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



27 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.

Toby said...

Many thanks for the write-up. I have a quick question about your FCF assumptions. 'Capitalised development' was until 2012 detracted from earnings, until they made a sudden change in their accounting practices. You assume it will drop off to almost 0 in 2016. I understand your reasoning, I wondered how sure you are of this, particularly because otherwise the company has shown no signs of being able to generate much cash, and thus seems far less attractive?

Thanks,

Toby

red. said...

Hi Toby,

Well, my thinking is as follows:

We're in the middle of a software upgrade cycle in order to satisfy the regulatory needs arising from the financial crisis.

After this, capex is simply maintenance work (fixing bugs, updating tweaks to the regulatory framework and so on)for the foreseeable period.I expect this maintenance work to be expensed rather than capitalized, and to not exceed a half million or so per year.

It is certainly possible that the company could use its FCF to pursue other niches via internal development or acquisition (which would complicate price discovery for the stock; more on that below), but I don't doubt that the current business is worth 3x the market cap in the M&A market.

Wisbey does well in highlighting the value of the business and does less well in assuring investors that he would allocate FCF to its best use.

At this share price, the best use of future FCF would be buybacks.

When he speaks in public, however, one does get the feeling that he wants the share price to go up so that he can issue more shares in order to pursue acquisitions.

And that, of course, sets up, if not a prisoner's dilemma, a bit of a conundrum. A stated intention to dilute cannot easily coexist with a wish that the share price go up.

Still, the shares are cheap, the business is stable, easy to understand, and as cash flow generative as one could wish for.

Eventually FCF will flow and the yield will be too high for the market to ignore.

I think it is the cheapest equity in the UK market.

Toby said...

Many thanks for your reply - it's really helpful to see your thinking. My only other worry would be revenues: have LRM only been able to charge higher prices because companies are upgrading to new models with new features, and once this upgrade is complete they'll expect a lower renewal cost? I think only about a half of revenues are recurring, so if this was the case it would be very damaging.

red. said...

Let's say that LRM's only business is the recurring subscription revenue, which is 8.6 million:

8.6 x 40% EBITDA margin less minimal capex less 24% tax = 2.6 million in earnings. Capitalized at 15x = 40 million which is above the current market cap.

There's an Analyst Reports section at LRM's IR page which is quite useful

Uk Value Investment said...

Hello Red.

I previously took a look at Lombard but discarded quite quickly because of their capitalised development costs leading to lack of FCF, as well as their repeated equity issuances. Having read this thread, I will take another look.

Have they explicitly said that development costs will drop?

Also, have you ever taken a look at Statpro? I wouldn't buy it today, but it could be a fantastic business if their cloud based business takes off.

red. said...

Hi

If it's a small B2B or B2G siftware business listed in the UK (or Europe), I've spent time on it. Statpro is fine and I suppose it will be good value one day.

"Have they explicitly said that development costs will drop?"
Yes and no. Development costs for current products? Yes. On the other hand they haven't said -- on way or another -- whether there will be other novel products in the future.


I think the trick to this stock is to take a step back & think about the nature of the business first and the accounting checklist second. The checklist approach may benefit from some context.

john said...

Hi red, how do you interpret this:

For the years 2015 to 2019 no new business is forecast with retention levels of recurring revenues averaging 90% per annum. In view of this, no sales and marketing or research and development costs are forecast for the years 2015 to 2019.

this also means lower capex right (which is Research and development). Not sure how high marketing is.

red. said...

Hi John,

That's a detailing of the assumptions used in testing the value of the goodwill on the balance sheet. It is likely to be as conservative as the auditors require and is therefore unlikely to reflect any optimism future growth potential.

Australian small-cap companies said...

Nice commentary Red. I am starting to put together a few blogs on a couple of UK micro - caps with Lombard Risk Management and Sanderson plc my picks. Do you believe the Lombard Risk CFO getting boned earlier in 2014 suggests something negative is happening on the coal face. The recent (2013) executive selling of the stock, and the lack of free cash flow slightly spooks me. There is a degree of trust required here and I don't quite get the right vibe from the Chairman and CEO. Am I worrying too much here?

red. said...

I think you're right in that the success or failure of this investment will turn on what Wisbey does with FCF in 2015/6. I don't worry too much about stock sales but I do worry about the lack of clarity on his future intentions for the business.

The past record implies (to me) that he'll sell/spin the risk/regulatory business and use some part of the receipts to build another.

But who knows?

demo said...

Hello Red,

I see you have halved your position here. Have you became less confident on growth following results or a case of better opportunities elsewhere?

red. said...

Seeking a better balance for the portfolio. Was hoping that we'd get some recognition in the aftermath of Finals but looks like we'll have to wait a few months.

Australian small-cap companies said...

Red,
Upon re-reading this work which is a excellent piece of research, my only real issue is the R&D at 10% of revenue in 2016, with zero R&D being capitalized in the same year. The net 2.4 million spend feels too low for an enterprise software company. I personally believe 20% technology spend as a percentage of sales is more likely for an enterprise software company. Have you bounced your 10% off management?

red. said...

Well, if you look at Idox, for example, or First Derivatives, R&D spend is 8.8% and 12.4% of revenues respectively. 20% sounds okay in the middle of a refresh cycle but I can't see it in the harvesting period. But no, I haven't asked management about it.