1) Recent Developments
You can read our last post here. Since the publishing of the Q3 results, the stock managed a 13.3% increase to 340 SEK. We are excited about an overall 150% increase since we discovered it. Main results JAN-SEP 2015 (as reported) were:
- Net sales SEK 448.3 m (350.4)
- Profit before tax SEK 67.8 m (42.4)
- Operating margin 16% (13)
- Earnings per share before dilution SEK 9.02 (5.47)
- Cash flow from operations SEK 106.4 m (91.1)
2) Income Statement Adjustments
2.1) Capitalized Development Costs
After talking to two great analysts I know, I feel I should talk about the mysterious treatment of capitalized development costs in the income statement a bit more. In the data output of the data provider we use, capitalized development costs are taken out of the income statement and since did not really affect our valuation. However, it does affect the profitability numbers stated by Vitec and, more importantly, the effective tax rate.
Here is a chart summarizing the adjusted income statement versus the reported numbers. For the 2015 estimate, I scaled the ordinary items up from 75% from Q3 (which works very well historically) and did a few minor adjustments. For taxes, I scaled up the taxable income as reported. I also subtracted amortization for these capitalized costs for 5 year periods. This closely matches what the management reported and our historical checks.
The second chart shows the income statement after all operating expenses:
Accordingly, the adjusted EBIT and profit margins are lower than reported:
After subtracting the whole capitalization and the according amortization, the current (!) margins do not look spectacular, but not bad either. How intangibles are amortized is to some degree a management decision. There already is a large amount of intangibles in the balance at 608 m at Q3 2015 (510 m Q3 2014). The YoY increase amounts to significant 19%. Each software product should be written down according to its expected feasibility. The only red flag on the first glance is the Media business that declined 54% in revenues YoY. We need some more information on the amortization policy and timeframes. As mentioned in earlier posts, all products are at most 5 years old and I consider that a valid assumption for expected life.
2.2) Tax implications
Capitalizing a large part of staff costs results in a higher tax expense upfront and lower tax in later years due to amortization or impairment. In effect, high capitalization will push revenues to today, but increases tax expenses significantly. For 2015, our estimate for 63 m SEK capitalized costs revenue means a 15 m SEK tax expense increase. This would be earned in later years through amortization and impairment.
3) Cash Flow Implications
Since the capitalization does not affect the cash flow statements, our cash flow valuation remains unchanged in some parts. For the future years, by writing off intangibles, lower tax expenses will increase free cash flows. Without going any deeper into our FCF valuation model, we expect an upside of 20.6% with a target of around 410 SEK per share.
4) Growth Prospects
We expect Vitec’s revenues to grow 21.5% in 2015. Our interim target for revenues was 600 m SEK for FY 2015. Our current estimate after Q3 announcements is 598 m SEK, not far from the previous one. Vitec itself says it sees ‘good conditions for continued acquisitions’. Recurring revenue is now at 81% (78% last year). A large part of the business is also shifting to SaaS. We have already covered acquisitions of Datamann and Infoeasy in our last post.
We will hold our (full) position in Vitec. With a target of 410 SEK (20.6% upside) we still think it is an attractive company with ongoing opportunities. I hope I was able to give some more insight into the income statement. The high amount of intangibles could be worrying and we still need to find out more about the amortization and impairment timeframe for the individual products, especially the status of Media. We are (as always) happy to get comments!
Disclosure: LONG Vitec Software Group AB