Lectra – Free growth
in a quality business.
Lectra is the world leader in integrated technology
solutions dedicated to industries using soft materials. The firm designs,
produces and markets full-line technological solutions – compromising software,
CAD/CAM (computer aided design and manufacturing) equipment and software and
associated services such as PLM. This mainly covers automakers, fashion and
apparel and furniture amongst other industries. Two founding brothers have a
combined 30% ownership of the business own the company.
They have been heavily spending on R&D recently,
planning to benefit from the longer term trend of brands modernising their manufacturing
processes, using seamless data and technological solutions to improve cost
efficiency and product quality. Lectra estimate they have around 25-30% market
share in CAD/CAM (computer aided design and manufacturing) software and
equipment business. This company is not statistically cheap on basic valuation
metrics, although the quality and earnings power of the company provide value.
Business
In 2011 they decided to invest for the long term and
transform the company. They have committed €50m to spend on innovation,
research and marketing in the years 2012-15. This is a company that is
investing for the long-term future of the business and is noticing the rapidly
changing requirements of the sector. They have actually spent around €20m per
year since 2012 on R&D, although French taxation and research
credits mean the net spend is actually around half this value. The company sells machinery with software, which is then contracted annually, providing Lectra with recurring revenues. Revenues from deploying new systems for new clients is the growth revenue of the business.
How much of a margin of safety
does the recurring revenue give and what are reasonable growth rates of the
growth revenue?
As always, lets think safety first. The recurring revenues
are from contracts of existing systems, spare parts and consumables. In 2014,
Lectra earned €122m in recurring revenues, which just about covers the fixed overhead
costs of running the business entirely. This fixed cost, which is mainly
salaries for the engineers and brains behind the solutions, amounts to around
75% of gross profit for the last 10 years. This recurring revenue has also been
around 55-60% of total revenues consistently and provides some safety, although
obviously subject to some risk.
How reliable are these revenues? How replaceable are they
for consumers, i.e. what is the replacement cost of the service and product
Lectra provides?
Lectra has around 23,000 customers from all industries, and
although they do not equally contribute to revenue, it would take many small or
a few large customers to literally shut down operations for Lectra to lose a
huge chunk of revenue. FY2014 – no single customer represented more than
7% of revenue, the 10 largest customers account for less than 20% and the 20
largest less than 25%. The sales are fairly evenly spread geographically with
46%, 24% and 23% coming from Europe, Americas and Asia respectively and are
evenly spread between both automotive and apparel sectors, with a small portion
in aeronautical and furniture. This provides some sustainability in revenues
and predictability in the underlying business.
I believe the replacement cost of the machinery Lectra
provides is fairly high. I am assuming here that once Lectra do employ a
system (machinery and software) for a client, like Oracle and other back office operating systems, it takes
huge cost and efficiency incentives for the client to change. A brand is not
going to replace all their systems, plus educate and teach their employees to
use a new system, with a new competitor once Lectra have installed their
software into the brand’s processes. Therefore, Lectra benefit from great first
mover advantages and the innovation and R&D provides high barriers to
entry. The main issue is recruiting and educating the clients on the solutions
they provide.
Growth
Selling new systems, the machinery and the software with it,
is the growth driver in this business. They have COGS made up of purchase and
freight costs which amount to around 25% of revenue giving a 5-year average
gross margin of 75%. Operating costs are c55-60%, which involve
fixed overheads and fixed and variable wages. This gives operational leverage
to the business and if they begin to sell many new systems, a large amount of
marginal revenue flows to bottom line. FY2014 the firm had operational leverage
of 2.27 (fixed costs / variables) and therefore for every 1% change in revenue,
operating income will increase 2.2x. These fixed costs have been around 55% of
revenue for the last 10 years consistently. The company has negative working capital requirements as they receive payments for their software and equipment and
then shift the goods/service. As long as gross profit from recurring contracts
cover personnel costs, a security ratio management refer to, the risk of this investment
is reduced. Lectra benefit from 30% R&D tax credit and employment tax credits
from French government enabling them to literally spend all cash generated on
growth.
