SciSys. Update. Investment summary: A very good December. Market Cap 14m. Investment case: Focus on margin expansion

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1 Update 27 January 2011 SciSys Price 48p Market Cap 14m Year End Revenue ( m) PBT* ( m) EPS* (p) DPS (p) P/E (x) Yield (%) Share price graph 12/ N/A 12/ /10e /11e Note: *PBT and EPS are normalised, excluding intangible amortisation and exceptional items. Investment summary: A very good December In its January trading update, SciSys has announced that its performance in the second half of FY10 has been better than expected. The group has been picking up a significant amount of smaller orders, which has filled the gap of larger fixed-price business that has been deferred or scaled back. Further, SciSys had very strong cash collection in December resulting in much stronger cash flow than we had expected. We have upgraded our forecast adjusted EBIT margin expansion to 6.0% by FY12, which would, in our view, support a share price nearer 90p. Investment case: Focus on margin expansion SciSys is a leading developer of ICT services, e-business and advanced technology solutions and operates in a broad range of market sectors. Software development is generally customer funded through projects and the board is placing a greater emphasis on re-using software that has been developed in previous projects. Further, a renewed focus on process, project management and taking a better share of the ROI SciSys creates for clients should help increase margins. Trading update: International growth for Media division ScisSys says it performed better than expected in H2 despite the difficult and uncertain market conditions. Further, cash flow was strong with net cash rising to 4.8m at the end of December, 1.8m more than we had expected. The group has announced several new contract wins for its Media Broadcast division, highlighting the attraction of its dira! product suite to international broadcasters. Forecasts and valuation: Margin forecasts move up While we have maintained our revenue forecasts, we have lifted our margin assumptions adjusted EBIT therefore rises to 2.0m in FY10, 2.4m in FY11 and 2.7m in FY12 from 1.8m, 2.2m and 2.5m respectively. The stock trades on less than 0.3x our FY11 revenue forecasts, and in line with book value, which reflects the group s modest margins. We anticipate the valuation will continue to expand with margin growth and, based on our forecasts, the stock trades on 8.5x earnings in FY10, falling to 7.0x in FY11 and to 6.8x in FY12. Share details Code SSY Listing AIM Sector Software & Computer Services Shares in issue 29m Price 52 week High Low 53.0p 37.5p Balance Sheet as at 31 December 2010* Debt/Equity (%) N/A NAV per share (p) 53.5 Net cash 4.8 *Estimated. Business SciSys provides a range of professional services in support of the planning, development and use of computer systems primarily in the space, government and media/broadcast sectors. Valuation e 2011e P/E relative 90% 81% 75% P/CF EV/Sales ROE 10% 10% 12% Geography based on revenues (2009) UK Rest of Europe Other 54% 45% 1% Analysts Richard Jeans +44 (0) Dan Ridsdale +44 (0) tech@edisoninvestmentresearch.co.uk SciSys is a research client of Edison Investment Research Limited

2 2 Edison Investment Research Update SciSys 27 January 2011 Trading statement: Ahead of market expectations The company says it expects to report adjusted EBITA for FY10 ahead of market expectations along with an improvement in net operating margin. While management was naturally very cautious following the new coalition government s commitment to public sector cuts, which has resulted in some reduced business including the Warrior upgrade contract, the group has been winning a lot of smaller time and material type work. Debtor collection was strong in December with the group finishing the year with net cash of c 4.8m, well ahead of our expectations. Short-term debts have been eliminated. The company expects to announce its preliminary results on March 29. Margin improvement. The group has continued to drive efficiency through the business, from improvements in bidding for contracts through to managing projects more effectively. This has resulted in much improved cost control and management has a goal of achieving adjusted EBIT margins of 8% in the medium term. Outlook. SciSys also says