Integrated Research (IRI) New SELL: H2 slippage and cash flow risk

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1 Date 06 June 2018 Theme Initiating Coverage Company Integrated Research (IRI) New SELL: H2 slippage and cash flow risk We initiate coverage on Integrated Research (IR) with a SELL rating and a TP of $2.65. IR is a software provider whose revenues are derived from its primary product Prognosis. Prognosis covers Unified Communications (UC), IT Infrastructure and Payments. We are attracted to IR s high-profile distribution partners, quality product backed by continual R&D investment, long term visibility and strong structural digital drivers. Conversely, we have some reservations about an acutely H2 weighted licence number, some cash-flow headwinds, risks around cloud migration and a de-rate given that we are below consensus in FY18/19/20. We believe IR could experience a de-rate given valuation is full versus peers (on an adjusted EBITDA basis). EV/EBITDA(adj.) of 19.6x FY19E compares to peers at 16.5x. Key points Quality product and distribution: 5-year embedded R&D of $106m represents 30% of total revenues over the same period and gives us confidence in product quality. IR s strong distribution network including CISCO, Avaya, Microsoft, ACI and HP provides global reach. IR currently services 1,200 customers worldwide, 125 of which are Fortune 500 companies. Maintenance renewal rates at 97% are high. Despite this, the evolution to cloud-based solutions from on-premise does create some risks for IR s product. Term-based licence structure: IR is strongly moving towards term-based licencing with the process accelerating since While this shift is a key longterm positive, it does result in weaker cash flow in the coming 24 months. Structural drivers seem plentiful: Investment in global digital communication channels is increasing. Particularly, Microsoft Skype is helping to drive market investment in UC product. Corporates are also having to manage infrastructure more efficiently. These are key drivers for IR and investment in Prognosis. Forecast growth below consensus: While there are some clear structural positives IR has an acute reliance on H2 licences. Similar to prior years, all of the licence fees are closed toward the end of H2 and FY18E is no different. Our forecasts sit below consensus by some -7.7% on NPAT in FY18E reflecting these H2 risks. Cash flow likely to be muted: The combination of a relatively high level of R&D capitalisation and a shift to term licences that are cash-settled on a deferred basis will mean FCF remains weak for c2 years. Valuation: When compared on a like-for-like basis (i.e. adjusting for R&D capitalisation schemes), IRI sits at a premium to peers. EV/EBITDA (adj.) FY19 at 19.6x versus peers at 16.5x. Our TP represents a blended mix of DCF, EV/EBITDA (adj.) and FCF yield analysis and points to -22.7% TSR. Risks and catalysts Catalysts: H2 licence sales are key catalyst and could trigger downside risk if forecasts are missed. Risks: rising competitive threats. Recommendation SELL 12-mth target price (AUD) $2.65 Share 06-Jun-18 (AUD) $3.51 Forecast 12-mth capital return -24.6% Forecast 12-mth dividend yield 1.9% 12-mth total shareholder return -22.7% Market cap $603m Enterprise value $593m Shares on issue 172m Sold short 0.4% ASX 300 weight 0.0% Median turnover/day Mark Bryan mark.bryan@wilsonsadvisory.com.au Tel James Bradley james.bradley@wilsonsadvisory.com.au Tel mth price performance ($) $0.5m 2.50 May-17 Sep-17 Jan-18 May-18 IRI XSI Rebased 1-mth 6-mth 12-mth Abs return (%) Rel return (%) Earnings forecasts Year-end June (AUD) FY16A FY17A FY18F FY19F FY20F NPAT rep ($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, Wilsons estimates, S&P Capital IQ Issued by Wilsons Advisory and Stockbroking Limited 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 Net Debt/Equity (%) Int. Cov er (100's x) 06 June 2018 Growth rates 29.0% 7.9% 6.3% 19.0% 14.8% 12.2% 12.1% Key assumptions FY15A FY16A FY17A FY18F FY19F FY20F FY21F Revenue growth (%) EBIT growth (%) NPAT growth (%) EPS growth (%) % FY17A FY18F FY19F FY20F Revenue Growth EPS Growth EBIT/sales (%) Tax rate (%) ROA (%) ROE (%) Returns 54% 56% 40% Margin trends 45% 40% 35% 30% 25% 20% 15% Solvency Free cash flow yield 4.5% 3.5% 2.5% 1.5% 44% Interims ($m) 46% 36% 37% 42% 41% 35% FY16A FY17A FY18F FY19F FY20F ROE ROIC -10% -15% -20% -25% -30% -35% FY16A FY17A FY18F FY19F FY20F EBITDA EBIT NPAT -8 FY16A FY17A FY18F FY19F FY20F Net Debt/Equity Interest Cover FY16A FY17A FY18F FY19F FY20F Free Cash Flow Yield (%) 1H17A 2H17A 1H18A 2H18E Sales revenue EBITDA EBIT Net profit Norm EPS EBIT/sales (%) Dividend (c) Franking (%) Payout ratio (%) Adj payout (%) Financial ratios FY15A FY16A FY17A FY18F FY19F FY20F FY21F PE (x) EV/EBITDA (x) Dividend yield (%) FCF yield (%) Payout ratio (%) Adj payout (%) Profit and loss ($m) FY15A FY16A FY17A FY18F FY19F FY20F FY21F 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 ($m) FY15A FY16A FY17A FY18F FY19F FY20F FY21F EBITDA Interest & tax Working cap/other Operating cash flow Maintenance capex Free cash flow Dividends paid Growth capex Invest/disposals Oth investing/finance flows Cash flow pre-financing Funded by equity Funded by debt Funded by cash Balance sheet summary ($m) FY15A FY16A FY17A FY18F FY19F FY20F FY21F Cash Current receivables Current inventories Net PPE Intangibles/capitalised Total assets Current payables Total debt Total liabilities Shareholder equity Total funds employed Page 2

3 Table of contents Investment thesis... 4 Company overview... 5 Entrenched customer base Commitment to R&D Cash flow headwinds Financials Valuation: Impending de-rate Page 3

