Appen (APX) COMPANY REPORT

Transcription

1 11 January 2018 INTERNAL ONLY RECOMMENDATIONS Rating BUY Risk High Price Target $10.00 Share Price $8.63 SNAPSHOT Monthly Turnover $89.8mn Market Cap $895mn Shares Issued 105.8mn 52-Week High $ Week Low $2.35 Sector Information Technology BUSINESS DESCRIPTION APX is a language services provider that offers large scale training data, linguistic models and consulting services. It operates within the language technology market and has a services capability in more than 140 languages and dialects. 12-MONTH PRICE & VOLUME RESEARCH ANALYST Michael Nolan michaelnolan@baillieuholst.com.au Nicolas Burgess, CFA nburgess@baillieuholst.com.au Nick Caley ncaley@baillieuholst.com.au Disclosure The author owns no shares in APX. Appen (APX) COMPANY REPORT As it appens it is all about the thematic Change of analyst: We note a change in analyst and revisit our financial projections and investment view. What s new: We have raised our price target to $10/share based on the results of our DCF valuation model. A 16% value gap and 1% dividend yield on below trend forward estimates coupled with a compelling thematic warrants an upgrade to BUY. The share price has tripled in the last 12 months. We believe it has more to go. Forward estimates: We have tempered our 2017 and raised our estimates to reflect the acquisition of Leapforce. Our 2017 EBITDA estimate mirrors company guidance. Our estimates are above consensus in out-years but we are in part to blame for that. Leapforce acquisition: A scale play in a product and geographic sense with a supportive business case to match. The company expects the acquisition to be 35%+ EPS accretive excluding synergies and unusual items in its first full year. More importantly, it is value accretive from the get-go by a healthy margin. Important to note these metrics undershoot accretion as they are based on the then US tax rate of 35% which has since been cut to 21%. Investment thesis: Organic revenue growth and EBIT margin in midteens, an effective tax rate of 27% and net investment rate of 10-11% translates to free cash flow to firm (FCFF) of $25m in 2018 and $35m in We expect the company to use funds to pay dividends, service debt and repay debt in absence of growth opportunities. The demand for data to support artificial intelligence appears set to continue to grow exponentially. A lean, extremely cash-generative business model with an established presence in a hot global industry is an alluring thematic by any measure. Risks: Appen depends on a small number of customers for its financial wellbeing. Their collective response to the acquisition of Leapforce remains to be seen with a push for better terms a potential battleground. That said, everyone is entitled to eat and EBIT margins of 16-17% are by no means excessive. The company relies on a 1.2m on-demand global crowd for data collection on a contract basis. Associated costs are the single largest operating expense item by a country mile. A change in classification would have implications for operating performance. Overall, these two key risks are well understood and managed by Appen and common across industry. INVESTMENT SUMMARY Year End: 31 December 2015 (A) 2016 (A) 2017 (E) 2018 (E) 2019 (E) Revenue $mn EBITDA $mn EBIT $mn Reported Profit $mn Adjusted Profit $mn EPS (Reported) EPS (Adjusted) EPS Growth % PER (Reported) x PER (Adjusted) x Dividend Yield % Franking % Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 1

2 Financial summary Code: APX Rating: Buy Analyst: Michael Nolan Price Target: $10.00 Date: 11/01/2018 Upside/dow nside: 16% Share Price: $8.62 Valuation: $10.00 Market Capitalisation: $912m Valuation method: DCF Year End: 31-December Risk: High INCOME STATEMENT ($m) FY15A FY16A FY17F FY18F FY19F EARNINGS (c) FY15A FY16A FY17F FY18F FY19F Revenue Reported basic EPS Operating expenses (68) (93) (130) (216) (249) Underlying basic EPS EBITDA DPS Amortisation & depreciation (1) (1) (3) (3) (3) Franking (%) EBIT Payout ratio (%) Net interest (0) (0) 0 (2) (1) Dividend yield (%) NPBT Income tax (4) (6) (8) (12) (14) VALUATION (x) FY15A FY16A FY17F FY18F FY19F Share of associates EV/EBIT Discontinued operations EV/FCFF Minority interest PER Underlying profit after tax Price/book equity Unusual items after tax (0) (0) (5) 0 0 Reported profit after tax ROIC (%) FY15A FY16A FY17F FY18F FY19F EBIT margin BALANCE SHEET ($m) FY15A FY16A FY17F FY18F FY19F Operating cash tax rate Assets NOPLAT margin Operating cash Revenue/invested capital (x) Excess cash ROIC incl goodw ill Trade receivables Inventory GROWTH (%) FY15A FY16A FY17F FY18F FY19F PPE Revenue Investments in associates EBIT Other intangibles NOPLAT Other assets Invested capital incl goodw ill Total Underlying basic EPS nmf 24.7 (0.5) Liabilities Trade payables MARGINS (%) FY15A FY16A FY17F FY18F FY19F Debt EBITDA Defferred tax liabilities EBIT Other liabilities Free cash flow to firm (55.8) Total Net assets INVESTMENT RATES (%) FY15A FY16A FY17F FY18F FY19F Payments PPE/depreciation Equity Gross investment Contributed equity Net investment Reserves Retained earnings (4) (4) (4) FINANCIAL LEVERAGE FY15A FY16A FY17F FY18F FY19F Minority interest EBIT coverage (x) Total Net debt/mkt cap'n (%) (1.2) (1.5) Net debt/ev (%) (1.2) (1.5) Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 2

