Inside the wire THE CITADEL GROUP (CGL) 14 June Key points. Risks and catalysts

Transcription

1 Initiating coverage 14 June 2016 THE CITADEL GROUP (CGL) Inside the wire We are resuming research coverage of The Citadel Group (CGL) with a BUY rating and a new price target of $6.25 per share. The company is evolving rapidly into a premium provider of professional and managed service applications across nationally important and sensitive verticals such as defence, education and healthcare. Our investment thesis is that Citadel s stock can re-rate by as many as 2.0x EV/EBITDA points over the next months, on the basis of higher earnings quality from Technology and as investors buy into Citadel s deeper, architectural play in Australian e-health integration. With this note we transfer research coverage to Dr Shane Storey. Key points Resuming coverage on Citadel. We are bullish on a re-rating for Citadel, heading into FY17. The company s managed service model should generate consistent, double-digit growth in earnings, featuring a growing proportion of recurring business, largely organic in nature, coupled with margin expansion and accretive acquisitions over the forecast period. Encompassing a wider e-health offering. Citadel s experience across other domains of national significance (defence, security) is potentially relevant to seeking a position in the development and implementation of Australia s e-health architecture. National e-health integration faces short-term structural barriers in Australia, creating opportunities for Citadel to work with state health departments, most of which have embarked on independent e-health strategies. In the shorter term, we assess opportunities to grow the Citadel Health business organically in public and private pathology. Forecasts. We are forecasting approximately 21% normalised EPS growth in FY16 and 52% growth in FY17, noting the recent acquisition of Kapish and the consolidation of Citadel s 50% ownership of filosoph-e. We are forecasting 40% EBITDA growth next year but see potential upside from organic initiatives. Valuation. Our 12-month price target of $6.25 per share is derived from our discounted cash flow valuation. The price target implies 21.4x FY17e EPS and 9.5x FY17e EV/EBITDA which are higher multiples than have been applied to the stock during its short trading history. We analyse the apparent discount and the conditions precedent for re-rating. Risks and catalysts Catalysts: a) reported revenue growth; b) evidence of margin expansion; c) new contract wins and/or renewals; d) accretive acquisitions. Risks: a) loss of key contracts; b) reduced volume through changes to vocational education and training funding; c) loss of key management; d) technology obsolescence; e) competition. 12-mth target price (AUD) $6.25 Share 10-Jun-16 (AUD) $5.15 Forecast 12-mth capital return 21.4% Forecast 12-mth dividend yield 2.5% 12-mth total shareholder return 23.8% Market cap $241m Enterprise value $216m Shares on issue Sold short ASX 300 weight Median turnover/day Shane Storey shane.storey@wilsonhtm.com.au Tel $ mth share price performance CGL XSI Rebased 47m n/a $0.0m 3.20 May-15 Sep-15 Jan-16 May-16 1-mth 6-mth 12-mth Abs return (%) Rel return (%) Year-end June (AUD) FY14A FY15A FY16F FY17F FY18F NPAT rep ($m) NPAT norm ($m) Consensus NPAT ($m) EPS norm (cps) EPS growth (%) P/E norm (x) EV/EBITDA (x) FCF yield (%) DPS (cps) Dividend yield (%) Franking (%) Source: Company data, WHTM estimates, S&P Capital IQ KEY CHANGES 14-Jun NPAT: FY16F 9.0 norm FY17F 13.8 ($m) FY18F 17.0 EPS: FY16F 19.4 norm FY17F 29.5 (cps) FY18F 36.4 DPS: FY16F 10.0 (cps) FY17F 13.5 FY18F 16.5 Price target: 6.25 Rating: BUY Wilson HTM Equities Research Issued by Wilson HTM Ltd (Wilson HTM) ABN Australian Financial Services Licence No , a participant of ASX Group and should be read in conjunction with the disclosures and disclaimer in this report. Important disclosures regarding companies that are subject of this report and an explanation of recommendations can be found at the end of this document.