4 Investment thesis IRI sells software licences across four modules: Unified Communications (UC), IT Infrastructure, Payments and Contact Centre. These modules are available through its primary product Prognosis. Revenues are derived from software licences, maintenance fees, consulting fees and testing solutions. Positives: Global customer base and recognised product: Strong distribution channels, highquality customers and 87% recurring revenues are reassuring. IR s Prognosis software licences are sold through a handful of high-quality distribution partners: CISCO, Avaya, HP and Microsoft. The partners increase the addressable market and revenue visibility. Digitisation as a structural driver: An independent forecaster, Nemertes Research, estimates that 70% of all companies are currently undergoing digital transformation. Out of their sample, some 50% of companies planned to increase their FY18 unified communications (UC) budget by 12% on average. IR s focus on UC products versus larger comps, which provide multiple services, puts them in a great position to leverage this trend. Embedded R&D: Over the past 5 years, IRI has invested some $106 in gross R&D which represents 30% of total revenues. We view this as a key positive for future years. This will be crucial given an impending move to the cloud is required. FedRAMP: In June 2016 CISCO purchased a number of Prognosis licences for the administration of a cloud solution to 7m US Government users. IR has flagged that this could generate $2.1m in revenues per month. There is scope for CISCO to add further sales on the back of this contract which is not currently in numbers. Shift to annual licensing: Since 2015 IR has been selling 3-5 year licences rather than perpetual licences. This provides for more visibility. In the long run this is a positive move adding to revenue visibility which we forecast materialising in FY20. Negatives: H2 weighting is significant: IR has always had a very H2-reliant business model. WILS forecasts $32m software licences in H218E of which the majority, similar to previous years, is closed toward the latter end of the half. This creates slippage risk. We also note that our forecasts are assuming a decline in EBITDA in H218 on H217 of around -16%. WILS sits below consensus: We see an EBITDA margin decline of c.-3% in FY18E from rising R&D and sales & marketing spend. Consensus full-year EBITDA is $40m Wilsons forecasts assume $38m. Cash flow headwinds: As IR continues to write deferred payments business and pushes for annual licensing, we see headwinds materialising in the coming two years with cash conversion rates continuing to trend lower. We forecast FCF/Revenue conversion of 5% for FY18E and 12% in FY19E compared to FY17A at 18%. Cloud technology and competitive landscape threat: IR has proven resilient to technology shifts in the competitive landscape. We understand that the majority of installations are on-premise and that a fairly small portion of R&D is being dedicated to the cloud. Key competitors include global bellwethers such as Huawei, Vonage and Amazon. The risk of technology shift and increased competition remains front of mind. Valuation seems full versus peers and risks: Given the risks outlined above we see scope for a de-rate. Our FY18E NPAT sits at $18.9m which is 7.7% below consensus. Within our coverage universe, if we fully expense capitalised R&D through the P&L, IRI is trading on an FY19E EV/EBITDA(adj.) of 19.6x a c.19% premium to the median of 16.5x. Notably, by our estimates IR trades on an unlevered FCF yield in FY19E of 2% versus peers at 3.8%. We see downside risk. Figure 1: Valuation Valuation Methodology $/share % w eight DCF $ % FCF Yield $ % EV/EBITDA(adj.) $ % Target price $2.65 Source: Wilsons estimates Page 4

5 Company overview IR is a leading provider of systems performance management software across the Americas, Europe and Asia Pacific through their primary product Prognosis. They service over 1,200 enterprise customers globally within a multitude of industries such as telcos, automotive, financial services and many more. Figure 2: Company overview Source: Company disclosure Product lines IR s Prognosis operates across four product lines which can be installed on premises or as part of a hybrid environment. These modules include: Unified Communications Payments Contact Center IT Infrastructure Figure 3: Product lines Source: IRI annual report FY17 Page 5

6 Figure 4: Product revenue breakdown 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY 13A FY 14A FY 15A FY 16A FY 17A FY 18E FY 19E FY 20E FY 21E Unified Communications IT Infrastructure Payments Consulting Source: Company disclosure Unified Communications UC is a product suite that enables a company s communication software (think Skype for business, IM, , telecoms, etc.) to be consolidated into a single dashboard. UC is becoming increasingly necessary as companies continue to expand their digital platforms to offer more forms of communication. The UC market is expected to grow at a 16.8% CAGR to 2024 reaching USD143bn. One of the major drivers of UC investment is the adoption of Microsoft Skype for business. Skype is now available as part of the Office 365 suite which has driven adoption. The communication platform is attractive given a cost advantage. UC investment is required to oversee all communications channels including Skype for business. UC products have evolved to differentiate through offering services beyond single-platformconsolidation such as real time systems analysis, data collection, real time quality optimisation/streamlining methods and outage predictions. UC currently makes up the majority of IR s revenues at 61%. Prognosis UC allows companies to: Access and monitor an entire communication network from one dashboard. Access and monitor communication networks before they are deployed. This is a particularly powerful vertical because customers who transition to cloud solutions are commonly unable to access their networks until the entire process is complete. Upgrade and migrate UC solutions across different platforms and between on premises and cloud. Innovative call recording assurance. Page 6

7 Figure 5: UC infrastructure example Source: IR website UC case study BT, (British Telecom), is transitioning a number of customers from an on-site solution to the cloud. During the transition, customers and BT service providers were able to monitor all systems regardless of the disruption. Prognosis was used to provide a streamlined dashboard that allowed these two parties to seamlessly transition to the cloud. BT states that IR was chosen because it is scalable, multi-vendor capable and didn t exist in a silo. BT is also a re-seller of IR product and industry contacts in the UK suggest a strong pipeline through their re-sale channel. Figure 6: UC case study snapshot Source: IR website Page 7