3 Earnings changes We have recast our estimates to reflect a more conservative assessment of operating performance and the acquisition of Leapforce in 2H17. New 2017 EBITDA estimate of $25m is 43% above pcp and within company guidance of 40-50% yoy growth. Leapforce to make its presence felt in terms of financial position in 2017 We assume Leapforce impacts the statement of financial position rather than the income statement in Acquisition was completed December 7, Goodwill on acquisition $98m, trade receivables $10m, institutional placement and share purchase plan $30m, vendor placement $15m and a forecast of $39m new debt are key adjustments. Impact on the income statement restricted to $7m in transaction costs, which we classify as unusual for presentation purposes. The latter will likely include an immaterial adjustment relating to the restatement of deferred tax balances due to the change in US tax rate. Leapforce will leave Appen with $39m in debt and no excess cash at end of 2017, in our estimations. The debt position is meaningful in an historic sense as this is the first time the company has used debt in a meaningful way to fund its activities. The forecast balance is undemanding in coverage and leverage terms and is forecast to be repaid in full by We assume organic revenue growth at constant currency of 15% in Headline estimates are 71% and 15%, respectively. EBITDA margin is forecast to increase from 16% on a standalone basis in 2017 to 18-19% inclusive of Leapforce in The latter is expected to report $20m ($18m in pcp) in EBITDA on $87m ($76m in pcp) in revenue, a margin of 23% (19% in pcp) in its first full year. and income statement in For comparative purposes, figures 1 and 2 below present revenue growth and EBITDA margin on assumption the Leapforce acquisition took place 1 January The point to note is our forecast revenue growth rate is below historic levels and EBITDA margin in line with historic levels. Underlying data shows Appen reported a higher revenue growth rate and lower albeit improving EBITDA margin than Leapforce in H17. Latter reflects pressure from Appen s customers to reduce prices offset over time by the strategy to recruit lower cost on-demand resources. FIG.1: REVENUE GROWTH 2015A-19E (%) FIG.2: EBITDA MARGIN 2015A-19E (%) No need to overcook books A 2016A 2017E 2018E 2019E 2014A 2015A 2016A 2017E 2018E 2019E, Company Source: Bailieu Holst, Company We do not expect operating leverage to feature prominently as labour costs represent more than three-quarters of operating expense base and are essentially variable in nature. Moreover, Appen has managed successfully to source additional on-demand resources in relatively high unemployment, low remuneration rate jurisdictions and thereby grow operating margins in recent times. We understand limited scope for more of the same in the years ahead. Amortisation and depreciation are forecast to approximate capital expenditure. Interesting to note ~$95m of the $105m paid for Leapforce is deductible on a straight line basis over 15 years for US tax purposes. While the recent US tax cut reduces the quantum, it is better to have a deduction than not even if it is at 21%. We assume an effective tax rate of 34% in 2017, which is in line with recent years. The rate is forecast to fall to 27% in as a result of the recently legislated US tax cut from 35% to 21% after 31 December The rider here is that all other US federal, state and local taxes remain constant. No reason to suggest otherwise. Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 3

