I looked at the Banking Industry and I invested in this Asian company! (Silverlake)

This is part six and at the same time the last piece of my series on banks, for the time being. In this post I will do a quick recap of the series and take a look at my learnings.

More important for you: I analysed a company I had on my to-do-list for some time now …

This is not investment advice. Please read the disclaimer.
I own shares (economic interest) in mentioned or related companies.

In my past articles in my series on banks I looked at several banks with individual business models, but non of them was a big global bank. Some of the banks I looked at could well deliver good returns in the coming years. But even with much more research, I believe hardy any of them would soon become a high conviction investment for me.

In my very first post about the banking industry I highlighted some of the challenges banks find in todays environment. Many have grown to big and very complex entities relying on old but essential technoloy. Historically low interest levels squeeze their interest margins, making it harder to invest and renew their acquinated processes. Additionally, nimbler fintechs cater to the needs of affluent millennials used to get everything done with a tap on their smartphone and go in for a better user-experience. If banks struggle so much, a good questions to ask might be who could profit?

The company I am going to write about is a leading enterprise technology, software and services company in the high growth Asia Pacific region. They want to create technologies to enable the digital economy.

Currently, it might be the overlooked investment opportunity within the SaaS and recurring revenue universe available at an attractive price.

Currently, their software project-based revenue is severly depressed due to the pandemic and related movement restrictions. This is where the investment opportunity might come from!

This was supposed to be another part of my series of Quickies on new companies but it became a more detailed analysis.

Silverlake Axis Ltd provides software solutions and services to the banking, insurance, retail, government, payment and logistics industries. The company (SAL, the group) has more than 380 enterprise customers in over 80 countries. Its origins and its foundation is a very strong position in the banking sector in South East Asia. A good overview of its services can be found within the AR 2020, p 6-7 (but more below).

»Today, at thirty, we are the partner of choice for 3 of the 5 largest ASEAN regional financial institutions; our core systems platform is deeply integrated with their operations.« – Silverlake Axis, about

Could SAL profit from the banking demise? With its product offerings the company could profit from banks’ challenges. They need to upgrade their old systems and introduce new ones. Furthermore, they could profit from efficiency enhancements (outsourcing services or software. Lets take a closer look at SALs numbers …

Useful currencies: SALs reporting currency RM stands for Malaysian ringgit (MYR) with RM 1 = 100 sen. SALs shares are listed in Singapore (SILV SP) and accordingly quoted in Sigapore Dollars (SGD).
MYR 100 ~ SGD 33 ~ USD 24 ~ EUR 20
The financial year ends June 30 for Silverlake Axis. The last full financial year or FY for SAL ended June 30, 2020 and is referred to as FY 2020.

Financial position

SALs financial position is very solid, despite some adverse affects from the pandemic on parts of the business due to movement restriction orders (more in revenues below). As of June 30, the group had a comfortable position of RM 500m in cash and equivalents, ensuring smooth operations during the current uncertainties. Furterh, the company has RM 30m in a money market fund, offset by total loans and borrowings, incl. leases (150m) and defined benefit liabilities (12m) on its balance sheet. I tend to neglect this going forward, since (a) the amount is low, and (b) several actuarial discount rates were lowered vs last years assumptions, indicating rather realistic assumptions (compared to many US pension plans!).

Interest payed was RM 3.6m in FY 2020 (p97) according to the cashflow statement

Current Trade and other payables increased significantly to RM 358m (up from 70m) and mostly consist of contingent consideration for its acquisition of SISG Group (276m, notes 33). This earn-out will probabaly settled to a significant portion via shares.

Total equity grew to RM 746m (up from 592m) accounting for a stable equity ratio of 50%, despite an additional drag on total equity of 56m treasury share purchases. The company capitalizes considerable software development expenses leading to RM 300m of intangible assets as of June 30, representing 40% of total equity (see appendix for more details and assumtpions on capitalisation software development expenses).

Most of its subsidiaries are wholly owned subsidiaries (AR 2020, p13). An 8.3% stake in listed shares of Global InfoTech Co. Ltd. or GIT was worth RM 310m as of June 30 and increased its value in preceding months. Here are the financial highlights

extract from AR 2020, p 18

Segments & revenues

extract from AR 2020

Software licensing comprises Silverlake Axis’ software solutions for the financial services, retail and logistics industries, with revenue being mainly generated thorugh large core banking deals. Large economic uncertainty resulted in falling revenues -44%. SAL has a strong pipeline and is optimistic for FY 2021. Of course, the near term outlook is muted compared to earlier estimates.