2 PRICE TARGET Valuation WACC (%) 11.3 Tg (%) 2.6 NPV fcst FCF 56.9 NPV perpetuity Net debt/(cash) 16.8 Valuation ($m) Price target DCF ($/share) 6.25 KEY ASSUMPTIONS Year-end June (AUD) FY13A FY14A FY15A FY16F FY17F FY18F FY19F FY20F Revenue growth (%) EBIT growth (%) NPAT growth (%) EPS growth (%) EBIT/sales (%) Tax rate (%) ROA (%) ROE (%) Price target ($/share) 6.25 INTERIMS ($m) Half-year (AUD) Dec 14 Jun 15 Dec 15 Jun 16 1HA 2HA 1HA 2HE Sales revenue EBITDA EBIT Net profit Norm EPS EBIT/sales (%) Dividend (c) Franking (%) FINANCIAL STABILITY Year-end June (AUD) FY15A FY16F FY17F Net debt Net debt/equity (%) <0 <0 <0 Net debt/ev (%) <0 <0 <0 Current ratio (x) Interest cover (x) < Adj cash int cover (x) < Debt/cash flow (x) Net debt (cash)/share ($) <0 <0 <0 NTA/share ($) Book value/share ($) Payout ratio (%) Adj payout ratio (%) EPS RECONCILIATION ($m) FY15A FY16F Rep Norm Rep Norm Sales revenue EBIT Net profit Notional earn Pref/conv div Profit for EPS Diluted shrs (m) Diluted EPS (c) RETURNS FY15A FY16F FY17F FY18F ROE (%) ROIC (%) Incremental ROE Incremental ROIC PROFIT AND LOSS ($m) Year-end June (AUD) FY13A FY14A FY15A FY16F FY17F FY18F FY19F FY20F Sales revenue EBITDA Depn & amort EBIT Net interest expense Tax Minorities/pref divs Equity accounted NPAT Net profit (pre-sig items) Abns/exts/signif Reported net profit CASH FLOW ($m) Year-end June (AUD) FY13A FY14A FY15A FY16F FY17F FY18F FY19F FY20F EBITDA Interest & tax Working cap/other Operating cash flow Maintenance capex Free cash flow Dividends paid Growth capex Invest/disposals Other inv flows Cash flow pre-financing Funded by equity Funded by debt Funded by cash BALANCE SHEET SUMMARY ($m) Year-end June (AUD) FY13A FY14A FY15A FY16F FY17F FY18F FY19F FY20F Cash Current receivables Current inventories Net PPE Investments Intangibles/capitalised Other Total assets Current payables Total debt Other liabilities Total liabilities Minorities/convertibles Shareholder equity Total funds employed Wilson HTM Equities Research 2

3 Table of contents Investment view... 4 Business overview... 5 Strategic initiatives and risks... 6 Valuation Wilson HTM Equities Research 3

4 Investment view We resume coverage of The Citadel Group (CGL) with a BUY rating and a new 12- month target price of $6.25 per share. With this note stock coverage is transferred to Dr Shane Storey. We resume research coverage on Citadel, noting the company s recent market update which described a new acquisition in knowledge management, new contract wins in law enforcement, an extension of its pathology contract term in NSW and new business opportunities in e-health. Our core thesis in resuming coverage, which is underpinned by an interactive scenario model (available for WHTM clients only), proposes that Citadel s stock can re-rate by as many as 2.0x EV/EBITDA valuation points heading into FY17 and FY18. While news flow on e-health will be important, we expect earnings quality to be the real driver of valuation gains. Notwithstanding the impact of recent acquisitions, the effect of recurring and incremental revenue, developed organically, should support margin gains and even earnings surprise in FY17e. Our $6.25 price target is set in line with our discounted cash flow valuation of Citadel shares. A snapshot of current investor sentiment on Citadel Citadel is trading at ~17.7x WHTMe FY17e EPS and 7.7x FY17e EV/EBITDA which suggests that investors are valuing the company as a vanilla IT contracting business with a flat bias towards future growth and margins. The market valuation reflects a 20% discount to the IT sector average. That contrasts sharply with our view and valuation (21.4x FY17e EPS and 9.5x FY17e EV/EBITDA), which recognises a premium for earnings quality and qualified support for Citadel s emerging e-health narrative. Analysing the apparent discount, it has two components, in our view: Proof that Citadel s differentiation translates to higher quality earnings. The market probably accepts Citadel s operational strengths but finds it difficult to price its somewhat esoteric opportunity set. Much of the work that Citadel bids on does not go to public tender and is therefore opaque to investment markets. While this is balanced by long contract tenure, a successful re-compete history and strong case studies, part of this discount may remain until Citadel delivers a string of financial results that differentiate its business from lesser peers on the basis of earnings quality. Market sees PJAS as a good acquisition but regards the broader e-health narrative as aspirational. Citadel s involvement in health pre-dates its PJA Solutions acquisition but is not as well recognised by investors. We think Citadel s experience across other domains of national significance (defence, security) is potentially relevant to seeking a leading position in the development and implementation of Australia s e-health architecture. National e-health integration faces short-term structural barriers in Australia, given the inherent complexity and inefficiencies associated with shared funding responsibilities between the Commonwealth and the states. States are pushing ahead regardless with their own e-health plans, which creates opportunities for Citadel to pursue contracts without the same competitive intensity that national schemes attract. Figure 1: Citadel s EV/EBITDA and PER trading multiples since 2014 IPO 11 EV / EBITDA 4y Average 21 P / E 4y Average Source: Bloomberg, WHTM Research Wilson HTM Equities Research 4