4 Hats off to US President Trump We expect company to base its dividend payout ratio on underlying rather than statutory net profit at the rate of 35% in 2017; this presupposes a desire to maintain the dividend in absolute terms in face of a lower statutory profit that year. Our estimates assume the dividend policy remains at 35% of underlying net profit in A lower effective tax rate is a non-issue from a franking viewpoint given the forecast payout ratio. Leapforce acquisition is forecast to increase US revenue to well beyond the current 75%. The fact overwhelming majority of customers are US-based, tax rate differential is material and ownership structure is increasingly international raises spectre of relocation. At first glance, the implications would be a net positive for equity value: lower effective tax rate and cost of capital. Regardless, we do not believe the matter is under active consideration at present. Another story for another time. FIG.3: FORWARD ESTIMATES Yr end ($m) 31-Dec Dec Dec-19 New Previous New Previous New Previous Revenue (4.0) EBITDA (4.8) EBIT (10.1) Profit before tax (9.6) Net profit (14.7) Down, up and away Our estimates are below consensus in 2017 and above consensus in Consensus revenue in the out-years looks reasonable. The converse applies to EBITDA to net profit after tax. We suspect consensus is yet to reflect fully Leapforce and the US tax cut. To the extent the sample includes our old estimates which factor neither, we are in part to blame. The inclusion of our new estimates will help to rectify situation. Consensus upgrade in pipeline as appears not to reflect fully recent developments Appen expects Leapforce to report EBITDA of US$14m (A$18m) based on the simple average USDAUD exchange rate in On that basis, consensus 2018 EBITDA should exceed 2017 by at least that amount and then some. Consensus is actually less at $17m, which implies negative organic growth, hardly! And the consensus effective tax rate is in the early 30s, in line with past years, when likely the rate is high 20s thanks to recent developments in US. FIG.4: FORWARD ESTIMATES VS BLOOMBERG CONSENSUS Yr end ($m) 31-Dec Dec Dec-19 BH Consensus Diff. BH Consensus Diff. BH Consensus Diff. Revenue (3%) % % EBITDA (2%) % % EBIT (4%) % % Profit before tax (3%) % % Net profit (8%) % % Valuation We value Appen at $10/share based on the results of our discounted cash flow model at 31 December Major risk to equity value is that operating performance post Leapforce undershoots or overshoots our expectations. Note Leapforce is Appen s first meaningful acquisition and, like all firsts, comes with a heightened degree of risk. However, the fact that the transaction was friendly provides an offset in part. We have prepared detailed interim and full year financial projections out to 31 December These projections assume annual revenue growth of 15%, an EBIT margin of 16- Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 4

5 17%, an operating cash tax rate of 27% and a net investment rate of 10-11%. Together these assumptions translate to FCFF of $35m in 2019 rising gradually to $66m in We assume a cost of capital of 7.7% assuming a risk free rate of 2.7%, a beta of , a revenue by country weighted equity risk premium of 5.2% and a gradual reduction in gross debt to market capitalisation from current 4% to 0% in 2023 onwards. We treat as the explicit forecast period and capitalise FCFF in 2024 by the cost of capital less risk free rate, 5% or 20x. Continuing value represents 84% of operating value, which is high given the length of the forecast period. Non-operating assets are negligible, debt and equivalents $23m and outstanding shares 106m at date of valuation. FIG.5: DCF VALUATION/SHARE Year end 31-Dec $/Share % total Explicit forecast period (PV FCFF in ) $ Continuing value (PV of FCFF in 2024+) $ Operating value $ Non-operating assets $ Debt & equivalents ($0.22) (2) Equity value $ ROIC is forecast to exceed cost of capital resulting in an increasingly positive investment spread of 19-38% in FIG.6: INVESTMENT SPREAD Year end 31-Dec (%) ROIC incl goodw ill Cost of capital Investment spread Sensitivity analysis Figure 7 shows equity value is most sensitive to average cost of capital followed by EBIT margin and least sensitive to capital turnover, revenue divided by invested capital. FIG.7: IMPACT OF A +/-10% CHANGE IN ASSUMPTION ON DCF VALUATION/SHARE Average cost of capital Average EBIT margin Revenue growth CV FCFF growth Capital turnover -20% -15% -10% -5% 0% 5% 10% 15% 20% Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 5

6 An atypically wide spread, in our experience BAILLIEU HOLST RESEARCH Key risks Appen services a small number of large companies. In 2016, more than 80% of revenue was derived from five customers. Leapforce will move the dial towards 90% albeit with a more even distribution across cohort. The degree of concentration has implications for pricing power, revenue growth and operating performance in a broader sense. Leapforce acquisition heightens associated risks as it s likely to be seen by customers as an opportunity to extract better terms. However, there is nothing new in that. In fact, pricing pressure borders on a given across industry. - As an aside, we note the 5-year Master Vendor Agreement with Microsoft expires in March. It was the only customer agreement to appear in the material contracts section of Appen s Prospectus late Understandable as Microsoft was then Appen s largest customer at ~50% of revenue. Its contribution is in the single digits these days due to an internal change in strategic direction at Microsoft and growth in Appen s product range and customer base between times. - The other point to note is Leapforce s customers with control clauses in their agreements have consented to the acquisition. Importantly, the relevant clients do not number among the largest two who together account for 99% of revenue. We understand discussions have taken place with each of these customers and there is nothing untoward to report. The company uses an on-demand crowd of 1.2m people and to a lesser extent third party partners to satisfy its data collection requirements. Associated costs account for more than two-thirds of the operating expense base. Each group is remunerated on a contract basis, a relatively low cost arrangement. A change in classification has the potential to impact operating margins and in turn equity value. Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 6