8 Figure 7: UC Voice systems interface Source: IR website IT Infrastructure The IT infrastructure module provides physical systems monitoring and server data analysis in real time. This allows IT departments to anticipate possible outages, predict server loads and better communicate issues to both customers and internal employees. Infrastructure makes up 27% of group revenues but over the long term we see this vertical declining as a percent of revenue due to flat industry growth conditions. In the short term the division is cycling over some tough comps which could lead to weakness. Prognosis IT infrastructure module enables: Proactive troubleshooting through intelligent alerts and automation of the tasks involved with fixing issues. A top down view of an entire server from a single dashboard. Real-time analysis of servers which allows IT staff to optimise their workflows. Monitoring of firm-wide software updates, CPU balance and workloads and hardware threshold breaches. Figure 8: IT infrastructure revenue % % % % % % % 0.0 H1 14A H2 14A H1 15A H2 15A H1 16A H2 16A H1 17A H2 17A H1 18A H2 18E H1 19E H2 19E H1 20E H2 20E H1 21E H2 21E -30.0% IT Infrastructure %Revenue %Growth Page 8

9 Payments Prognosis Payments solution helps customers to understand the performance of their transactions systems and to analyse the issues which push performance down. Capabilities include the monitoring of payment switches and fraudulent payment detection. The payments solution makes up 8% of group revenue and we have a positive view on its growth going forward. Our estimates assume that it will continue to grow at a 12.4% CAGR FY18E-21E. Key product features include: Real-time data feeds on the performance of ATM fleets and point of sale (POS) systems. Insights on machine faults and fraudulent activity. Minimisation of outages through real-time troubleshooting. Automation and/or alerts on regulatory compliance protocols Figure 9: Payments fraud detection Source: IR website Figure 10: Payments analytics dashboard Source: IR website Page 9

10 Figure 11: Payments revenue FY 13A FY 14A FY 15A FY 16A FY 17A FY 18E FY 19E FY 20E Payments %Revenue %Growth 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Consulting Services IR s consulting service offers customers expertise in optimising their IT solutions and is mainly focused on the initial analysis and installation process. Consulting makes up 7% of group revenue as at 1H18A. Competitive landscape Key competitive advantages: According to Nemertes research, IR s customers enjoy the lowest OPEX per user endpoint 33% and 56% lower than direct comps Riverbed and Nectar respectively. Having a laser focus on UC solutions (61% of revenue) allows the majority of IR s resources to be devoted into the depth of Prognosis. Competitors with a suite of revenue streams are largely producing a good enough service. Broad multi-vendor integration capability allows IR to manage complex hybrid environments such as systems transitions or a particularly diverse client software base. IR is the only provider to be certified across Microsoft, Avaya and CISCO networks. Continual investment in key supplier networks increases their TAM and drives further build-out of their relationships. This is particularly important given the positive feedback loop between more customers, more data and better product. Probe-less solution means that customers do not have to install physical probes into their systems for monitoring. The advantage of this is that set-up becomes faster and less intrusive. Page 10

11 Figure 12: Competitive overview Company Description Pros vs IRI Cons vs IRI Nectar Nectar is very close operationally to IR and operates out of Jericho, New York. Nectar is likely the most important competitor for IR. Evolution quality of service (QoS) solution is market leading, having been named a winner in the 2017 UC Product of the Year award by TMC. Evolution is UC device agnostic. Call Analysis is more fleshed out than IR s and offers call stitching, vendor knowledge modules and Call Detail Records (CDRs). Uses probes to monitor the digital landscape versus IR s probe-less solution. Higher OPEX cost per user endpoint. Riverbed Riverbed is San Francisco based and offers multiple software solutions globally across various verticals including UC. A broad range of products on offer drives scale and cross sales capability. Larger customer base across more geographies. Riverbed s UC product is not as deep as IR and could be viewed as a good enough solution. Higher OPEX cost per user end point. Uses probes to monitor the digital landscape versus IR s probe-less solution. CISCO Prime CISCO was founded in 1984 in San Francisco. Although CISCO is a distributer of IR s product, CISCO Prime has maintained its own monitoring solution outside of IR s. Backed by CISCO which operates on a much larger scale than IR in terms of both revenues and customers. More developed cloud offering allows them to address an additional market. Appears to be a good enough solution versus IR s more focused and deep Prognosis. Mitel Mitel focuses primarily on offering VoIP services globally and is based out of Canada. While Mitel s services are more heavily slanted to the platform provider space, they still do control the number 1 UC market share in Europe. Mitel operates on a much larger scale than IR. Currently controls the number 1 market share of UC in Europe. More diversified product offering raises TAM. UC cloud product gives Mitel access to the fast growing cloud vertical. Uses probes to monitor the digital landscape versus IR s probe-less solution. A larger product suite leads to a less focused UC solution where IR is able to focus all of its efforts in this space. Does not control the same superlative distribution network as IR and while scale somewhat makes up for this, it does not provide a truly environmentally agnostic service. NEC NEC is a Japanese provider of IT services that operates on a global scale. NEC is a member of the Sumitomo Group. Large-scale corporation with an expansive product range means that NEC operates on a much larger scale than IR. Larger product suite drives TAM and cross sale opportunities. IR is able to provide a probe-less solution. NEC is primarily focused on the Japanese market with little footprint throughout Europe and America. Source: Wilsons Figure 13: Annual OPEX per end-point Source: Company disclosure Page 11

12 Entrenched customer base Prognosis solutions are offered across 16 million devices within 1,200+ enterprise customers globally. Customers exist across a wide range of industries including automotive, banking, telcos and many more. Customers appear to be largely entrenched as evidenced by a 97% maintenance renewal rate. Prognosis is certified with and run across the Microsoft, Cisco and Avaya platforms which widens the addressable market. Of particular note is the Cisco partnership where Prognosis UC, Video and Contact Centre modules are offered under the Cisco SolutionsPlus Program. Figure 14: Recurring revenues FY15A FY16A FY17A FY18E FY19E FY20E FY21E Recurring Revenue Non-Recurring Revenue Figure 15: Global reach Source: Company disclosure Page 12