5 Business overview Introduction The Citadel Group has built a business developing, marketing, implementing and supporting knowledge management and other enterprise software systems. Citadel s core clients are typically those that seek to capture and manage sensitive data in complex environments such as defence, immigration, health, education and government. These are a key verticals over which Citadel today demonstrates singular expertise and trusted credentials on both national security and personal privacy grounds. In most of its important markets, Citadel inhabits and exploits a potentially lucrative middle ground between multinational developers and consultancies that maintain an Australian presence and a fragmented array of privately held SMEs. These projects often create opportunities for long-term incumbency as a managed service provider, with relatively infrequent market re-testing and lower price consciousness. Citadel differentiates itself from other enterprise systems/software developers by providing an end-to-end service which starts by assisting clients define the desired application through consultation, to the development and implementation of a proprietary system or platform. Citadel s business model offers clients a complete solution, managed by one company. Citadel s position as trusted incumbent often provides follow-on work as the client and applications themselves evolve. Technology (Managed Services) Citadel s Technology segment provides services predominantly under long-term contracts in complex and sensitive environments, such as secure communications, knowledge management, enterprise content management, and e-health information and integration. Clients include all levels of government in Australia including associated departments and agencies. Other clients include Australian universities, Lockheed Martin Australia, Tatts Group, Leighton Holdings and a leading Australian telecommunications company. Technology provides 92% of our forecast FY17e EBITDA. Education Citadel s education business Australian Business Academy (ABA) is a registered training organisation (RTO) and an accredited VET FEE-HELP and Commonwealth Register of Institutions and Courses for Overseas Students (CRICOS) provider. Citadel s business is a high quality operator, distinguished from many of the troubled RTOs through client quality (white collar students) and results. ABA generates revenue by charging students a fixed price for courses delivered over a month period. Citadel receives no direct government subsidies for the education services it delivers, but students can receive loans under the federal government VET FEE-HELP scheme. Education contributes 8% of forecast group EBITDA in FY17e. Table 1: Earnings summary for Citadel FY14a FY15a FY16e FY17e FY18e REVENUE ($m) grow th n/a 45.9% 29.6% 30.6% 4.7% EBITDA ($m) grow th n/a 75.1% 103.7% 41.8% 9.6% - margin 11.7% 14.0% 22.1% 23.9% 25.0% EPS (cps) grow th n/a 29.1% 20.9% 52.5% 23.2% DPS (cps) grow th n/a -71.0% 72.4% 35.0% 22.2% Source: WHTM Research Wilson HTM Equities Research 5

6 Strategic initiatives and risks The strategic opportunity that attracts The Citadel Group is that of creating a successful, nimble next generation systems developer which can win meaningful pieces of business in Australia, often at the expense of international players. Its competitor set differs by vertical but we immediately observe Cerner, Meditech, GE, Siemens and Epic in Australian healthcare, with Fujitsu, CSC, Capgemini, Lockheed Martin, Accenture, IBM and even Microsoft featuring in other theatres. The company s technical prowess, from development and project management perspectives, does appear strong enough to support the vision evidenced by having successfully delivered large-scale, complex projects over more than two decades. Yet a significant part of Citadel s domestic prospects will ultimately depend on how multinational players choose to address the Australian technology markets. Globally, many of Citadel s large competitors are themselves in transition, facing declines in licensing fee growth and feeling margin pressure as their solutions become dependent on must have, disruptive, third party pieces of equipment, developed by the sector s many new innovators. A redirection back to protecting core markets may cause their commitment to Australia to waver, favouring high quality domestic players including Citadel. In specific areas such as healthcare IT (HCIT), product offerings developed abroad may not suit the domestic setting without significant retro-fitting, limiting operability and initiating renewed scrutiny around price. Technology strategies (general) House disparate intellectual property (IP) generation under the one roof. Increasingly, Citadel has centralised the management and deployment of its IP across the various development houses it operates. Source code and other IP generated in one vertical are often leveraged into solutions in adjacent areas. An example is the Royal Adelaide Hospital project which leveraged unified communications technology originally developed in defence projects. Knowledge transfer from client projects is subsidised R&D funding. New IP or improvements to existing IP developed in the course of working with clients remains the property of Citadel and can be exploited in other fields. Knowledge transfer to clients is limited by licence agreements. Figure 2: Citadel leverages three core offerings across five broad verticals with increasing cohesion Source: Citadel Wilson HTM Equities Research 6

7 Target business where price is a lower ranking selection criterion. Ideal projects tend to deal with applications where the clients own public accountability risks are very high: national security, privacy protection, hospitals and healthcare. Citadel is often able to sustain its contract pricing in return for assuming a large portion of this accountability risk through wholly outsourced solutions. Thoughts on organic growth prospects in Technology: a) Closed networks. We understand that a proportion of defence and similar work does not go to public tender, but instead is offered to relatively closed supplier panels, of which Citadel is a member. b) Incumbency. Successful contract re-compete episodes often result in higher pricing for base services, extended scope of works and longer contract period extension options. Over the years, this phenomenon has increased the average contract length, which is now ~4.5 years across the top 10 contracts by value. c) Mission creep. Some contracts, particularly those relating to defence and security comprise activity-based, variable upside, which has tended to increase in value as the world s (and Australia s) global security risks have escalated. Similarly, applications evolve with the client over the project life, presenting opportunities to bolt on additional work in addition to the original base service deliverables. Business development objectives. Successful case histories are useful in accessing new projects and helping transfer skills across sectors. Citadel also often partners with other non-competitive contractors (construction companies, facilities managers) which may then select Citadel as their technology partner of choice. M&A outlook positive. We assess that there is ample supply of listed and unlisted SMEs that may make rational targets for Citadel in the future. The Australian HCIT industry is likely to throw up dozens of small companies over the next 5-10 years offering one-off pieces of technology. Given the increasingly narrow and shallow small/microcap equity capital markets in Australia, these companies may struggle to develop high public market valuations and thus be perpetually cheap. Citadel is in a strong financial position to acquire good technology assets in an accretive manner. Case study Kapish acquisition Citadel recently acquired software and services company Kapish. It was an attractive target because the business broadens Citadel s relevance in the managed service market relating to the capture, management and access to secure documents and records (electronic document records management services or EDRMS). Citadel s EDRMS credentials had previously been centred around the Objective enterprise content management (ECM) software, although not exclusively. Kapish has built much of its business around an alternative market-leading platform HP Trim from Hewlett Packard. Kapish has approximately 180 clients across local and state government clientele and expects to make $4m in EBITDA in FY17e. Citadel acquired Kapish for ~4.4x FY17e EBITDA. Under Citadel s stewardship, Kapish may be able to extend its presence in markets outside Victoria. Wilson HTM Equities Research 7

