Bruno A. Carraro (bac43@cam.ac.uk) March 2015 Yevgeniy Kogan (yk326@cam.ac.uk) Lu Zhou (lz357@cam.ac.uk) Value Investing SIG Disclaimer Figures shown are based on public available information only. The views expressed in this report reflect the Cambridge Value Investing SIG s views about the subject company and its securities and should not be associated with the any views of the University of Cambridge and/or Judge Business School whatsoever. The Cambridge Value Investing SIG is a student-run not-for-profit club that does not promote any given securities upon compensation and does not charge any fees in connection with the preparation of its investment reports.
Investment thesis Engineering Ingegneria Informatica SpA ( Engineering or the Company ) is an Italian IT consulting group specialised in systems integration and business process outsourcing solutions 600m market cap (1), 659m EV (1) No. 5 player in the Italian IT services market with an estimated 5.1% market share (2) The founding family holds a 35% stake with a 29% stake that is held by a private equity consortium Excluding non-recurring costs and income, the Company generates 812m net turnover (3), 106m EBITDA (3) and 63m EBIT (3) Implied EV/EBITDA of 6.2x, EV/EBIT of 10.5x, EV/NOPAT of 14.5x and P/E of 13.9x Asset-light company with little financial debt, net debt / EBITDA (3) being 0.5x The market is undervaluing the stock, which is trading at discount to peer group: Only 11% of turnover is generated abroad and turnover s 5-year CAGR did not exceed market s Single-digit EBIT margin and significant exposure to the Public Sector that pays in arrear and therefore hits ROCE The Company can benefit from two identified catalysts for value: DSO from the Public Sector can fall by 50% as a consequence of a law approved in 2012 Slight change in the Company s staff mix which at the moment consists of too many managers Discounted Cash Flow and Earnings Power valuations indicate upside potential and good downside protection: DCF: Using WACC of 7.0-7.5%, current stock price implies negative perpetual growth rate of 1.25-0.75% EPV (4) : In event of no future growth in earnings/assets, the current stock price implies a WACC of 7.0-7.5% The position can be hedged by shorting Reply SpA ( Reply ), the Company s closest competitor: Reply stock trades at EV/EBITDA of 9.0x, EV/EBIT of 10.0x, P/E of 17.3x Reply s higher EBIT and ROCE than Engineering s do not justify a 300% stock outperformance in the past 5 years The Cambridge Value Investing SIG estimates the upside potential to be 30%+ v current price 1 Note: (1) As of 8 Mar 2015; (2) Elaboration by the Cambridge Value Investing SIG based on estimate by IDC as of 31 Dec 2013; (3) Financials have been adjusted excluding negative goodwill in connection with the acquisition of T-System Italia (FY 2013), restructuring costs (FY 2011, FY 2013), and non-recurring turnover (FY 2009). Net debt includes pension liabilities and operating leases; (4) Used 5-year normalised earnings as a basis for valuation. Please turn to page 8 for details.