13 Figure 16: Key customers Distribution Partners Microsoft CISCO Avaya ACI Hewlett Packard Source: Company disclosure Customers Hewlett Packard BT Wells Fargo Sprint AMEX Dell Boeing Continued customer base growth Growing digitisation trends give us confidence in IR s addressable market going forward. This trend describes the continual adoption of software solutions to aid in the completion of day-today tasks. Adoption arises due to perceived efficiency gains, medium-term cost savings and increased functionality from the software employed. Additionally, increases in modules on offer and further partnerships contribute to a growing TAM. Drivers for customer growth include: Digital transformation: A study by independent researcher Nemertes points out that nearly 70% of organisations are undergoing a digital transformation. This gives us increased confidence in revenue visibility going forward and we forecast an 87% recurring revenue mix. UC budget growth: 50% of the companies observed by Nemertes plan to increase their 2018 UC budget by 12.3% on average. This has the potential to drive cross-sales going forward. Increasing modularity: Additional solutions are being added such as compliant call recording and additional cloud capabilities. We see headroom for increased recurring revenues and operational leverage in future years. Competitive cost save: According to Nemertes research, IR customers enjoy the lowest OPEX spend per user end point versus their closest operational competitors Event Zero, Riverbed and Nectar. This should act as an attractive sales point to new customers. Growing addressable market: IR s most recent distribution partnership was struck with CISCO on the 19 th September As IR continues to add to this portfolio of distribution partners their TAM will grow as well. Figure 17: Customer trends Source: Nemertes Research Page 13

14 Commitment to R&D We see IR s continuing commitment to R&D investment as a key positive. R&D positives: $106m of vested gross R&D for the past 5 years represents 30% of total revenue over the same period. Commitment to net R&D at 18% of sales going forward represents a return to the prior 5- year average after a tough cash year in FY16. We note that IRI has consistently upgraded Prognosis over time with new modules and system streamlining. Figure 18: R&D profile % % 41.9% 42.1% 41.3% 36.6% 35.7% 40.0% 35.0% % 22.1% 23.1% 20.8% 18.8% 16.6% 17.7% 16.1% 16.3% 14.7% 18.0% 17.5% 30.0% 25.0% 20.0% 15.0% 10.0% % 0.0 FY 13A FY 14A FY 15A FY 16A FY 17A FY 18E Net R&D Capitalised R&D % of R&D capitalised Gross R&D % of Total Revenue Net R&D % Total Revenue 0.0% Page 14

15 Cash flow headwinds Figure 19: Perpetual licensing P&L C/F B/S Large, Upfront Licence Fee Large, Upfront Licence Fee No Impact Annual Maintenance Fee Cash Every Year Yearly Deferred Revenue Source: Company disclosure Figure 20: Term-based licensing P&L Term Licence (3-5 Yrs.) C/F Instalments Over 3-5 Yrs. B/S Deferred Revenue Over 3-5 Yrs. Annual Maintenance Fee Cash Every Year Yearly Deferred Revenue Source: Company disclosure We see a number of headwinds for cash in the coming 24 months caused by a combination of the licensing structure change outlined in figures 19 and 20 and H2 slippage risks. OpCF conversion as a percent of revenue should decline short term with a mixture of H2 risk and a larger accounts receivable balance. We forecast FY18E OpCF/Revenue at 16.4% which is down 12% pcp. Cash receipts conversion should decline from historical levels due to higher term-based Licences in the mix being recognised through the P&L similar to perpetual Licences but having cash recognised in instalments. Maintenance fees should decline as a percentage of revenues because of a continual push (largely through pricing) towards term-based licensing versus perpetuals. IR is writing deferred payments business which will materialise in a high accounts receivables balance and could cause working capital headwinds. Page 15

16 Figure 21: FCF conversion % 42.5% 38.1% 39.4% 45.0% 40.0% % % % % % % 13.5% % % 25.0% 20.0% 15.0% 15.7% 15.0% 12.1% 10.0% 5.0% 0.0 FY15A FY16A FY17A FY18E FY19E FY20E FY21E Free cash flow ($m) FCF as % of revenue FCF conversion (% of EBITDA) 0.0% Figure 22: Deferred revenue FY 13A FY 14A FY 15A FY 16A FY 17A FY 18E FY 19E FY 20E FY 21E Deferred Revenue Light at the end of the tunnel It is important to note that while cash will feel pressure in the coming 24 months, if IR is able to stabilise through this timing disruption there should be no change to the cash generative natures of the business in the long run. We look to FY20E as the year of stabilisation. Additionally, in FY15 CISCO purchased a number of Prognosis Licences as part of a large US Government cloud-solution contract. If CISCO returns for further licences, this could de-rail our SELL rating by providing short-term cash support. The magnitude of CISO s original Licence purchase for 7m Government users is $2.1m per month we note that under current conversion rates this would equate to an additional $6m of OpCF in FY19E. Page 16

17 Financials Revenue model IRI currently generates 85% of revenues through licence and maintenance fees historically this was 90%. IRI previously focused on long-term (c.10yr) term-based licences however shifted towards perpetual licensing c.2009 where licence fees were recognised upfront through revenue and maintenance fees were annually recognised as deferred revenue. More recently, IR has been pushing for a larger portion of term-based business which should see maintenance declining in the revenue mix. The remaining 15% of revenue is derived from testing solutions and consulting fees which fluctuate in the mix due to 50% of testing solutions being one-off and consulting fees being entirely one-off. Licence fees: This revenue stream is primarily derived from the sale of term-based licences for Prognosis. IR takes 3-5 year licences to revenue initially and each year recognises an annual fee. These annual fees are booked as deferred revenue and materialise yearly. We forecast FY18E-21E CAGR of 17%. Maintenance fees: Recognised rateably to the P&L over the contract term. Given an increasing mix of term-based licensing where maintenance as a percentage of Licence value drops, we forecast flat maintenance fees. We estimate FY18E-21E CAGR of 0.9%. Consulting and Testing Solutions fees: Typically non-recurring sources which are recognised over the service period as work is performed. We forecast consulting and testing solutions revenue to grow at an FY18E-21E CAGR of 4% and 17% respectively. Figure 23: Regional breakdown 14.7% 17.0% 67.9% Americas % of Revenue Europe % of Revenue APAC % of Revenue Source: Company disclosure IR s group wide NPAT has a 4.8% delta to a one cent change in the AUD/USD rate and a 1.6% delta to a once cent change in AUD/GBP. In future years we expect licences to increase as a percentage of revenues due to declining maintenance fees in term based licensing and growing UC and payments verticals. IT infrastructure posted -16% revenue growth in 1H18A which we forecast decreasing a further -10% in 2H18E leading to a full-year estimate of $21m. This is largely driven by a slowing IT infrastructure market. Page 17