8 Citadel s strategy to grow its healthcare IT (HCIT) business The opportunity for HCIT is to increase patient safety and manage system costs through the capture and sharing of patient data. All developed world health sectors are under pressure to control cost growth. National healthcare systems are complex, but relatively lazy ecosystems. Rightly, governments and other payers (health insurance companies, patients) are targeting the inefficiency and waste in healthcare, such as unnecessary or duplicated medical tests (pathology, radiology), avoidable medical errors, non-compliance with treatment (wasted drug costs) and redundant layers of administration. Citadel believes that the HCIT opportunity in Australia is open to it, on the basis of its intellectual property and reputation, given that governments are the key prospective clients. Government health authorities are driving growth in HCIT worldwide, attracted by savings. The USA s Centres for Medicare and Medicaid Services (CMS), the Department of Health and Ageing in Australia (DoHA), the UK s National Health Service (NHS) and similar organisations agree that the best route to savings is to enable the sharing of patient medical records in a health information exchange (HIE). The US Office of the National Coordinator for Health IT estimates that savings from HIEs could total US$80bn. The Australian government has estimated A$7bn in annual savings are possible. Specific areas of short-term strategic focus for Citadel Health Retention and growth of Queensland Health business. Citadel Health is the incumbent provider of the Laboratory Information Management System (LIMS) that is used across pubic pathology in Queensland. Queensland Health is obligated to periodically retender this project, and media speculation earlier this year suggested that Queensland was contemplating a market re-test this year. Expanding Citadel s market share in the pathology LIMS market. Citadel recently announced a three-year contract renewal with Pathology North in NSW out to 2019 (with two one-year extension options). The company s recent incorporation of e-bloods provides new capabilities in blood inventory and supply chain management. E-Bloods was developed by Citadel s client, Pathology North, which is one of the five public pathology networks under NSW Health Pathology. The other regions are Pathology West, South Eastern Area Laboratory Services (SEALS), Sydney South West and Forensic & Analytical Sciences. Citadel is now able to act as the corporate sponsor for e-bloods, which is only one of two LIMS that are certified interfaces to operate with the National Blood Authority s BloodNet platform 1. Major competitor Cerner (LIMS supplier to Pathology West and Sydney South West) has commenced work on interfacing its Millennium PathNet system with BloodNet. It is unclear whether Integrated Software Solutions has plans to enable OMNI-Lab, which is the incumbent platform at SEALS. Figure 3: Citadel s e-bloods is a certified interface with the National Blood Authority s centralised system for managing blood and blood products Source: National Blood Authority, WHTM Research 1 The National Blood Authority (NBA) manages BloodNet, which is a web-based system used across Australia to order blood and blood products in a standardised way, securely. In March 2016, the NBA introduced a validation and certification process for Laboratory Information Systems (LIS) interfaces, which link into BloodNet, so as to avoid double-entry and improve security and guarantee of supply. Wilson HTM Equities Research 8

9 AUSLAB/AUSCARE/EVOLUTION technology R&D and product development. Various versions of this LIMS platform hold ~50% market share across Australian public pathology and continues to evolve. Cloud-enabling work and other enhancements are obviously transferrable elsewhere, potentially as a premium support offering as a platform as a service (PaaS). Other developments include: enabling foreign specimen labels to be used for electronically ordered specimens (Eastern Pathology in Victoria); integration between Citadel s software and HealthRFID s ControlPoint Solution (used to track products through supply chains); integration with My Health Record, which is Australia s only federally sponsored Electronic Health Record (HER) system, currently in development; and clinical management add-ons, possibly via big data analytics which could comprise both real-time decision-making support in hospitals and/or modules helping healthcare facilities or doctors better manage patients with chronic disease. Citadel s software has harvested more than 50m de-identified data points which the company believes it can monetise via AUSLAB/AUSCARE/EVOLUTION or other platforms. Access to private pathology market. Leading corporatised pathology operators such as Sonic Healthcare and Primary Health Care maintain internally developed, legacy LIMS which are unlikely to interface well with My Health Record or other systems. If national EHR integration does become an important federal agenda, then provider compliance could be mandated by government, given that more than 80% of their funding is derived from the Medicare Benefits Schedule. Researching entry into new markets. There is a vast amount of HCIT work ahead if Australia is to implement a world s best practice e-health integration strategy. The roadmap below from Deloitte s 2012 paper on national strategy illustrates the potential touchpoints that Citadel Health may evaluate and seek to participate in. Figure 4: Roadmap for e-health implementation in Australia Source: Deloitte Wilson HTM Equities Research 9