it continues to trade well and has a good order book across all sectors. Government & Defence has diversified its mix of business while the Environment Division has a healthy short-term order book in spite of government cutbacks. The other divisions are largely unaffected by UK public sector cuts and retain healthy order books. New business wins. MBS international, which represents the group s Media Broadcast business outside of the UK and German speaking countries, has won a further 2.5m of orders for its dira! product suite. This includes orders from Oman Radio and Sharjah Radio in the UAE, which come in wake of the contract success in Egypt last year. It also includes orders with Flemish public broadcaster VRT in Belgium and RUV in Iceland. Exhibit 1: SciSys revenues ( m) and operating profit margin (%) m % 6% 5% 4% 3% 2% 1% 0% e 2011e 2012e 2013e Revenues Operating profit margin Source: Company accounts/edison Investment Research Investment case: Expansion in margins SciSys is a specialist systems house with a focus on four vertical markets (space, government & defence, environment, and media & broadcast). The group has blue-chip clients, industry expertise, and growing revenue visibility. The challenge is translating this opportunity into profitable growth. The group s customers are large, competitors can be sizeable, and the software requirements are often complex and expensive. Therefore, winning business is a challenge (on average, sales cycles are six to 18 months), but equally once the customers have signed up, there are often significant

3 3 Edison Investment Research Update SciSys 27 January 2011 opportunities to win additional projects. We estimate across the group over 80% of revenues come from existing customers, which, together with the long-term contract profile of many of the deals, highlights the visibility within the business. We forecast that revenues will grow over the next three years (we forecast 10% growth in FY10 easing to 2% in FY11), but, as we highlight in Exhibit 1, the real driver of earnings and valuation in the medium term should be an expansion in margins. We believe there are a number of factors that will contribute to our current assumption of EBITA margin growth from 4.7% in FY10 to 6.0% by FY12. Pricing and project management. Over the last year management has increasingly focused on value pricing (charging for core software, pricing based on customer ROI etc) and far greater project management skills within the organisation. Re-usability of platform software. While core third-party software platforms are consistent across many projects (ie use of Oracle, Microsoft etc), nearly all customer solutions are bespoke to their requirements. However, in many cases in specialised industry verticals (eg media, military, trading exchanges), SciSys has developed key software IP. Management has focused project teams not only on efficient re-use of this IP, but increasingly on charging customers for the value of using it (ie 100% gross margin licences). Workforce profile and rationalisation. Within a consulting business like SciSys, human resources will always be the major cost, typically expensive, and difficult to manage in a flexible way (ie management teams in the sector often do not like to cut consultants in a quiet period as they can be very difficult to hire back when business picks up). However, there are a number of opportunities for SciSys to restructure its workforce in the medium term, not only in terms of cultural focus on profitability, but also through the more efficient utilisation of experienced consultants (eg high level consulting and mentoring), while developing the junior cohort under them. Improved group structure and succession planning. In FY07 the group suffered from a lack of communication between project managers and management, and employees were often promoted without having the appropriate skills. Layers of management have been removed and the group has been investing in an improved career development strategy as well as providing more appropriate succession planning. The senior management structure has been re-organised to operate through an executive board. Smarter bidding. Because of the nature of the target markets, bids are lengthy and therefore costly. We conservatively estimate that lost bids probably affect the P&L by c 0.2m a year. This is