Company overview Company profile Founded in 1980 by Michele Cinaglia who was joined by Rosario Amodeo in 1984, Engineering Ingegneria Informatica SpA (the Company or Engineering ) is an Italian listed group with 7,300 employees and 40 offices (37 in Italy and 3 abroad) The Company offers systems integration and business process outsourcing solutions, and develops cloud computing solutions out of 6 data centres Engineering has a portfolio of 1,700 clients operating in 4 industries: Public Sector, Utilities & Telecoms, Industrials, Financials In June 2013, ONE Private Equity acquired the 29.9% stake held by the Amodeo family; after JP Morgan shut down its private equity activities, the stake was acquired, as part of a larger private equity secondary transaction, by a consortium consisting of Alpinvest, Blackstone and Lexington ( OEP Secondary Fund ) Key management: Mr Cinaglia (Chairman), Mr Pandozy (CEO), Mr Iorio (CFO) As of 8 th March 2015, the Company has a market cap of ~ 600m Summary financials (1) millions, FY ending Dec FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 H1 2014 LTM Q3 2014 LTM Operating turnover 724.0 758.6 775.7 770.0 822.8 834.9 843.5 Other turnover 26.9 20.3 17.6 15.6 22.7 29.6 30.9 Net turnover 697.1 738.3 758.1 754.4 800.1 805.3 812.6 y/y growth% (2.9)% 5.9% 2.7% (0.5)% 6.1% 1.3% 2.2% EBITDA adj. 88.6 92.0 92.3 92.6 106.3 106.8 105.8 EBITDA adj. margin % 12.7% 12.5% 12.2% 12.3% 13.3% 13.3% 13.0% EBIT adj. 64.9 70.3 66.3 64.1 58.5 60.9 62.7 EBIT adj. margin % 9.3% 9.5% 8.8% 8.5% 7.3% 7.6% 7.7% Net profit adj. 34.7 36.6 30.2 41.4 28.9 24.5 43.3 Net profit margin % 5.0% 5.0% 4.0% 5.5% 3.6% 3.0% 5.3% Free cash flow adj. 42.233 45.7 27.5 29.3 89.1 51.3 na EBITDA-to-FCF 45.1% 49.7% 36.0% 31.6% 88.4% 50.6% na Capital employed 298.7 299.7 326.3 349.2 339.7 350.4 na ROCE 25.8% 27.1% 23.2% 21.3% 20.2% 20.0% na Capex 13.2 14.2 21.6 20.8 12.9 15.2 na Capex / Net turnover 1.9% 1.9% 2.9% 2.8% 1.6% 1.9% na Net debt (cash) 37.9 74.0 118.5 111.5 41.4 43.3 51.9 Net debt (cash) / EBITDA 0.4x 0.8x 1.3x 1.2x 0.4x 0.4x 0.5x Shareholder structure (2) Net turnover breakdown (3) 39.7% 38.7% 26.4% 29.4% 28.9% OEP Secondary Fund, 29.2% Other, 21.1% AXA IM, 1.3% Norges Bank, 1.5% ING, 2.0% Bestinver, 10.0% 35.6% 38.5% 21.2% 21.1% 22.2% 34.2% 32.1% 31.7% Cinaglia Family, 35.0% 24.7% 22.8% 18.2% 17.4% 17.3% 2009 2010 2012 2013 H1 2014 Financials Public Sector Industrials Utilities & Telecoms 2 Source: Company reports, S&P Capital IQ, Thomson Reuters. Note: (1) Financials have been adjusted excluding negative goodwill in connection with the acquisition of T-System Italia (FY 2013), restructuring costs (FY 2011, FY 2013), and non-recurring turnover (FY 2009). ROCE = EBITA / capital employed. Intangible assets not included in capital employed. Net debt includes pension liabilities and operating leases. (2) Other includes treasury shares (2.5%) and other institutional investors, most notably SW Mitchell Capital and Dimensional Fund Advisors. (3) Data as of H1 2014 as no details were provided in Q3 2014 report. Net turnover split between Industrials and Utilities & Telecoms not available for years prior to 2011.
Business model Receivables and construction contracts 100 ~282 days to convert into cash Avg provision for doubtful receivables (1) 5 No conversion into cash Avg unbilled invoices and construction contracts (2) 31 ~534 days to convert into cash Turnover = 129 Net receivables from billed invoices 64 ~184 days to convert into cash Cost of personnel 61 54% of operating costs Salaries 45 41% of operating costs Social security 12 11% of operating costs Operating costs = 112 Post-employment benefits 3 2% of operating costs Other operating costs (3) 51 46% of operating costs ~ 13% Gross margin 3 Source: Company reports. Note: Indicative figures, normalised over the 2009-14 period. (1) Provision the Company sets aside for receivables deemed difficult to collect; (2) Construction contracts reported net of billed work in progress; (3) Mostly outsourcing contracts, plus building rental and maintenance and travel expenses.