10 Assessing further opportunities in Australian HCIT implementation Nationally based HCIT implementation in Australia is not straightforward. The Australian healthcare system remains highly disjointed on the subject of embracing information technology to take better care of patients and control the cost of healthcare delivery. The key steps on the journey have included: National Electronic Health Transition Authority (NeHTA) established in 2005 to promote e-health initiatives and create standards for the healthcare sector to adopt; development of a National e-health Strategy in 2012; establishment of PCEHR (My Health Record) in 2012 universal platform for the storage and management of health information; review of PCEHR in 2014 established My Health Record as a central repository of data for general health and chronic disease management, with access currently limited; and NeHTA will transition to the Australian Digital Health Agency in July Australia does have a National e-health Strategy, but the complex and inefficient manner in which federal and state governments handle funding and accountability poses important barriers. Resistance may also come from primary healthcare providers themselves (GPs, specialists, pathology and radiology operators) who have a vested interest in preserving Australia s fee for service approach to medicine. Offshore, reimbursement trends have moved inexorably towards value-based payments, enabled by HCIT integration. Decentralised HCIT landscape favours smaller developers. Individual Australian states have responded to the idea of HCIT by developing their own e-health strategies. This decentralised decision-making significantly improves the competitive position for small companies such as Citadel, at least over the short to medium term. Our view is that the cost saving opportunities under HCIT are too compelling to ignore and that the Australian government will ultimately legislate further integration of HCIT. We see national HCIT implementation as a likely action item coming out of the system of healthcare reform processes currently under way. The Parliamentary inquiry into Chronic Disease Management reported in May The Medicare Benefits Schedule Review and the Private Health Insurance Review and investigations report this year and we expect both to highlight the role of HCIT in reform plans. In the longer term Citadel may seek new opportunities to participate in national HCIT integration projects. The nature of this work appears to fit well with Citadel s strengths, namely: Complex integration the creation of a unified, centrally consistent, national health dataset needs to combine federal government data (Medicare, the Pharmaceutical Benefits Scheme, Aged Care) with state government data (public hospitals and other settings) along with private healthcare service providers (hospitals, pathology, radiology), private physicians and allied health caregivers. Myriad data sources healthcare data exists in multiple sources, formats and quality. Multiple datasets of patient information exist with replication between providers, insurers and government. The potential to access that de-identified or secure member data, to supplement any consolidated government patient data, is a compelling reason to investigate sharing and consolidating data related to chronic disease and wider health status and outcomes. Analytics and decision support HCIT is meaningless unless it enables the planning of adequate care and measures treatment outcomes. Consolidating diverse data sets into a single, longitudinal patient record may yield insights into health trends and effectiveness of interventions undertaken. Inevitably, HCIT will allow government and insurers more precise analysis of which interventions are cost effective and which are not leading to value-based reimbursement. Wilson HTM Equities Research 10

11 Risks Citadel as a contracts business. Citadel s short-term earnings outlook does have a degree of concentration in that we understand that 80% of the FY17e revenue (excluding Kapish) is attached to the top 10 contracts. Citadel Health s contract with Queensland Health is the only major contract facing a market re-test in the short term. Outside that, there are no contract expiries or re-tests expected until the end of calendar year 2017 (1HFY18). Contracts may include provisions allowing the client to seek early termination (generally only in the event of a material breach of terms) to vary the scope of the work or seek other variations. Legislative and regulatory risks. While Citadel s Education draws no direct funding from government, the majority of its students rely on the federal VET FEE-HELP system. VET- FEE HELP is essentially a loan, provided to students studying for diploma level or higher qualifications. If the scheme were abolished or materially restricted, then it would impact enrolments for Citadel. If government were to seek savings from education in future years, we think it more likely to withdraw funding from directly subsidised schemes first, given that VET FEE-HELP is ultimately repaid by students. Elsewhere, Citadel does hold a variety of regulatory assets (licences, memberships and registrations), the loss of which would impact its ability to bid for or deliver services to government and other agencies. Technological obsolescence. The risk of Citadel s technologies being superseded by those of its competitors should be acknowledged. The pace and scope of international technology development is large, internationalised and very difficult to monitor and evaluate with reference to Citadel s core intellectual property. Although Citadel invests in its own technology, its R&D budget is very small, compared to those of international peers. Key people. Key management play an integral role in originating and negotiating contracts, in what is a relationship-oriented business. Unexpected changes in senior management could adversely impact Citadel s shareholders. Diverse competitive spheres. In Education, Citadel competes with other vocational education and training providers such as tertiary institutions, other registered training organisations and TAFEs. There are few if any ASX-listed peers of direct relevance. In Technology, the competitor set is global and wide-ranging. In sensitive areas such as defence, although competition is limited by panel membership, Citadel regularly encounters companies such as Fujitsu, CSC, Capgemini, BAE Systems and in previous years Lockheed Martin. In health, Cerner, IBM, Oracle, Orion et al have been active in Australia for many years. A relatively new player in e-health: Development versus acquiring a presence. HCIT is exceedingly complex and Citadel will be competing with companies that have spent decades in the industry. Even large companies such as IBM and Microsoft have tried and abandoned aspirations in HCIT. Citadel may have to acquire its way towards building critical mass in the short term, rather than develop capabilities internally. High risk makes for slow decision making. There are significant consequences if the software that runs healthcare systems breaks down. This tends to result in long sales cycles to implement new systems. It also makes it difficult to win new contracts by dislodging incumbents, with years between contracts falling due for market re-tests. Will ex-health case studies be convincing enough to jump the gap? Given the conservative nature of governments and other healthcare decision makers, there may be resistance in accepting Citadel s case studies developed in areas outside health. This may be a disadvantage when competing against pure-play HCIT companies with international credentials. Wilson HTM Equities Research 11