18 Figure 24: Revenue breakdown % % 84.3% % % 77.0% % FY15A FY16A FY17A FY18E FY19E FY20E FY21E Maintenance fees Testing Solution fees Licence fees Consulting fees % recurring revenue 88% 86% 84% 82% 80% 78% 76% 74% 72% 70% P&L forecasts Revenues: We see revenues being driven primarily by UC licence sales which are currently growing at 25% at 1H18A with our forecasts assuming c.20% growth in 2H18E. IT Infrastructure will likely struggle over the long term and we forecast -12% growth in FY18E. We forecast solid growth in payments from FY19E onwards as the solution gains further traction we forecast 12% CAGR FY18E-21E. Recurring revenues should take a hit short term with maintenance fees declining as a percentage of total revenue but as more term-based licences come through this should begin to climb again. EBITDA: Given that high margin licences make up the large majority of revenues, EBITDA margins should remain relatively solid at c.39% over the coming years. That said, this is a -3.4% decline from FY17 margins at 42% and is caused by increasing net R&D (FY17 was low due to cash crunch in FY16) and increasing S&M with +45% FTEs in the UK and more to come (c.4/5 per annum). NPAT: We note that with a decrease in US tax rates, IR s deferred tax assets will be devalued and lead to a higher effective tax rate of c.30% in FY18E. This will likely decrease towards 28% in the coming years. This leads us to a normalised NPAT estimate of $18.9m in FY18E which is -7.7% below consensus at $20.5. Consensus does not appear to have catered for this re-evaluation followed up a declining tax rate long term. Figure 25: Wilsons vs consensus Wilsons Est. vs Consensus ASX:IRI FY 18E FY 19E FY 20E Wilsons Est. Cons % diff Wilsons Est. Cons % diff Wilsons Est. Cons % diff Revenue % % % EBITDA % % % EBIT % % % NPAT % % % EPS % % % Source: Wilsons estimates Page 18

19 Figure 26: P&L summary P&L (A$m) Y/E: 30 Jun FY15A FY16A FY17A FY18E FY19E FY20E FY21E Licence fees % growth 46.3% 11.4% 16.9% 8.0% 18.0% 17.0% 16.0% Maintenance fees % growth 15.3% 14.6% -1.0% 0.5% 0.7% 0.9% 1.1% Testing Solution fees % growth % 27.0% 22.0% 17.0% 12.0% Consulting fees % growth 19.7% 32.8% -7.9% 3.0% 3.5% 4.0% 4.5% Revenue % growth 32.0% 20.3% 7.9% 6.3% 12.3% 12.1% 11.7% EBITDA (norm.) margin 38.9% 37.0% 42.0% 38.8% 38.7% 39.3% 40.0% % growth 46.5% 14.6% 22.3% -1.8% 12.2% 13.7% 13.6% D&A EBIT margin 25.9% 24.4% 29.6% 27.6% 28.8% 29.5% 30.2% % growth 64.1% 13.5% 30.6% -1.0% 17.2% 14.8% 14.4% Net interest expense/(income) Profit before tax Tax expense NPAT (norm.) margin 19.2% 18.1% 21.7% 19.5% 20.9% 21.4% 21.9% % growth 44.8% 13.8% 29.0% -4.6% 20.4% 14.7% 14.6% Abnormals NPAT (reported) Diluted EPS (based on NPAT norm.) (cps) % growth 44.0% 13.3% 29.0% -4.8% 19.6% 14.7% 14.6% Figure 27: Revenue forecasts % 32.0% % % % 19.1% % % 11.7% 12.1% % % % 20 5% 0 0% FY15A FY16A FY17A FY18E FY19E FY20E FY21E Americas Europe Asia Pacific Group revenue growth % Figure 28: EBITDA forecasts 60 70% 64.1% % 42.0% % 38.7% % 38.8% 39.3% 40.0% % % % 30% % 17.2% 14.4% 13.5% 14.8% 10% % 0% 0-10% FY15A FY16A FY17A FY18E FY19E FY20E FY21E EBITDA ($m) EBITDA margin EBITDA growth Page 19

20 Figure 29: NPAT forecasts 35 50% 44.8% % % 30% % 20.4% 13.8% 14.6% 14.7% 10% % -4.6% 0-10% FY15A FY16A FY17A FY18E FY19E FY20E FY21E NPAT (norm.) ($m) NPAT growth Figure 30: R&D forecasts % 41.9% 42.1% 36.6% 41.3% 35.7% 24.7% 23.1% 18.8% 16.6% 18.0% 16.3% 22.1% 20.8% 17.5% 17.7% 14.7% 16.1% FY 13A FY 14A FY 15A FY 16A FY 17A FY 18E Net R&D Capitalised R&D % of R&D capitalised Gross R&D % of Total Revenue Net R&D % Total Revenue 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Cash flow We see material headwinds to cash flows in the coming 24 months despite having only c.15% perpetual Licence customers left on the books to cycle through. This is for a number of reasons: Accounts receivable: IR is writing deferred payments business which materialises in a high accounts receivables balance. Receivables days in 1H18A were 267 compared to 237 at FY17 we see this increasing going forward. This large increase in accounts receivable materialises in significant working capital headwinds in FY18E. Deferred revenue: Deferred revenue is likely to increase in coming years which somewhat cushions headwinds caused by accounts receivable. This is due to part of term-based licence being booked as deferred revenue. We forecast deferred revenue increasing to c.25% by FY21E versus 22% in FY17A. Operating cash flow: We forecast operating cash flow well below consensus at $15.9m for FY18E. The catalyst which may de-rail our thesis is FedRAMP where CISCO had previously purchased Prognosis Licences in FY15 for a large government cloud contract. If CISCO returns for further sales before FY20, IR could see some OpCF respite through earnings. Free cash flow: Given decreasing upfront recognition our FY18E FCF/Revenue sits at 5% a material de-rate from 18% in FY17A. We see this recovering somewhat over the coming years as the deferred revenue increases outpace accounts receivable driving a less demanding WC cycle and subsequently higher FCF. Cash receipts: Cash receipt conversion should continue to decline in the long term due to the term-based licence structure. Page 20