partly unavoidable. However, management is now far more selective about the bids it tenders for (ie typically high value, high chance of winning). Competition. In some areas of the business, such as media, the competitors are small and specialist (eg Dalet, Globecast, Utel, David). However, many large enterprise and public sector projects require a wide range of hardware and software integration. Therefore, in many cases the major consultants are on the shortlist (Deloitte, Cap Gemini etc), as are the major electronics suppliers (IBM, Fujitsu etc). While these players have massive balance sheet strength and pricing power compared with SciSys, they

4 4 Edison Investment Research Update SciSys 27 January 2011 often lack the very specialist know-how and IP in specific industry verticals. Therefore, as customers recognise the need to outsource to an IT expert we believe SciSys can continue to take market share. Forecasts: Margin forecasts shift up Given today s positive trading news, we have upgraded our margin outlook, while maintaining revenue forecasts. Adjusted EBIT therefore rises to 2.0m in FY10, 2.4m in FY11 and 2.7m in FY12 from 1.8m, 2.2m and 2.5m respectively. Consequently our EPS forecasts rise from 4.9p, 6.2p and 6.4p to 5.7p, 6.8p and 7.1p in the respective years. The group had c 4.8m net cash on its balance sheet as at 31 December We forecast free cash flow will dip to 0.4m in FY11 (we conservatively assume working capital will rebuild) rising to 2.0m in FY11, with 4.9m net cash at the end of FY11 increasing to 6.6m a year later. Exhibit 2: Forecasts e 2011e 2012e Revenues ( '000s) Space 16,739 16,723 17,141 17,741 18,375 Government, defence & environment 11,081 13,767 14,111 14,605 15,127 Media & Broadcast 6,757 7,898 8,095 8,379 8,678 Support 3,153 2,989 3,064 3,171 3,284 Central Group Revenue 38,056 41,720 42,763 44,260 45,842 Growth (%) Administrative expenses (37,199) (40,044) (40,765) (41,814) (43,110) Adjusted EBIT 857 1,676 1,998 2,446 2,732 EBIT Margin (%) Growth (%) (159.5) Net interest (32) (69) (75) Profit before tax norm 825 1,607 1,923 2,496 2,832 Amortisation of acquired intangibles (1,800) (857) Share based payments (161) (67) (130) (200) (225) Exceptional items (net of tax) (28) (173) (90) 0 0 Profit before tax (1,164) 510 1,703 2,296 2,607 Tax charge 282 (171) (269) (459) (708) Profit after tax (882) 339 1,434 1,836 1,899 Adjusted EPS (p) P/E - Adjusted EPS Source: Edison Investment Research Sensitivities: Public sector spending The commitment by the UK coalition government to reduce public sector spending has put pressure on some of the group s customers. Following the government s spending review, Defra, which includes the Environment Agency (one of SciSys s main customers), had its budget cut by 30%. However, the effect on SciSys s business remains unclear. Likewise, the Warrior upgrade programme, for which SciSys is part of a consortium bidding for the work, is facing lengthy delays. Nevertheless, SciSys now has a balanced portfolio, with many of group s public sector contracts in key priority areas (eg, RNLI, digital switchover [Arqiva], Environment carbon reduction commitment and Media Broadcast BBC). Further, roughly half of group revenues are now in Europe. In all, we view SciSys as a relatively robust business with a low-risk customer base and we note that the group has no bad debtors.

5 5 Edison Investment Research Update SciSys 27 January 2011 Valuation: A play on margin expansion SciSys has developed a strong niche as an expert player in highly specialised IT markets. As these markets continue to gain in complexity, SciSys should, in our view, benefit from an improving negotiating position. We have highlighted in this report several factors that should help the group expand margins and believe the management has the determination to drive margins higher. We note the peer group s mid-cycle margins have traditionally been in the 8-10%+ range and Logica currently has c 7% operating margins and trades on c 10x FY11 consensus earnings. We highlight the following points on the group s valuation: Cash generation. We estimate the group generated free cash flow of nearly 3.0m in FY10 representing a FCF yield of 21%. Based on our forecasts, this slips to c 3% in FY11 and rises to c 15% in FY12. We also note the growing cash pile (c 4.8m at end 2010). Discounted cash-flow