12 Financials FY16 earnings preview The Citadel Group s 1H result benefited from a few one-offs which likely overstated the Technology division s operating margin and introduced an unnatural 1H skew. Within the 2H result we are expecting Technology revenue to be flat on 1H, and to see further slippage in the Education business, where we understand that vocational education and training enrolments have been weaker. Our adjusted full-year EBITDA forecast of $20.7m would represent more than double the previous year s earnings. We are expecting Citadel to report 17% normalised EPS growth to 18.7cps and for the board to announce a final dividend of 5.2cps (10.0cps full year). Table 2: Short-term earnings summary and FY16e outlook INCOME STATEMENT FORECASTS FY15-16e Source: WHTM Research 1HFY15a 2HFY15a FY15a 1HFY16a 2HFY16e FY16e REVENUE Technology Education revenue growth (v pcp) 37% 53% 46% 59% 10% 30% Operating EBITDA Technology Education EBITDA growth (v pcp) 76% 55% 61% 211% 14% 135% EBITDA (WHTM adj.) growth 209% 102% 64% 270% 23% 104% - margin 11.3% 15.9% 14.0% 26.3% 17.9% 22.1% EBIT growth 287% 40% 77% 248% -11% 74% - margin 9.9% 14.1% 12.4% 21.7% 11.5% 16.6% Net interest 0.2 (0.0) 0.1 (1.5) (0.1) (1.6) PBT Tax Minorities NPAT EPS (cps) growth 48% 16% 29% 211% -33% 21% DPS (cps) Table 3: WHTM estimates versus consensus, FY16-18e Revenue ($m) FY16e FY17e FY18e WHTMe Consensus % variation 0.2% 0.3% -0.2% The Citadel Group is not widely covered by sell side research (n=2), so the value of consensus earnings is somewhat limited EBITDA ($m) WHTMe Consensus % variation -1.6% 2.8% 3.5% Normalised EPS (cps) WHTMe Consensus % variation 0.6% -4.7% -2.4% DPS (cps) WHTMe Consensus % variation 5.3% 0.0% -2.9% Source: IRESS, WHTM Research Wilson HTM Equities Research 12

13 FY17 outlook We provide some qualitative commentary on our forecasts. Clients are encouraged to obtain our interactive Citadel model to understand the quantitative detail behind the high level numbers published in this report. Clearly, the most significant contribution to FY17e earnings growth should come from the recent acquisition of Kapish (~$4m EBITDA) and from Citadel s increased equity interest in filosoph-e. Citadel will consolidate 100% of the revenue and EBITDA of that latter business from FY17, having recently moved to 50% ownership. Turning to the continuing businesses from FY16, we are forecasting further decline in Citadel s Education segment next year, but see that being more than offset by gains in Technology. At this stage we have not forecast anything new from the NRAH project, although the market understands that Citadel is pitching for a long-term managed service contract for that facility, alongside Spotless as the facility manager. Citadel s recent contract win with Monash University is a partial replacement for the NRAH earnings. Recently announced successes in defence, law enforcement and health combine to support 40% EBITDA growth in aggregate, after corporate costs in FY17e. Figure 5: Forecast FY16-17e EBITDA waterfall noting potential upside $35.0 $30.0 Other Health $29.3 $32.3 $25.0 $20.0 $20.7 Acquisitions $15.0 $10.0 $5.0 $0.0 FY16e Corporate Education Technology FY17e Upside FY17e* Source: WHTM Research Further ~$3m in EBITDA upside from various sources. We understand that Citadel is shortlisted for a number of new contracts that may manifest in the FY17 year. Further opportunities may also originate from within the current contract book, including: NRAH managed services we estimate a new base contract might generate between $2m and $4m in annual revenue at high margin, with higher value opportunities to periodically refresh the technology in the outer years. Upside from Kapish management has expressed an objective to grow Kapish in the NSW and Queensland markets and explore a deeper partnership with Hewlett Packard Enterprise (HPE). Upside from change in filosoph-e ownership structure we understand that this company s focus is likely to be broadened considerably now from its historical concentration around defence. Incremental work at Monash FY17 forecast is mid-range $9m revenue relating to base services only with no additional work. Citadel is in a good position to take on ancillary projects at the site via a competitive supplementary supplier panel process. E-Bloods bring other NSW health jurisdictions contestable for Citadel Health with Citadel now able to be act as corporate sponsor for this system, Citadel Health can seek a larger share of the NSW public pathology market. Wilson HTM Equities Research 13