Instead of asking the obvious questions around growth; why/how
will they sell these new systems and what kind of growth rates can we expect, I
am going to invert the question and say how is it possible they will not grow
and in what scenario would this happen?
Lectra estimate they have around 25-30% market share in
their core business of CAD/CAM equipment and services. I have mentioned before
about the replacement cost of their services and that it would need a seriously
highly efficient, low cost service provider to take Lectra’s clientele. Another way to not grow is to implode and this would cause a global crisis to halt all manufacturing in the fashion and apparel and automotive industries.
The
company’s cost base is largely in euros in France, which has given Lectra an
edge over its US competitor for the last year. Adjusting for Lectras intangible
strength, mainly customer relationships and brainpower in this niche field, and
the remaining assets shows the reproduction asset cost of business is around
1.5x book value. The value of the assets actually needed to start a competitor
in this niche field is around €160m. The earnings power and reproduction cost
show the company have a competitive advantage. The majority of the assets are intangibles and therefore the main risk is a large competitor entering the market with greater innovative solutions. This is a risk, although the niche nature of the business makes it highly inefficient for a large player to spend as much time as Lectra to enter a small market.
I feel there is definitely spare capacity in the demand on
the micro level for Lectra’s services as global brands move towards using
technology and data in all processes. I am confident in the long-term growth in
new systems as it is clear more and more brands will need to adopt systems that
enable the full use of seamless data and technology to maintain their brands
cost efficiency and quality. The business is sustainable on
recurring revenues and operational leverage is going to accelerate
earnings once new systems are employed. Also, Lectra have publicised a 10-year plan to speed up China’s product development and add value to their
design and manufacturing activities. Their strategy to targeting growth seems
to be adequate although valuing this growth is difficult. To attempt an
estimate of the value of growth I use the basic Greenwald method:
Lectra have spent c€20m a year on innovation, engineers,
marketing and revamping the business. This R&D is fully expensed each year
and actually only amounts to 70% of the total value due to tax credits.
Assuming 5% growth
rate and 10% WACC:
Future cash flow = (ROC – g) * Capital invested
= (.35 - .05) * 55m = 16.5m
Value of a growing firm = 16.5m * 1 / ( .1 - .05) = 330m or this can be proven by:
(ROC – g ) * Capital / (r –g).
This value of future growth gives 25% upside to the current
value of the firm.
Valuation
Greenwald states that ‘when earnings power is above market
value, growth comes for free’, and Lectra seems to provide this. The firm has
great potential to evolve into a high growth stock. Average operating margins
for the last 5 years have been around 11-12% and the operational leverage in the business provides space for expansion as they grow.
Management claim to have around 25-30% market share in the
CAD/CAM software and equipment sector, and they have patents running until 2022
that protect this share and therefore margins. The power of these patents were
recently proven when Lectra won a battle with a German manufacturer claiming
they had infringed on Lectra’s airbag cutting system. I feel there is a high
chance Lectra will remain global leader in the CAD/CAM sector and I do not consider any growth in the PLM market as this is a very competitive service.
The current price of Lectra is not cheap by any means.
Trading at around 9.8x EBIT and 16.8x FCF with a PE of 16.8 with all metrics
higher than their 5 year averages. However, it’s clear you are paying for
quality here. Insider ownership, 35% 5-year average ROIC and consistent cash
flow proves the quality of this company. Lectra's main competitor is a private company called Gerber. Vector Capital bought Gerber Scientific, in 2011, for $282m. This price was at around P/S 0.5 of the last 4 years total revenue, and a huge PE of over 40 but no recent data is available on Gerber.
I have calculated the earnings power value of Lectra to be
around €12.09, giving an 11.5% margin of safety to the market price. This is
using a 10% cost of capital and being conservative with adding back only 10% of
SG&A and R&D. This current earning power eases some of the uncertainty
against future growth in new systems. I am happy to pay for quality here. Also,
looking plainly at the facts of the firm investing over €60m in the last 3
years, with an average ROIC of around 35%, this has a high probability of
returning at least €21m in cash in the coming years.