The Italian IT services market and the competitive landscape IT services market in Italy, bn Top 10 players in IT services by market share BPO 6-year CAGR: 2.3% Traditional IT services 6-year CAGR: 0.5% IT services 6-year CAGR: 0.9% IBM Accenture 6.7% 7.6% 4.6 4.7 4.9 5.0 5.1 5.3 Hewlett Packard Engineering 5.1% 5.5% 10.1 10.0 10.1 10.2 10.3 10.4 Selex Reply SIA Almaviva 2.9% 2.8% 2.6% 2.5% 2012 2013 2014E 2015E 2016E 2017E Traditional IT services BPO NTT Bassilichi 1.6% 1.8% Sector (1) split of the 100 largest IT services companies operating in Italy and Engineering s sector positioning (2) Consumer, 8% Public Sector 3 Services, 21.0% Financials, 28.0% Financials 5 Industrials, 21.0% Public Sector, 22.0% Industrials 4 Utilities & Telecoms 2 4 Source: IDC, Cambridge Value Investing SIG estimates. Note: Data refers to turnover as of FY 2013. (1) Utilities & Telecoms are included in Services. (2) Software providers excluded.
Feb 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Apr 12 Jun 12 Aug 12 Oct 12 Dec 12 Feb 13 Apr 13 Jun 13 Aug 13 Oct 13 Dec 13 Feb 14 Apr 14 Jun 14 Aug 14 Oct 14 Dec 14 Feb 15 Share price evolution and main events 60 55 1 2 3 4 5 6 7 8 9 50 45 40 35 30 25 20 15 10 Event # Date Description 1 16 Jun 2010 The Company acquires Consulting Board Room, a small IT consultancy operating in San Marino 2 2 Jul 2010 Engineering buys a data centre from Seat Pagine Gialle 3 18 Jun 2012 The Company denies the market rumours over a sale of the stake held by the Amodeo family 4 31 Jan 2013 The Amodeos (1) resign from the board 5 8 Mar 2013 Engineering acquires T-Systems Italia for 1m, with T-System injecting 25m of fresh capital 6 14 Jun 2013 ONE Private Equity announces the acquisition of a 29.9% stake from the Amodeo family for a share price of 32, implying 5.3x LTM EBITDA (2) 7 3 Feb 2014 The Company acquires for 6.0m MHT, a provider of ERP and CRM solutions to SMEs with 9.4m turnover 8 21 Jan 2015 ONE Private Equity sells its stake to Alpinvest, Blackstone and Lexington as a part of a larger private equity secondary transaction (3) 9 25 Jan 2015 The Company acquires WebResults, a cloud computing solutions company with 2.5m turnover 5 Source: S&P Capital IQ, Company reports and website. Data as of 8 Mar 2015. Note: (1) Ms Costanza Amodeo resigned on 31 Jan 2013, and Mr Rosario Amodeo resigned on 26 Mar 2013; (2) EBITDA adjusted excluding negative goodwill in connection with the acquisition of T-System Italia, restructuring costs, and non-recurring turnover. Net debt includes pension liabilities and operating leases. (3) JP Morgan sold 50% of ONE Private Equity portfolio to Alpinvest, Lexington and Blackstone for 4bn. The investment professionals of ONE Private Equity established a new company and were given mandate by Alpinvest, Lexington and Blackstone to manage the portfolio companies they acquired.
Catalysts for value Catalyst Description Impact per share In order to comply with a law that was passed by the Italian government in late 2012, the Public Sector s must pay back its commercial liabilities within 60 days from the invoice date Improvement in receivable collection As of H2 2014, Engineering held 168.5m overdue receivables from the Public Sector, equal to 39.4% of the total billed receivables held by the Company Conservatively assuming the target DSO to be ~155 days (50% improvement from the current 310 days), and not taking into account a decrease in bad debt provision and a rise in turnover, the net working capital would decrease by 60.2m 4.9 Lower cost of personnel The annual average salary of Engineering s employees is ~ 40.6k compared to ~ 37.1k average salary in other Italian IT consultancies (1) Such a difference is mostly due to the high number of mid-level managers that Engineering employs (1,500+) Given that the reported staff turnover amongst managers is ~5% and that Engineering plans to recruit ~200 fresh graduates each year, the Company can change its staff mix, switching towards a less expensive personnel structure, with average annual salary of ~ 38.6k (2) 1.0 The weighted impact of identified catalysts can be ~ 6.0 per share 6 Source: Company reports, Cambridge Value Investing SIG, Assinform, OD&M Consulting, Note: (1) Calculated by weighing the average salaries earned by executives, managers and professionals of the IT consulting sector in Italy by the number of Engineering personnel in each of the 3 staff categories; (2) Assuming the all of the managers who leave are replaced with less experienced staff for the first yea to change the staff mix and from then onwards that staff mix remains the same. In the new personnel structure, managers would be paid on average 10% more than peers at other IT consultancies and junior professionals would be paid 5% more than peers at other IT consultancies.