14 Medium-term income statements A summary of our outer year forecasts to FY20e are provided below. Table 4: Medium-term earnings summary INCOME STATEMENT FORECASTS FY15-20e FY15a FY16e FY17e FY18e FY19e FY20e REVENUE Technology Education revenue growth n/a 29.6% 30.6% 4.7% 8.4% 8.6% EBITDA growth n/a 103.7% 41.8% 9.6% 11.9% 9.1% - margin 14.0% 22.1% 23.9% 25.0% 25.8% 26.0% EBIT growth n/a 73.6% 49.2% 9.5% 14.2% 10.6% - margin 12.4% 16.6% 19.0% 19.8% 20.9% 21.3% Net interest 0.1 (1.6) (3.2) (2.0) (2.0) (1.8) PBT Tax (2.0) (4.9) (6.8) (6.5) (7.3) (8.2) Minorities - - (1.9) (2.1) (2.2) (2.3) Reported NPAT Normalised EPS (cps) growth n/a 20.9% 52.5% 23.2% 4.8% 11.4% Source: WHTM Research Technology segment revenue characteristics Citadel generates revenue from providing three basic types of service, some recurring and some one-off, at different levels of margin contribution. Briefly: Consulting revenue (one-off). A number of Citadel s businesses provide consulting services in the first instance, often as a lead-in to providing a particular technology solution and longer-term project. Implementation services and licensing (one-off). This revenue is generated from configuring and installing solutions, which are often 100% outsourced managed services. Citadel does not allow third parties any involvement in delivering its solutions, and often deploys dedicated teams on specific contracts for the duration. Licence fees may be charged in relation to proprietary software or other forms of Citadel intellectual property. Managed service (recurring, longer term). This business is typically the highest margin work that Citadel engages in, relating to ongoing technical product support and maintenance of Citadel s solution/system. In other instances Citadel may host the solution and charge clients either ongoing licensing, access or subscription fees depending on the project. Examples include software as a service (SaaS), data as a service (DaaS) or platform as a service (PaaS). Continuity in core contracts in preparing our longer-term forecasts we have assumed that Citadel successfully re-competes on core contracts as they become eligible for market re-test, without significant changes in commercial terms or operating margin. Citadel management has achieved this over several decades in some instances. Organic technology growth only, with no new contracts our forecasts imply a degree of organic growth averaging 7% per annum over the FY17-20e period. This ought to be achievable from within existing projects, particularly those active in defence, where variable upside and piecemeal, bolt-on work routinely arises. Margin expansion in Technology as organic revenue growth is limited to that within current contracts, we assess scope for margins to improve through fixed cost leverage. No growth in Education but maintaining margins our forecasts have Education declining to just 5% of operating EBITDA by the end of FY20. Wilson HTM Equities Research 14

15 Figure 6: Investors have a moderate degree of visibility out to the end of 2018 Source: Citadel, WHTM Research Forecasts leave for upgrades. We understand that Citadel has been shortlisted for a range of new projects that may be announced over the next 12 months and feed into the FY18-20e forecasts. Depreciation and amortisation. We are forecasting D&A of $5.1m in FY16 compared with $1.2m in FY15. The increase reflects capital investment in Education campus facilities, development of learning curriculums, considerable ICT investments, and amortisation of assets associated with acquired healthcare assets. Kapish-related amortisation expense lifts FY17e and FY18e D&A to $6.1m and $6.7m, respectively (including non-recurring amortisation items). Tax. We model a higher tax rate in FY17 to accommodate the tax treatment of the PJA Solutions acquisition, on which deferred consideration payments were adjudged non-tax deductible. Effective tax rates moderate over the forecast period. Minorities. From FY17 we account for non-citadel shareholder interests in filosoph-e NPAT. EPS growth profile. Our forecasts imply 52% EPS growth in FY17e and an average of 13% for the following three years, again, excluding new contract wins and new acquisitions. Wilson HTM Equities Research 15

16 Cash flow statements A summary of our cash flow forecasts is provided in the table below. Table 5: Cash flow forecast A$m Source: WHTM Research FY15a FY16e FY17e FY18e FY19e FY20e EBITDA Working cap and other items (1.6) (2.1) (2.1) (2.5) (3.0) (3.3) Net interest paid 0.1 (0.2) (3.2) (2.0) (2.0) (1.8) Tax (1.8) (3.8) (6.8) (6.5) (7.3) (8.2) Operating cash flow Conversion of EBITDA (post tax) 68% 70% 59% 65% 66% 66% Dividends paid (4.1) (4.9) (5.2) (7.0) (8.4) (9.3) Cash flow after dividends Capex (0.8) (1.5) (1.8) (2.1) (2.4) (2.7) Cash flow for growth projects Other investing (9.1) (20.0) (17.8) (18.0) Surplus/(deficit) cash (7.0) (12.0) (7.6) (6.1) Equity Debt issued (repaid) Cash DPS (cps) Debt balance Operating cash conversion. We are forecasting Citadel to maintain high rates of EBITDA conversion given negligible debt and good cash flow characteristics. The business is capable of ~90% conversion on a pre-tax basis and 65-70% post-tax. Citadel typically invoices (and recognises) work undertaken on larger projects on a proportion of completion basis but is sometimes not paid in cash until the project is complete. Managed service cash flows are received and recognised on a more regular cadence. Capex requirements modest. We are forecasting $1.8m in capex for FY17, distributed across leasehold improvements, computer equipment and software. Like many development companies, Citadel does tend to capitalise a portion of its R&D costs, which can tend to overstate reported earnings. Although we adopt the same approach in preparing our forecast financial statements, we have put the full cash cost of forecast R&D through our free cash flow estimates, on which our discounted cash flow valuation is based. Deferred consideration and earn-outs relating to PJAS acquisition blunt free cash flow in the short term. Citadel has agreed to make further payments of up to $40m in relation to the PJA Solutions acquisition. Two further tranches, totalling $25m, are payable over the next 18 months, subject to the achievement of agreed performance hurdles. An additional earnout payment of up to $15m is also payable subject to achieving financial growth objectives. Dividends. Citadel appears well placed to maintain fully ranked dividends over the forecast period. We are forecasting 10.0cps in FY16e and 13.5cps in FY17e which represents >50% of NPAT. Wilson HTM Equities Research 16