21 Figure 31: FCF forecasts % 41.2% 39.6% 37.8% % % % 16.0% 13.5% 14.9% 12.1% % % 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.8% 15.0% 10.0% 5.0% % FY15A FY16A FY17A FY18E FY19E FY20E FY21E Free cash flow ($m) FCF as % of revenue FCF conversion (% of EBITDA) Figure 32: OpCF ex. cap. R&D FY15A FY16A FY17A FY18E FY19E FY20E FY21E OpCF ex. Cap. R&D OpCF % R&D Capitalised 44% 42% 40% 38% 36% 34% 32% Figure 33: Licence structure cash receipt effects % % 98% 102% 88% 87% 100% % 74% % 80% % 53% % % 0.0 0% FY13 FY14 FY15 FY16 FY17 FY18E FY19E FY20E FY21E Revenue Receipts Conversion % Figure 34: OpCF profile 40 90% % % 67.6% 68.9% % 61.5% 70% % % 42.4% 50% % % 30.5% 28.3% 30% % 16.4% 23.8% 26.6% 20% 5 10% 0 0% FY15A FY16A FY17A FY18E FY19E FY20E FY21E Operating cash flow ($m) OpCF %EBITDA OpCF %Revenue Page 21

22 Figure 35: Cash flow summary Cash flow summary (A$m) Y/E: 30 Jun FY15A FY16A FY17A FY18E FY19E FY20E FY21E NPAT Non cash adjustments Net change in WC Others Net operating cash flow (A$m) Operating cash flow conversion 78.4% 51.8% 67.3% 42.4% 61.5% 67.6% 68.9% Capitalised development costs Payment for PPE Others Net cash flow from investing (A$m) Net cash flow from financing (A$m) Net cash inflow /(outflow ) Opening cash balance Fx impact Closing cash balance Net operating cash flow Less: capex and R&D Free cash flow ($m) FCF grow th (%) 55% -45% 163% -69% 160% 37% 19% FCF as % of revenue 16% 7% 18% 5% 12% 15% 16% FCF conversion (% of EBITDA) 41% 20% 43% 14% 31% 38% 40% Page 22

23 Balance Sheet IR s balance sheet has no debt and modest cash of $9.6m at 1H18A. We expect FY18E to be a tough year for cash however this balance will likely increase in future years as WC tailwinds from deferred revenues outpaces accounts receivable headwinds. Figure 36: Cash forecasts FY15A FY16A FY17A FY18E FY19E FY20E FY21E Net cash (A$m) Deferred revenue improving: IR s balance sheet contains a sizeable $20.5m of deferred revenue at 1H18A. We forecast this increasing as the term-based model takes licence fees to deferred revenues. Tax liability and assets re-valuation: Due to a decrease in the US corporate tax rate, IR should experience a net devaluation of tax assets and liabilities. This leads us to an effective tax rate of 30% in FY18E which we see declining towards 28% into FY21E. Accounts receivable investment: IR carries significant current and non-current accounts receivable of $67m. This may increase even faster than we have forecast given the nature of cloud Licences which may be an increasing mix of licence fees going forward. We expect total accounts receivable of $76m for the full year 18. Intangibles: Largely made up of capitalised R&D and ongoing goodwill from acquisition of IQ services In FY15. Page 23

24 Figure 37: Balance Sheet summary Balance Sheet (A$m) Y/E: 30 Jun FY15A FY16A FY17A FY18E FY19E FY20E FY21E Assets Cash and cash equivalents Trade and other receivables Current tax asset Other current assets Total current assets Receivables Other financial assets Property, plant and equipment Intangible assets Deferred tax assets Total non-current assets Trade and other payables Provisions Income tax liabilities Deferred revenue Other current liabilities Total current liabilities Deferred consideration for acquisition Deferred tax liabilities Provisions Deferred revenue Other non current liabilities Total non-current liabilities Net assets Issued capital Reserves Retained earnings Total equity Page 24

25 Valuation: Impending de-rate We see significant risk to IR s current valuation which trades at a premium to peers. The following points drive our SELL rating: FY19E P/E of 23x is in line with peers at 24x however FCF yield at 2.2% is -42% below peers at 3.8%. We do note that IR s EPS growth is strong at 22% for FY19E versus peers at 14% however we feel that the cash flow risk outweighs this. This view is reinforced by the observation that on all multiples which fully account for capitalised development costs, IR trades at a significant premium to peers. Fully expensing capitalised R&D puts IRI on an FY19E EV/EBITDA (adj.) of 19.6x vs our coverage at 16.5x. Applying the same method to OpCF, IR trades at an FY19E EV/OpCF(adj.) of 43.7x times versus peers at 20.2x greater than 100% more than a sample space including Xero and ELO. H2 leverage leading to slippage risk should demand some risk premium in our view given that H2 trades through the Christmas period. While recurring revenues are strong at 87%, this may be misleading as they do not capture short-term renewal tenor which is a key litmus test for the business cash flow risk or safety in future years. Given the shift to term-based licences this should drop in the short term but naturally increase over time. Cash flow headwinds over the coming 24 months decrease business optionality and increase risk. The de-railing factor to this thesis is FedRAMP which may provide shortterm cash flows if this revenue stream mobilises swiftly we ascribe a low probability to this outcome. We see a material risk for a consensus de-rate. We use an even mixture of DCF, EV/EBITDA(adj.) and FCF yield to value IRI. We feel that a DCF captures the short-term cash flow risk but does not ignore the longer-dated normalisation of cash. EV/EBITDA (adj.) is selected because it allows us to compare IRI on a L4L basis to relevant technology comps without a high R&D capitalisation rate colouring the output. FCF yield is used because it effectively captures our short-term cash flow views and is an important metric for technology companies with a lower revenue growth profile. Figure 38: Valuation methodology Valuation Methodology $/share % w eight DCF $ % FCF Yield $ % EV/EBITDA(adj.) $ % Target price $2.65 Source: Wilsons estimates Page 25