Software project services include software customisation and implementation to deliver the core banking, payment and retail software solutions ensuring full functionality. Revenues fell (-28%) toghether with software licensing revenue. SAL is cautiosly optimistic amd is pursuing many opportunites in digital banking.

Maintenance and enhancement services is the most important revenue category, accounting for 69% of total revenue (62% in FY 2019) after growing 9% yoy. SALs customers receive neccessary round-the-clock software maintenance support services as well as enhancement services making new capabilities available to their end-customers. Revenue is being progressively recognised for ongoing long-term maintenance contracts for a large number of customers and is recurring and stable by nature. Growth is dependent on the installed base of its software and has remained stable throughout the year and there seems to be a large pipeline spurring future growth. SAL is optimistic in getting a greater share of wallet from leading banking franchises’ spend, due to challenger digital banks and Fintech players coming to market at speed.

Sale of software and hardware from third parties is a rather small (4%) and low-margin segment. SAL does not expect outsized growth.

Credit and cards processing was a small segment (2%), with probably even less profit contribution which was wind down in FY 2020.

SaaS insurance processing, undertaken by Merimen Group (a subsidiary), focuses on providing cloud computing platforms for policy administration, claim processing and data analytics for the insurance industry. It connects the insurance ecosystem of insurers, repairers, loss adjusters, parts suppliers, agents, brokers and direct corporate clients. Insurance companies make use of more efficiency-enhancing tools. FY 2020 revenues accounted for 5% of total revenues. Revenue grew by 4% yoy, despite Merimen’s revenue model being based on the volume of claims and policies transacted by its customers, which was severely impacted by COVID-19 movement restriction orders during last four months. Merimen continues to see increasing demand for its proven collaboration platforms. Before the pandemic, SaaS insurance revenue grew 24% in Q2 2020 yoy. Expansion in Japan is proceeding and another first customer could turn out to act as a springboard for Merimen’s regional expansion in the Middle East.

extract from AR 2020

Total revenues fell -3% to RM 664m (USD 160m), driven by falling project-based sales from its software licensing (-44%) and software project services segments (-28%). These strong decreases can largely be attributed to the pandemic and related high economic uncertainty. It is quite likely, that they will rebound accordingly. SALs recurring revenues performed quite well and include revenue from its maintenance and enhancement services (+9%) as well as its SaaS insurance processing revenues (+4%).

Outlook

A recovery in project based revenue could take some time to fully unfold while economic uncertainty and operational impediments reside. Near term, profits coudl remain on a lower level, especially if higher margin project based revenue stays depressed. Additionally, deferred IT projects will result in some recurring revenue deferral. But, IT projects can only be deferred so long and some projects are driven by regulations. Additionally, the pandemic resulted in customers shifting even more activities online making it a requirement for banks to adapt fast(er) and in the meantime, operations have adjusted to our new reality: more remote work, wearing masks, better hygiene.

• A margin slump is addressed by its SAL People Strategies in Response to COVID-19 including a hiring freeze and units’ relocation to Malaysia (AR 2020, p38)
• On Oct 9th, Malaysia imposed a monthlong conditional movement order in most states as new infections hit a record on Friday.
• Oct 9: Big vaccine news moving markets today! Anyway. It would be a long way until a considerable share of people is vacccinated. So it does not move my thesis too much.

Recurring revenues bring stability and the foundation to invest further in Silverlake Axis’ value proposition for its clients. Overall, it is well positioned in its markets to profit from higher economic growth. Many of its solutions have a lock-in-effect with high switching costs acting as SAL’s economic moat.

I initially discovered Silverlake Axis watching Pat Dorsey videos on economic moats – a great topic! I re-watched his presentations at google and Texas Lutheran and spotted the company on his slides. But I know he at least mentiones the name in one video, since I had a hard time to understand the company name. Though I did not find it.

Its core customer group is the banking industry. These customers are very much locked in and will work with Silverlake’s core banking products for many years if not decades to come (and generate revenues). Additionally, SAL is primed to offer its banking customers solutions for new system requirements. The long-term outlook is quite good here and brings a high visibilty to the investment case. Their MÖBIUS banking platform approach sounds like they very much go in the right direction.

Its insurance SaaS product seems to bring real benefits to ecosystem participants: staff can handle more claims (2.5x), processing time is significantly reduced (-78%) increasing customer satisfaction and suspicious claims are detected. SAL profits from subscription fees and transaction based revenues. Additional clients are onboarded, indicating to a bright future. ASEAN economies are growing and so are its middle classes. Usually, households want to protect their material wealth, if they achieve a certain level, also indicating positive underlying trends. SaaS service revenues might expand in the retail industry.

