HL SELECT UK GROWTH SHARES
HL SELECT UK INCOME SHARES

Fidessa bounces on acquisition announcement

Managers' thoughts

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Charlie Huggins (CFA) - Fund Manager

26 February 2018

Fidessa, the financial software provider, has agreed to be acquired by Swiss software peer Temenos Group. We have held Fidessa in both the HL Select UK Growth and UK Income Shares Funds since launch. Its current weighting is around 5% in both funds, making it the largest and second largest individual stock holding, respectively.

The all-cash offer values Fidessa at £36.47 including dividends , around a 40% premium to last week’s closing price and around a 25% premium to the closing price on Monday 19 February (the day of Fidessa’s full year results release). The transaction is subject to approval by Fidessa shareholders, receipt of certain anti-trust and regulatory clearances and other customary conditions.

Takeover candidate

Of all of the stocks we own, Fidessa had always seemed the most likely takeover candidate. However, since the financial crisis its customers have had to contend with numerous headwinds and this has tended to mask the long term potential.

These headwinds have meant that Fidessa has struggled to grow in recent years whilst margins have stagnated. Back in April last year the company warned of the rising impact of political uncertainties around the world on customer confidence. This, said Fidessa, was leading to some potential clients deferring decision-making. The price fell below £25 and we decided to buy more for both funds.

Despite struggling to generate much growth, the shares have tended to attract a rather lofty valuation. The price to earnings ratio (P/E) has averaged 25x over the last 3 years, around a 67% premium to the wider market.

So, given the above, why did we own it in the first place and why does Temenos want to buy it now?

Long term potential

We always focus on the long term. Our major concern is not what the company will be earning one year from now but what the company might be earning five or ten years from now.

We could see that profit growth was likely to be fairly pedestrian in the short term and it’s fair to say that our own patience has been tested on occasion. But we felt the investments Fidessa were making in its business, combined with some easing of the external challenges facing its customers, could support stronger growth in the longer term.

We like to invest in companies that take a long term view when it comes to managing their business. It’s easy to boost short term profits through acquisition or shedding costs, and very tempting when your remuneration is based on a one-year earnings number. This is why a lot of publicly listed companies take this route. The problem is that these short term actions often end up damaging the business in the long run.

We want to own companies that invest to deepen their advantage over the competition. Fidessa has been doing so in spades over many years and has supported its customers through a period of unprecedented regulatory change (often, without charging for the privilege).

The goodwill this has created amongst the customer base has yet to show up in the profit and loss account. This is partly why Fidessa’s operating profit margins have averaged about 14% over the last decade whilst many established software companies are making at least double that.

The mere hint within Monday’s full year results that margins could rise in FY19 was enough to send the shares up 10%, the day before the takeover bid was announced. Within the results announcement Fidessa also talked about a number of contract wins and its increased confidence in winning market share from other ‘weaker vendors’.

Fidessa’s willingness to make long term investments in its business while largely avoiding acquisitions (the last major deal was over a decade ago) stands in stark contrast to many of its competitors. We suspect this goes a long way to explaining why it is winning in the marketplace.

The other features of Fidessa’s business model which attracted us are:

Strong barriers to entry - if you gave us a few billion pounds to try and set up a business to compete (and win) against Fidessa, we wouldn’t be able to do it. Their systems are too well-integrated into their customers’ operations and their reputation too well ingrained. Most customers simply wouldn’t risk switching away from Fidessa.
Recurring revenues - recurring revenue represented 88% of total revenue in FY17 . When customers keep coming back, it's easier to generate good returns, even if your customer base is under a lot of pressure, as Fidessa’s have been.
Strong cash flow – everyone loves growth, but if it’s not backed up by cash flow, it is unlikely to be sustainable. A business with strong free cash flow can always fund growth opportunities in front of it. That’s why we focus on cash flow first and foremost. While Fidessa hasn’t grown much in recent years, cash generation has been mightily impressive. Since 2010 the business has generated some £260m of free cash flow (cash leftover after interest, tax and investments in the business), equivalent to about half of the market capitalisation at that time. Pretty much all of this cash has been paid out to shareholders as dividends.
Strong balance sheet – the business has always maintained net cash on its balance sheet. We’re big fans of sleeping well at night and so far, because of their financial strength, we’ve never had to worry about the company getting into financial difficulty.

What happens now?

Fidessa shareholders will vote on the deal in early April. If approved, the transaction is expected to complete shortly afterwards. The shares are currently trading at a slight premium to the offer price. This could be investors speculating on a higher offer emerging, either as a result of a new bidder coming forward or Fidessa’s major shareholders holding out for an improved offer (we are aware of a well-known activist investor who has just declared a 5% stake in the company).

We are waiting to see how the situation unfolds before deciding whether to sell the funds’ holdings in the open market or accept the offer terms.

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