26 Elmo Limited EML Payments Limited Reckon Limited ARQ Group Limited MYOB Group Limited Class Limited Technology One Limited EML Payments Limited Reckon Limited Melbourne IT Limited MYOB Group Limited Class Limited Technology One Limited Bravura Solutions Limited 06 June 2018 Figure 39: EV/EBITDA (adj.) multiples 25.0x 20.0x 15.0x 10.0x 5.0x 0.0x Source: Wilsons estimates Figure 40: EV/OpCF(adj.) multiples 50.0x 45.0x 40.0x 35.0x 30.0x 25.0x 20.0x 15.0x 10.0x 5.0x 0.0x Source: Wilsons estimates Page 26

27 DCF Assumptions Margins: We see margins improving slightly over time as operational leverage comes through from declining costs and potential cross sales. We see operating margins climbing to 31.4% over the long run. Capex and D&A: IR s D&A has been substantially above their Capex for the previous five years and is largely driven by high R&D capitalisation and low PPE. We note that R&D capitalisation may include growth or maintenance R&D. WACC: We assume a WACC of 9.4% to reflect the more consolidated nature of the business versus our remaining coverage universe. Despite short-term cash headwinds, we do see headroom for cash stabilisation in future years. Of note is that ROIC has been consistently high at 42% on average since FY15 compared to FCF ROIC at 30% on average. This coupled with our more positive long-term view reinforces our choice of a slightly lower WACC compared to our coverage. Figure 41: DCF assumptions DCF Assumptions (30 June Y/E) 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E Revenue grow th 6.3% 12.3% 12.1% 11.7% 12.2% 12.6% 12.9% 13.1% 13.2% 13.2% Operating margin (EBIT) 27.6% 28.8% 29.5% 30.2% 30.4% 30.6% 30.8% 31.0% 31.2% 31.4% EBITDA margin 38.8% 38.7% 39.3% 40.0% 40.1% 40.2% 40.2% 40.2% 40.2% 40.1% D&A / Revenue 11.2% 10.0% 9.8% 9.8% 9.7% 9.6% 9.4% 9.2% 9.0% 8.7% Capex / Revenue 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% Capitalised R&D and intangibles capex / Revenue 10.2% 10.7% 10.7% 10.7% 10.6% 10.5% 10.4% 10.3% 10.2% 10.1% Working capital grow th 179.0% -48.3% -27.9% 5.4% 12.2% 12.6% 12.9% 13.1% 13.2% 13.2% Tax rate 30.3% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% DCF cash flows 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E TV Revenue Operating profit (EBIT) % growth 17.2% 14.8% 14.4% 12.9% 13.3% 13.6% 13.8% 13.9% 13.9% EBITDA Tax benefit/(expense) (8.1) (8.8) (10.1) (11.6) (13.1) (14.9) (16.9) (19.2) (21.9) (25.0) EBIT (1-t) Add back D&A Deduct capex (1.0) (1.1) (1.2) (1.4) (1.5) (1.7) (1.9) (2.2) (2.5) (2.8) Deduct capitalised softw are development and intangibles capex (9.9) (11.6) (13.1) (14.6) (16.2) (18.1) (20.2) (22.6) (25.4) (28.5) Change in net working capital (14.8) (7.6) (5.5) (5.8) (6.5) (7.3) (8.3) (9.4) (10.6) (12.0) FCFF Discount factor Present value Source: Wilsons Page 27