Relative valuation suggests that Engineering is undervalued Figures in millions, as of 8 Mar 2015 Company Name Market Cap LTM Turnover EV/EBITDA LTM EV/EBIT LTM P/E LTM Net debt/ebitda LTM LTM EBITDA Margin % LTM EBIT Margin % LTM Net Profit Margin % Exprivia SpA (BIT:XPR) 41.6 144.8 6.8x 8.4x 13.9x 3.2x 8.0% 6.5% 0.0% Reply S.p.A. (BIT:REY) 695.1 617.7 9.0x 10.0x 17.3x 0.3x 12.9% 11.5% 6.4% CAD IT SpA (BIT:CAD) 38.3 54.8 5.7x 24.5x 135.9x 0.1x 11.7% 2.7% 0.5% Be Think Solve Execute SpA (BIT:BET) 71.5 92.0 6.3x 10.0x 73.3x 1.8x 17.2% 10.8% 1.1% TXT e-solutions S.p.A. (BIT:TXT) 100.2 54.6 13.7x 15.5x 17.7x (1.0)x 12.5% 11.0% 9.8% Indra Sistemas, S.A. (CATS:IDR) 1,671.2 2,968.8 15.2x 21.2x 12.5x 4.6x 5.3% 3.8% 4.3% Altran Technologies S.A. (ENXTPA:ALT) 1,512.0 1,685.4 10.4x 11.2x 18.5x 0.9x 9.5% 8.8% 4.7% Average Regional Players 590.0 802.6 9.6x 14.4x 41.3x 1.4x 11.0% 7.9% 3.8% Cap Gemini S.A. (ENXTPA:CAP) 11,594.6 10,573.0 9.3x 11.3x 19.8x (1.0)x 10.6% 8.7% 5.5% NTT Data Corporation (TSE:9613) 10,426.2 10,873.3 7.2x 18.8x 39.5x 1.0x 15.1% 5.8% 2.4% CGI Group, Inc. (TSX:GIB.A) 12,069.7 7,362.3 11.1x 13.5x 18.9x 1.1x 16.5% 13.5% 8.7% Atos SE (ENXTPA:ATO) 7,349.1 9,051.2 6.0x 9.1x 27.8x (0.9)x 11.8% 7.8% 2.6% Computer Sciences Corporation (NYSE:CSC) 8,935.2 11,091.3 7.9x 20.5x NM 0.3x 10.5% 4.0% (0.2)% Infosys Ltd. (BSE:500209) 36,821.0 7,613.2 14.7x 15.8x 21.0x (2.1)x 28.8% 26.6% 23.2% Wipro Ltd. (BSE:507685) 23,805.7 6,610.2 14.3x 16.2x 19.0x (1.5)x 22.7% 20.0% 18.5% Average 2nd Tier Global Players 15,857.4 9,024.9 10.1x 15.0x 24.3x (0.5)x 16.6% 12.4% 8.7% Accenture plc (NYSE:ACN) 52,408.7 26,897.5 11.3x 12.4x 19.4x (0.9)x 15.8% 14.4% 9.9% Hewlett-Packard Company (NYSE:HPQ) 55,793.6 97,004.9 5.3x 7.8x 13.3x 0.5x 11.9% 8.0% 4.5% International Business Machines Corporation (NYSE:IBM) 144,168.0 81,727.4 8.0x 9.9x 10.4x 1.3x 26.3% 21.4% 13.0% Fujitsu Limited (TSE:6702) 12,103.7 35,356.9 5.1x 10.7x 15.3x 0.9x 7.4% 3.6% 2.1% Average Large Global Players 66,118.5 60,246.7 7.4x 10.2x 14.6x 0.5x 15.3% 11.9% 7.4% Total Average 27,521.9 23,358.1 9.0x 13.2x 26.7x 0.5x 14.3% 10.7% 6.6% Engineering Ingegneria Informatica S.p.A. (BIT:ENG) 600.5 812.6 6.2x 10.5x 13.9x 0.5x 13.0% 7.7% 5.3% Δ v Regional Players (3.3)x (3.9)x (27.4)x (0.9)x 2.0% (0.1)% 1.5% Δ v 2nd Tier Global Players (3.8)x (4.5)x (10.5)x 0.9x (3.6)% (4.6)% (3.3)% Δ v Large Global Players (1.2)x 0.3x (0.7)x 0.0x (2.3)% (4.1)% (2.0)% Δ v Total Average (2.8)x (2.7)x (12.9)x 0.0x (1.3)% (3.0)% (1.3)% 7 Trading comps valuation and catalysts suggest 29.6% upside potential Avg EV / EBITDA adj. LTM 9.0x Size discount 20.0% EV / EBITDA adj. LTM 7.2x EV ( m) 764.2 Net debt ( m) 51.9 Minority interests ( m) 7.0 Equity value ( m) 705.3 NOSH 12.2 Target share price ex. catalysts ( ) 57.8 Per share impact of catalysts ( ) 6.0 Target share price ( ) 63.8 Upside potential v current share price 29.6% Source: S&P Capital IQ. Data as of 8 Mar 2015. Financials for Engineering have been adjusted excluding negative goodwill in connection with the acquisition of T-System Italia (FY 2013), restructuring costs (FY 2011, FY 2013), and non-recurring turnover (FY 2009). Net debt includes pension liabilities and operating leases.
DCF and EPV indicate upside potential and downside protection DCF valuation (1) Earnings Power Value LTM FCF (2) 51.3m Normalised earnings (4) 44.8m Net debt (3) 51.9m Normalised net debt (5) 40.8m Minority interests 7.0m Minority interests 7.0m Share price sensitivity Share price sensitivity WACC Perpetual growth 51.2 (2.0)% (1.5)% (1.0)% (0.5)% 0.0% 0.5% 1.0% 1.5% 2.0% 6.0% 47.7 51.2 55.3 59.9 65.3 71.6 79.3 88.6 100.3 6.5% 44.7 47.7 51.2 55.3 59.9 65.3 71.6 79.3 88.6 7.0% 41.9 44.7 47.7 51.2 55.3 59.9 65.3 71.6 79.3 7.5% 39.4 41.9 44.7 47.7 51.2 55.3 59.9 65.3 71.6 8.0% 37.2 39.4 41.9 44.7 47.7 51.2 55.3 59.9 65.3 8.5% 35.2 37.2 39.4 41.9 44.7 47.7 51.2 55.3 59.9 9.0% 33.4 35.2 37.2 39.4 41.9 44.7 47.7 51.2 55.3 WACC 6.0% 57.2 6.5% 52.5 7.0% 48.5 7.5% 45.0 8.0% 41.9 8.5% 39.2 9.0% 36.8 If the Company grows in line with the 6-year CAGR of Italian IT services market, the investment can return up to 71% Implied negative perpetual growth rate of 1.25-0.75% with 7.0-7.5% WACC Under the no-growth scenario, the 5-year normalised earnings give comfort over capital protection in event of an entry at current share prices 8 Source: Company reports. Data as of Q3 2014. Note: (1) Perpetuity valuation to retrieve the implied growth rate priced in by markets; (2) Adjusted excluding negative goodwill in connection with the acquisition of T-System Italia (FY 2013), restructuring costs (FY 2011, FY 2013), and non-recurring turnover (FY 2009); (3) Net debt includes operating leases and pension liabilities; (4) The 5-year normalised earnings derive from EBIT adj. that has then been smoothed by assuming it to be equal to 8.5% of net turnover every year (actual average was 8.4%). Then, NOPAT has been calculated by applying the Italian corporate tax rate (27.5%). D&A tax shield has been added back whereas maintenance capex has been deducted to calculate the normalised earnings; (5) Net debt includes operating leases and pension liabilities and has been adjusted by excluding acquisition financing.