valuation. Based on our forecasts (including a 6.6% long-term margin target) and a weighted average cost of capital (WACC) of 12%, our DCF model values the shares at 88p, or 83% above the current share price. Discounting back from our forecasts, the market is attributing a break-even WACC of 23.4% to the stock (see Exhibit 3). Traditional valuation measures. In traditional P/E valuation terms, the stock trades on 8.5x our forecasts in FY10, falling to 7.0x in FY11 and to 6.8x in FY12. Sector M&A. Vega Group, a key rival to SciSys especially in the space industry, was acquired by Finmeccanica in 2007 for c 71m, valuing the enterprise at roughly 1x sales. Detica was purchased by BAE in July 2008 for c 531m or roughly 2.6x FY08 sales, though Detica had underlying operating margins of 13.3% in the year to March Exhibit 3: Valuation DCF valuation % owned m - Per share -- Assumptions SciSys operations 100.0% p WACC: 12% Number of shares 29.0m WACC: 20% Share price 48.0p Division % 0.0 0p WACC: 20% Market capitalisation 13.9m Total consolidated assets p Group Enterprise Value p Less: Adjusted net (debt)/add cash p Group Equity Value ( m) p Up/(down)side from current price 83% Ratio Analysis 2010f 2011f Grp DCF Scenarios Terminal growth rate % EV/Sales EV/EBITDA % 54p EV/EBIT % 61p Price/Book Price/Earnings % 70p Price/Op Cash Flow % 84p ROE 10% 12% Gearing (30%) (27%) 10.0% 108p Interest Cover N/A N/A Breakeven WACC 23.4% WACC Margin sensitivity Revenue sensitivity Long-term margin target 4% 6% 8% 10% Multiple 0.20x 0.30x 0.40x 0.50x Revenue Y2 ( m) Revenue Y2 ( m) Implied EBIT Implied EV ( m) Implied net income (28% tax) Net cash( m) Implied EPS Grp equity value ( m) Share 10x EPS Per share (p) Source: Edison Investment Research

6 6 Edison Investment Research Update SciSys 27 January 2011 Exhibit 4: Financials '000s e 2011e 2012e Year end 31 December IFRS IFRS IFRS IFRS IFRS IFRS PROFIT & LOSS Revenue 25,601 38,056 41,720 42,763 44,260 45,842 Cost of Sales Gross Profit 25,601 38,056 41,720 42,763 44,260 45,842 EBITDA (960) 1,474 2,338 2,614 3,342 3,660 Operating Profit (before amort. and except.) (1,440) 857 1,676 1,998 2,446 2,732 Amortisation of acquired intangibles (600) (1,800) (857) Exceptionals (496) (28) (173) (90) 0 0 Share based payments (119) (161) (67) (130) (200) (225) Operating Profit (2,655) (1,132) 579 1,778 2,246 2,507 Net Interest 58 (32) (69) (75) Profit Before Tax (norm) (1,382) 825 1,607 1,923 2,496 2,832 Profit Before Tax (FRS 3) (2,597) (1,164) 510 1,703 2,296 2,607 Tax (383) 282 (171) (269) (459) (708) Profit After Tax (norm) (1,765) 1,107 1,436 1,654 2,036 2,124 Profit After Tax (FRS 3) (2,980) (882) 339 1,434 1,836 1,899 Average Number of Shares Outstanding (m) EPS - normalised (p) (7.1) EPS - FRS 3 (p) (12.1) (3.1) Dividend per share (p) Gross Margin (%) EBITDA Margin (%) (3.7) Operating Margin (before GW and except.) (%) (5.6) BALANCE SHEET Fixed Assets 13,073 10,962 9,803 9,871 9,971 10,074 Intangible Assets 8,350 6,607 5,701 5,701 5,701 5,701 Tangible Assets 4,723 4,355 4,102 4,170 4,270 4,373 Investment in associates Current Assets 14,785 16,810 15,859 16,544 18,537 20,640 Stocks Debtors 11,900 12,341 11,596 10,386 12,249 12,687 Cash 2,345 4,144 3,888 5,774 5,889 7,541 Current Liabilities (11,517) (11,012) (9,680) (9,369) (9,575) (9,815) Creditors (9,329) (9,316) (9,194) (9,369) (9,575) (9,815) Short term borrowings (2,188) (1,696) (486) Long Term Liabilities (1,848) (1,805) (1,256) (1,257) (1,257) (1,257) Long term borrowings (869) (1,086) (957) (957) (957) (957) Other long term liabilities (979) (719) (299) (300) (300) (300) Net Assets 14,493 14,955 14,726 15,789 17,676 19,642 CASH FLOW Operating Cash Flow (66) 1,413 2,614 3,887 1,652 3,429 Net Interest 58 (32) (69) (75) Tax 490 (431) (355) (171) (269) (459) Capex (553) (510) (681) (684) (996) (1,031) Acquisitions/disposals (7,815) Financing 2, (21) 0 () 0 Dividends (385) 0 (87) (285) (322) (387) Net Cash Flow (6,027) 877 1,401 2, ,651 Opening net debt/(cash) (5,934) 712 (1,362) (2,445) (4,817) (4,932) HP finance leases initiated Other (619) 1,197 (318) (300) 0 (0) Closing net debt/(cash) 712 (1,362) (2,445) (4,817) (4,932) (6,584) Source: Company Accounts/Edison Investment Research EDISON INVESTMENT RESEARCH LIMITED Edison is Europe s leading investment research company. 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