28 Figure 42: ROIC forecasts ROIC A 2018E 2019E 2020E 2021E EBIT (norm.) Tax expense/(benefit) NOPAT Free Cash Flow (m) Net Working Capital Fixed Assets Intangible Assets Invested Capital ROIC 47.0% 35.6% 42.3% 30.5% 31.8% 32.9% 34.0% FCF ROIC 40.2% 14.4% 35.1% 8.3% 18.7% 23.3% 24.7% ROE 36.5% 37.3% 40.4% 33.4% 33.2% 32.1% 31.0% Invested Capital Excluding Intangibles ROIC Excluding Intangible Assets 119.9% 72.7% 74.3% 45.0% 45.6% 46.9% 48.2% FCF (%) / Invested Capital 40.2% 14.4% 35.1% 8.3% 18.7% 23.3% 24.7% FCF (%) / Invested Capital (ex intangibles) 102.3% 29.4% 61.7% 12.3% 26.8% 33.1% 35.0% Figure 43: Peer comparison table IRI Comparable Company Analysis Data as at: 06/06/2018 Company Name Ticker Currency Year-end Mkt cap EV/EBITDA EV/Revenue P/E (norm.) EPS grow th EBITDA margin ufcf Yield (m) FY18 FY19 FY20 FY18 FY19 FY20 FY18 FY19 FY20 FY18 FY19 FY20 FY18 FY19 FY20 FY18 FY19 FY20 Domestic Softw are MYOB Group Limited ASX:MYO AUD 31-Dec 1, x 10.2x 9.2x 4.5x 4.1x 3.8x 16.5x 15.8x 14.1x 77% 5% 12% 42% 41% 42% 6.2% 6.2% 7.5% Xero Limited ASX:XRO NZD 31-Mar 5, x 42.0x 27.8x 10.6x 8.2x 6.5x NM 115.8x 63.9x -160% 432% 82% 14% 20% 23% 0.4% 0.8% 0.3% Altium Limited ASX:ALU USD 30-Jun 2, x 38.7x 32.2x 16.0x 13.5x 11.5x 58.2x 47.2x 39.4x 149% 24% 20% 33% 35% 36% 1.7% 2.4% 2.9% Hansen Technologies Ltd ASX:HSN AUD 30-Jun x 12.4x 11.9x 3.7x 3.5x 3.4x 20.6x 19.0x 18.3x 86% 8% 4% 27% 28% 28% 5.1% 5.3% 5.8% Class Limited ASX:CL1 AUD 30-Jun x 13.7x 11.5x 7.7x 6.5x 5.6x 34.0x 27.1x 22.5x 16% 26% 20% 46% 47% 48% 2.3% 3.4% 4.6% IRESS Limited ASX:IRE AUD 31-Dec 1, x 14.3x 13.1x 4.3x 4.1x 3.8x 24.1x 21.2x 18.7x 53% 13% 14% 27% 28% 29% 4.4% 5.2% 5.5% Isentia Group Limited ASX:ISD AUD 30-Jun x 6.2x 5.9x 1.6x 1.6x 1.5x 10.3x 9.3x 8.8x 58% 11% 6% 24% 26% 26% 13.1% 12.5% 13.1% Infomedia Ltd. ASX:IFM AUD 30-Jun x 7.9x 6.9x 3.7x 3.3x 3.0x 23.1x 18.5x 15.5x 24% 25% 20% 38% 42% 44% 2.6% 4.9% 7.3% Wisetech Global Limited ASX:WTC AUD 30-Jun 4, x 43.4x 33.1x 20.9x 16.0x 13.1x 105.2x 71.8x 50.8x 58% 47% 41% 35% 37% 40% -2.8% 0.1% NM Technology One Limited ASX:TNE AUD 30-Sep 1, x 16.4x 14.4x 4.4x 4.0x 3.5x 27.4x 23.6x 20.8x 16% 16% 15% 23% 24% 24% 3.7% 3.9% 4.6% Bravura Solutions Limited ASX:BVS AUD 30-Jun x 15.6x 14.1x 3.2x 2.9x 2.7x 27.0x 24.7x 22.1x 114% 9% 12% 18% 19% 19% NM NM NM GBST Holdings Limited ASX:GBT AUD 30-Jun x 11.5x 9.2x 1.6x 1.5x 1.4x 23.7x 20.6x 14.7x 105% 15% 40% 11% 13% 15% 4.7% 5.4% 7.3% Median 16.2x 14.0x 12.5x 4.4x 4.0x 3.7x 24.1x 22.4x 19.7x 58% 16% 17% 27% 28% 28% 3.7% 4.9% 5.6% Average 25.6x 19.4x 15.8x 6.8x 5.8x 5.0x 33.6x 34.6x 25.8x 50% 53% 24% 28% 30% 31% 3.8% 4.5% 5.9% International The Sage Group plc LSE: SGE GBP 30-Sep 7, x 13.7x 12.5x 4.3x 4.0x 3.7x 20.2x 18.7x 17.1x 41% 8% 10% 29% 29% 29% 4.3% 4.9% 5.6% Intuit Inc. Nasdaq:INTU USD 31-Jul 53, x 21.6x 19.4x 8.8x 7.9x 7.2x 37.5x 31.8x 28.0x 69% 18% 14% 37% 37% 37% 3.2% 3.6% 4.4% Workday, Inc. Nasdaq:WDAY USD 31-Jan 27, x 38.1x 28.9x NM NM 6.4x 101.4x 76.9x 58.9x NM 32% 31% 19% 21% 22% 1.5% 2.0% 2.3% Atlassian Corporation Plc Nasdaq:TEAM USD 30-Jun 15, x 49.2x 40.6x 17.2x 13.4x 10.8x 135.4x 96.7x 74.1x NM 40% 30% 27% 27% 27% 1.8% 2.3% 3.0% Adobe Systems Incorporated Nasdaq:ADBE USD 01-Dec 124, x 24.6x 21.4x 13.6x 11.5x 9.9x 39.3x 34.6x 28.9x NM 13% 20% 46% 47% 46% 2.8% 3.4% 4.3% salesforce.com, inc. NYSE:CRM USD 31-Jan 99, x 26.5x 21.5x 7.3x 6.1x 5.2x 57.5x 49.2x 38.4x NM 17% 29% 23% 23% 24% 2.6% 3.3% 4.2% Mitel Networks Corporation Nasdaq:MITL USD 31-Dec 1, x 7.9x NM 1.4x 1.4x NM 10.4x 9.4x NM 527% 10% NM 17% 18% NM 7.7% 12.1% 0.0% NEC Corporation TSE:6701 JPY 31-Mar 792, x 5.9x 5.1x 0.4x 0.4x 0.4x 22.4x 12.6x 9.4x NM NM NM 5% 7% 7% 9.1% 11.7% 16.2% Huawei Culture Co., Ltd. SZSE: CNY 31-Dec 5,004 NM NM NM 3.6x 3.0x NM 10.8x 8.8x NM NM NM NM NM NM NM NM NM NM Vonage Holdings Corp. NYSE:VG USD 31-Dec 2, x 14.3x 12.6x 2.9x 2.7x 2.5x 29.2x 29.7x 26.7x 194% -2% 11% 19% 19% 20% 4.2% 3.3% 1.1% Oracle Corporation NYSE:ORCL USD 31-May 192, x 9.3x 8.8x 4.6x 4.5x 4.3x 15.3x 14.1x 13.0x NM 9% 9% 47% 48% 49% 6.7% 7.1% 7.7% SAP SE DB:SAP EUR 31-Dec 117, x 13.1x 11.8x 4.8x 4.5x 4.1x 22.7x 20.5x 18.3x NM 11% 12% 34% 34% 35% 3.3% 3.7% 4.5% Median 15.3x 14.3x 16.0x 4.6x 4.5x 4.7x 26.0x 25.1x 27.4x 131% 12% 14% 27% 27% 28% 3.3% 3.6% 4.3% Average 24.5x 20.4x 18.3x 6.3x 5.4x 5.5x 41.8x 33.6x 31.3x 208% 16% 18% 28% 28% 30% 4.3% 5.2% 4.8% ASX:IRI AUD 30-Jun x 12.4x 10.6x 5.8x 4.9x 4.2x 28.1x 23.0x 19.2x 28% 22% 20% 41% 39% 40% 0.8% 2.2% 3.0% Group Median 15.8x 14.3x 12.9x 4.4x 4.1x 4.0x 24.1x 22.4x 21.4x 63% 14% 15% 27% 28% 28% 3.5% 3.8% 4.6% Group Average 25.1x 19.9x 16.9x 6.6x 5.6x 5.2x 37.9x 34.1x 28.3x 89% 36% 21% 28% 29% 31% 4.0% 4.9% 5.3% Source: S&P Capital IQ Page 28