Feb 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Apr 12 Jun 12 Aug 12 Oct 12 Dec 12 Feb 13 Apr 13 Jun 13 Aug 13 Oct 13 Dec 13 Feb 14 Apr 14 Jun 14 Aug 14 Oct 14 Dec 14 Feb 15 Pair trade: Engineering is trading cheaply compared to Reply 80 70 1 2 60 50 40 30 20 10 Engineering Reply 1 2 Period Correlation Performance (1) Feb 2010 Jul 2014 97.2% Jul 2014 Mar 2015 86.0% Engineering: +63.1% Reply: +232.8% Engineering: +17.9% Reply: +41.5% Engineering s share performance during the last 5 years lags behind that of Reply, its closest competitor, by ~300% Since July 2014, Engineering stock rose 16.7% less than Reply stock, with correlation that decreased to 86.0% from 97.2% 9 Source: Bloomberg. Data as of 8 Mar 2015. Note: (1) Share price performance excluding dividend distributions.
but ROCE potential is higher if working capital and EBIT improve Key metrics (1) Engineering Reply Market share in Italy % 5.1% 2.8% Turnover generated abroad % 11.0% 28.2% Turnover 5-year CAGR % 3.3% 13.6% Normalised EBITDA margin % 12.7% 12.8% Normalised EBIT margin % 8.5% 11.6% Normalised ROCE 22.9% 31.8% Net debt / EBITDA 0.5x 0.3x Working capital / Turnover 39.4% 19.3% Avg cost per employee ( k) 55.6 66.5 Market is valuing Reply at a premium to Engineering due to (i) higher international exposure and (ii) double-digit turnover CAGR over the past 5 years The Cambridge Value Investing SIG believes that Engineering is not achieving its potential in terms of ROCE, mostly due to (i) high working capital and (ii) low EBIT margin Engineering Working capital / Turnover 19.3% ROCE 37.6% EBIT margin % 11.6% ROCE 29.2% 1 2 Same Working Capital / Turnover as Reply Same EBIT margin % as Reply 10 Source: Company reports, IDC, Cambridge Value Investing SIG estimates. Note: (1) Normalised figures calculated as the average of the past 5 years (as of Q3 2014).
Key risks and mitigating factors Risk Description Mitigating factors Reliance on the stagnant Italian IT services market The Company generates 90% of its turnover in Italy, where demand for IT services dropped by 2.4% y/y as of H1 2014, with the fall in IT outsourcing and systems integration being particularly acute (-5.2% and -2.8% respectively) Italy lags behind the other European countries in terms of internet usage (1) and investments in IT were halted in recent years; the trend has to reverse in the coming years While traditional IT services have been declining in the past years, cloud computing solutions can drive future growth as corporates Increased competition in a business whose barriers to entry are low Given the capital light nature of the IT services sector, Engineering may face competition from large companies that can count on economies of scale and afford to set cheaper fees to get market share Engineering is among the top 5 IT service providers in 4 sectors and the most likely way for newcomers to gain market share is via M&A Working capital is difficult to reduce due to exposure to the Public Sector The Italian Public Sector has historically paid in arrear and the Company s biggest and most profitable projects are with municipalities and public hospitals The Italian Government passed a law in 2012 (legislative decree 192/2012) that requires the Public Sector to pay bills within 30 or 60 days (2) Limited levers to pull to reduce fixed costs Engineering pays salaries that are 9.3% higher than the IT services sector s average (3), and has probably the hands tied with respect to salary cuts because of unionised staff and its need for limiting staff turnover to keep clients satisfied 25%+ of the workforce consists of executives and managers (compared to 20-21% in other IT consultancies ), whose contracts provide less security compared to junior professionals and can be therefore fired more easily 11 Source: Company reports, Assinform, OD&M Consulting, IDC, Eurostat. Note: (1) In particular, only 21% of Italian population uses online banking regularly compared to 40% in other EU countries, and only 19% of Italian population uses the Public Sector s online services compared to 44% in other EU countries; (2) 60 days is for Public Health Service only; (3) Calculated by weighing the average salaries earned by executives, managers and professionals of the IT consulting sector in Italy by the number of Engineering staff in each of the 3 staff categories.