17 ROE 14 June 2016 Balance sheet and returns A summary of our balance sheet forecasts are provided in the table below. Table 6: Balance sheet and returns fy15-20e BALANCE SHEET AND RETURNS FY15a FY16e FY17e FY18e FY19e FY20e ASSETS Cash Other current assets PP&E Intangibles LIABILITIES Debt Other liabilities EQUITY NPAT ROA 5.2% 7.4% 7.8% 8.6% 9.4% 9.8% ROE 11.5% 14.7% 17.2% 19.8% 20.8% 20.7% Source: WHTM Research Debt. While Citadel has chosen to fund recent corporate activities from cash, the business is profitable enough to contemplate reconfiguring the balance sheet. Earn-out related cash commitments in FY17-18 may see Citadel leverage its returns via modest gearing. Equity. Following IPO Citadel has only issued further stock as part consideration for the PJA Solutions acquisition. We are forecasting no further equity issues, expecting that this would only be contemplated in the context of EPS accretive acquisitions. Returns. Citadel makes good returns on equity, although our forecasts imply no growth in that return, principally because we have not factored any new contracts into our forecasts and relied on modest organic growth only. Scenario analyses show that lifting Technology revenue growth to ~10-15% per annum can readily provide return on equity expansion, even without modifying capital structure. Figure 7: 10-15% annual growth in Technology, driven by new contract wins, can support ROE expansion past 25% compared to our conservative base case 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY15a FY16e FY17e FY18e FY19e FY20e base case 10% Technology growth 15% Technology growth Source: WHTM Research Wilson HTM Equities Research 17

18 Valuation DCF valuation Our 12-month price target of $6.25 per share is derived from our discounted cash flow valuation. The price target implies 21.4x FY17e EPS and 9.5x FY17e EV/EBITDA which are higher multiples than have been applied to the stock during its short trading history. Table 7: DCF framework for Citadel Valuation The Inputs PV of FCFF ($M) = 57 Forecast period FY16-21 PV of Terminal Value ($M) = 218 Risk-free rate 3.5% Value of Operating Assets of the firm ($M)= 275 Risk premium 7.0% - Net Debt ($M) 17 D/E 0.0% Equity value ($M) = 292 Beta 1.2 Value of Equity per share = $6.25 WACC 11.3% Tg 2.6% Implied multiples consistent with DCF FY17e PER (x) 21.4x FY17e EV/EBITDA (x) 9.5x Source: WHTM Research Aside from the earnings forecasts detailed in the previous section, the key assumptions behind our $6.25 per share DCF valuation include: Weighted average cost of capital 11.3%. Listed US HCIT and ASX-listed software service peers have average equity betas that range between 0.9 and 1.4. Citadel s stock is too illiquid for a reliable calculated equity beta but we have a value of 1.2, which puts Citadel in the company of higher growth and risk. We select a risk-free rate of 3.5% and a market risk premium of 7%. We estimate an appropriate terminal WACC for Citadel as 11.3% which is towards the top end of the range of comparable companies with SaaS and/or managed service business models. Terminal growth rate of 2.6%. Our broader healthcare valuation practice tends to use terminal growth rates between 1.5% and 3.5%, reflecting our view that healthcare is a GDP+ sector, irrespective of geography. We have selected a terminal growth rate towards the top end for valuing Citadel, as we think that the HCIT sector will grow faster than the other healthcare sub-sectors and that Citadel is well placed to establish a leadership position. Comparable listed company considerations Our DCF valuation of $6.25 per share implies multiples of 21.4x FY17e EPS and 9.5x FY17e EV/EBITDA. To cross-check the reasonableness of our valuation, we analysed the valuations of HCIT companies offshore (predominantly US) and looked at a broad group of ASX-listed IT companies, with varying relevance. Among HCIT companies, we chose a mix of companies involved in hospital electronic medical records (EMRs), primary care EMRs, health information exchanges an integrators, practice management developers, billing technology and population health IT. HCIT peers trade on EV/FY+1 revenue multiples of x (average 3.5x) with consensus forecast sales growth of 5-64% (average 19% over the next two years). We are forecasting Citadel to grow its HCIT revenues at similar levels, but have no new contract wins factored into our estimates at this stage. Among ASX-listed companies we stripped out online companies, hardware developers and software re-sellers. The basket of stocks is broad ranging and is not intended to reflect Citadel. Rather, we were interested in deriving a sector multiple against which we could compare Citadel s valuation. Wilson HTM Equities Research 18