREP, Dodd-Frank, EMIR, Basel III's CRD IV and CRR, and so on, take hold in the immediate and medium terms. 

Needless to say, reporting requirements are about to become a great deal more complex and comprehensive than they were, and Excel and scratch paper will no longer cut it.


COREP: 10x times the data

LRM, already the leading provider of compliance and regulatory reporting software in the United Kingdom (and among foreign banks in the US), stands to benefit. 

That it stood to benefit was not so obvious in years past, at least to me: the very complexity of the reporting requirements may have led one to reasonably suspect that financial institutions would call in the Accentures and the Moody's Analytics of this world who would then sell their partners' or their own software solutions, leaving LRM out in the cold. It hasn't turned out that way: LRM is taking share and is signing up new clients at a fast clip. 

This is what the Compliance segment looks like:




Looks measly doesn't it? That's where the opportunity comes from.

LRM (along with most enterprise software companies) reports revenue on a percentage of completion basis and the finalization of the COREP/FINREP regulations was delayed by 9 months to January 1st 2014. Lombard Risk's fiscal year runs from March to March, so the revenue recognition from the clients won thus far will be mostly recognized in the second half of the year. 

The Big Picture

There is, at the same time, a great deal of operating leverage at work: ~75% of the company's current costs are fixed meaning that incremental revenue above, say, 9.5 to 10 million largely drops to the bottom line. This is what the operating leverage looks like on a consolidated basis: 




and this is what the consolidated income statement should more or less look like:



We know that the company is more than half way through its major software development program, so we can deduce that capitalized development expenditure will look like this:



and free cash flow will look something like this:



Management

It is clear that LRM's sweet spot is at the junction of risk and compliance and management is therefore in a tricky, game-theoretic spot. It would like to see itself as a consolidator in that specialty and is evidently averse to debt. It would therefore like a strong share price as  currency for so-called "tuck-in" acquisitions and it is perhaps this that has led them to talk up the value of the company -- not quite to the point of vulgarity but not far from it, either. 

In any case, I don't doubt that, in the final analysis, they could sell the company for two or three times its current valuation if they chose. (IDOX, after all, was spun out from LRM; they are no strangers to the M&A market). 

Value

LRM is worth more than its current market cap. Given its growth profile, 5 year contracts, and 95% client retention rate, 10x 2016 EBIT is probably at the low end of fair value, giving the shares a reasonable 100% to 150% upside.

Disclosure: I own some shares in LRM



13 comments:

TboneSam said...

Interesting find, as always, Red.

Any idea what the strange gap-down in the stock price was during 1-H this year?

red. said...

That was around the time that it sunk in that implementation of COREP was going to be delayed until January.

Mackie said...

Nice write up. I personally think the Accentures stay out in part due to institutional dynamics - regulatory consulting is not a sexy business and their partners would much rather focus on M&A, etc, leaving LRM a nice niche to fill.

Agree here the big part of the thesis is the takeover value. High product investment is masking intrinsic profitability and beyond this their cost structure has gotten out of hand. Could definetely see a competitor (FRS Global) or a PE firm coming in and taking out the fat .

You'd have to think Wisbey rides it out until the regultion wave peaks in ~2015 and sells out for sizeable premium.

red. said...

Thanks for the comment, Mackie.

I see three possible outcomes: (1) the FCF yield in 2015 forces the issue; (2) Wisbey sells inthe company 2015 or 2016; or (3) LRM uses its cash to acquire other businesses.

None are bad but the the last of these is the least desirable because were the stock may remain hostage to market sentiment.

About our first point, I'm not so sure. I've been stalking LRM for a couple of years and it was this sort of thing that pushed it to the bottom of my watchlist:
http://www.accenture.com/us-en/Pages/service-alliance-murex.aspx
(There's a lot more; that's just a teaser)

That worry is now moot, though, since once you're in, you're in and LRM has signed up enough clients on to support a generous run-rate FCF yield.

Mackie said...

Good point, it would be naive to think an anointed "hot sector" would go without competitors. I think the Societe Generale seleciton in 2011 was big for them in signaling to other large banks the legitamacy of their offerings.

My sense is they are bit more protected on the regulatory side of the business. The amount they have invested in hiring industry professionals, conducting webinars, etc to understand and make sense of these regulations would require a firm committment from a competitor wishing to go head-to-head with them.

Let us hope its (1) or (2) and no more strategic share placings..

red. said...

Yeah, I think people have underestimated just how tricky it has been to write learn the rules, code, educate, and market the product while the regulations have been all the while in flux. No mean feat and important because it was a first come first served kind of situation in the race for market share.

Ps. I agree with your caution wrt Dolan's e-discovery business & I thought your write-up best fit my own view on the opportunity.

Mackie said...

Yeah DM is an attractive opportunity and just the situation I look for but believe some people got carried away with it as usual.

These consulting firms can live and die with the workload from their clients and interpreting higher engagements as sustained growth can be dangerous IMO. One of my concerns I have not seen discussed yet is if BofA is their largest customer do we really believe the business Dolan is getting from them is at a sustainable level? I can't think of a firm in the world that has been party to more litigation and gov't investigations in the past 4 years..

Anonymous said...

Hi, How do you buy this? It is not on IB, and there is a huge spread on UK broker. Maybe fidelty?

thanks

red. said...

I use a UK account to buy these and other UK securities. The bid-ask spread shouldn't be greater than 5%. Fidelity has a UK affiliate so asking them about what's possible might prove productive.

László said...

What is happening to the stock price? Also, I am still in the process of learning about investing...I would be very thankful if you could tell me how to follow stock news. I know of yahoo finance, but often I still miss news since not everything is published there (as in the case of LRM potentially, since I did not find anything that would cause such a drop in the share price). Thanks in advance. Laszlo

red. said...

Hi Laszlo,

I set up RSS feeds and goole news alerts for the stocks that I'm interested in.

If a share price drops on above average volume, as with Lombard today, I also go to the company's investor relations website. to their twitter account and to http://www.investegate.co.uk/Index.aspx?searchtype=3&words=lrm to make sure I haven't missed anything.

LRM's fundamentals are driven by the finalization of the rules for banking reporting, so I do a search for that, too.

I did all that this morning, found nothing, and bought some more shares.

You should check for yourself, though.

SaneSaver said...

Hi Red,

How significant do you think the recent alliance with Broadridge is for selling Colline in North America?

There are a small number of Lombard investors on the UK site of ADVFN under the ticker: LRM. Maybe you could pop in and say hello.

Regards

Simon Gordon

red. said...

Hi Simon,

Broadridge is a pretty good distribution channel to have for Colline, esp in North America where Lombard Risk is a minnow and Broadridge is well known.

The market's disinterest in LRM's shares is somewhat puzzling.

I'll pop by though I doubt I'd have anything to add to what seems to me a compelling investment case.