7 Appendix FIG.8: LONG TERM MOMENTUM INDICATORS Source: Iress FIG.9: SHORT TERM MOMENTUM INDICATORS Source: Iress Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 7

8 This document has been prepared and issued by: Baillieu Holst Ltd ABN Australian Financial Service Licence No Participant of ASX Group Participant of NSX Ltd Analysts stock ratings are defined as follows: Buy: The stock s total return is expected to increase by at least percent from the current share price over the next 12 months. Hold: The stock s total return is expected to trade within a range of ±10-15 percent from the current share price over the next 12 months. Sell: The stock s total return is expected to decrease by at least percent from the current share price over the next 12 months. Baillieu Holst Analysts stock ratings distribution as of 12 December 2017: Buy: 68% Hold: 29% Sell: 3% Disclosure of potential interest and disclaimer: Baillieu Holst Ltd (Baillieu Holst) and/or its associates may receive commissions, calculated at normal client rates, from transactions involving securities of the companies mentioned herein and may hold interests in securities of the companies mentioned herein from time to time. Your adviser will earn a commission of up to 55% of any brokerage resulting from any transactions you may undertake as a result of this advice. When we provide advice to you, it is based on the information you have provided to us about your personal circumstances, financial objectives and needs. If you wish to rely on our advice, it is important that you inform us of any changes to your personal investment needs, objectives and financial circumstances. If you do not provide us with the relevant information (including updated information) regarding your investment needs, objectives and financial circumstances, our advice may be based on inaccurate information, and you will need to consider whether the advice is suitable to you given your personal investment needs, objectives and financial circumstances. Please do not hesitate to contact our offices if you need to update your information held with us. Please be assured that we keep your information strictly confidential. No representation, warranty or undertaking is given or made in relation to the accuracy of information contained in this advice, such advice being based solely on public information which has not been verified by Baillieu Holst Ltd. Save for any statutory liability that cannot be excluded, Baillieu Holst Ltd and its employees and agents shall not be liable (whether in negligence or otherwise) for any error or inaccuracy in, or omission from, this advice or any resulting loss suffered by the recipient or any other person. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Information, opinions and estimates contained in this report reflect a judgment at its original date of publication and are subject to change without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of securities and financial instruments is subject to exchange rate fluctuation that may have a positive or adverse effect on the price or income of such securities or financial instruments. Baillieu Holst Ltd assumes no obligation to update this advice or correct any inaccuracy which may become apparent after it is given. Baillieu Holst Ltd ABN Australian Financial Service Licence No Participant of ASX Group Participant of NSX Ltd Melbourne (Head Office) Address Level 26, 360 Collins Street Melbourne, VIC 3000 Australia Postal PO Box 48, Collins Street West Melbourne, VIC 8007 Australia Phone Facsimile melbourne@baillieuholst.com.au Adelaide Office Address Ground Floor, 226 Greenhill Road, Eastwood SA 5063 Postal PO Box 171 Fullarton SA 5063 Phone Facsimile adelaide@baillieuholst.com.au Bendigo Office Address Level 1, Forest Street Bendigo, VIC 3550 Postal PO Box 84 Bendigo, VIC 3552 Phone Facsimile bendigo@baillieuholst.com.au Geelong Office Address 16 Aberdeen Street Geelong West Vic 3218 Postal PO Box 364 Geelong Vic 3220 Australia Phone Facsimile geelong@baillieuholst.com.au Gold Coast Office Address Suite 202 Level 2, Eastside Building 6 Waterfront Place, Robina QLD 4226 Phone Facsimile goldcoast@baillieuholst.com.au Newcastle Office Address Level 1, 120 Darby Street Cooks Hill, NSW 2300 Australia Postal PO Box 111 The Junction, NSW 2291 Australia Phone Facsimile newcastle@baillieuholst.com.au Perth Office Address Level 10, 191 St Georges Terrace Perth WA 6000 Australia Postal PO Box 7662, Cloisters Square Perth, WA 6850 Australia Phone Facsimile perth@baillieuholst.com.au Sydney Office Address Level 40, 259 George Street Sydney, NSW 2000 Australia Postal PO Box R1797 Royal Exchange, NSW 1225 Australia Phone Facsimile sydney@baillieuholst.com.au Baillieu Holst Ltd ABN Page 8