Profitability will be depressed in current financial year. This is based on lower revenues from high-margin business (porjects and services). This is partially mitigated through the company’s costs savings program and lower revenues from low-margin segments: wind down of the low-margin credit card business and normalizing (lower) reve ues of hardware and software sales.

What do normalized margins look like? In many financial periods, the company reported material other income and/or unusual expenses. I tried to unwind those and got a grab of sustainable normalized margins. I feel like Ebitda margins of 35% and 40% thereafter will be about right. With rising project-revenues profitability will rise again.

Alarmingly, the company reports on a cybersecurity incident but SAL itself seems not to be affected. If and to what level customers’ operations were interrupted is unclear so far.

extract from AR 2020, note 45. p 220

Acquisitions

Strategic acquisitions and partnerships form an important building block of SAL’s business and current market position. Recently, SAL formed a partnership with nordic fintech dreams. Such collaborations could result in huge future businesses. In dreams’ case, strong economic growth in the below regions and the demand for efficient savings solutions could drive future profit.

This collaboration entitles Silverlake Symmetri to become the exclusive distribution partner of the Dreams Platform in Asia (excluding Mainland China and North Korea), Africa and the Middle East.

extract from AR 2020, p 35

Of course, there is the risk that capital is allocated unwisely and destroy shareholder value.

Former acquisitions and conditional payments due, will influence future financials.

a) SIA X Infotech Group (XIT, p154). SAL intends to acquire the remaining 20% and acquired 80% of XIT’s equity for and initial consideration (IC) of € 17.6m, consisting of an € 12.6m upfront payment and € 5m deferred payments. As of June 30, 2020 ‘there were no initial deferred consideration payable for the acquisition of 80% equity interest in XIT’. As of June 30, 2020 ‘there were no amounts accrued for in respect of EOC’ (Earn-Out Consideration).

• SAL has a call options for the remaining 20% and XIT has a put option for the stake.

b) Silverlake Investment (SG) Pte. Ltd. (SISG, p160). The aggregate base consideration or BC of RM 154.9m (equivalent to SGD 49.7m) was satisfied by the reissuance of 70.1m treasury shares of the company (…) amounting to RM 123.8m upon completion in the financial year ended 30 June 2018.

• The earn-out consideration (EOC) depends on the profit development of the acquired entities and is now included in current payables: RM 276m.

My base case

A reasonable base case scenario for me comprises depressed project-based revenues for the current financial year at current levels with a strong recovery afterwards. Recurring revenues should in general grow at low single-digit rates at minimum and probably much higher soon (transaction levels on insurance platform currently depressed due to movement restrictions). Its operating margin should follow its project-based recovery. This base case scenario sounds very likely (>50%) to me.

• Total revenue will increase 1.5% in FY 2021 and grow faster afterwards, for a
  • CAGR of 4.8% from 2019 to 2026 and grow 4% p.a. afterwards
• I estimate an Ebitda margin of 35% in FY 2021 and 40% thereafter

The discount rate I feel comfortable with and use in my dcf valuation is 9% and may seem rather high. It is almost purely based on the cost of equity (low debt to market value). It based on a relatively low equity risk premium on top of debt cost after tax, due to a rather low-risk business model (see my general risk framework). The relevant cost of debt depends on relevant sovereign yields and currencies as well as on the company’s regional activities.

• Geographically, SAL is active mostly in
  • … Malaysia (50%), Singapore and Latvia, regarding non-current assets, and
  • … Malaysia (41%), Singapore, Indonesia, Thailand with regard to revenues.
• Despite high 10yrs sovereign interest rates for MYR Malaysia of 2.6%, comparable rates for Singapore (SGD) and the US (USD) are much lower at about 0.8%. According to Note 29 (p176), SAL payed
  • an effective rate of 2.58% for a SGD/USD revolving credit facility, though these are (short term) floating interest rates.
  • 4% p.a. for a 5yr term-loan (with some external guarantee)

Income tax rates differ between different countries. But using the 24% of Malaysia (higher than Singapore’s 17%) seem reasonable on the basis of operations. Some subsidiaries will lose their tax privilidges.

Net cash of RM 398m (SGD 130m) results from cash and equivalents (+497m), listed GIT shares (310m) and a market money fnd (30m) minus contingent consideration for SISG acquisition (-276m), total loans and borrowings (-150m, thereof leasing liabilites: 28m) and pension liabilities (-12m).

Other scenarios

Of course, other scanrios are possible as well, though I believe the base case scenario is rather likely in SAL’s case. Additionally, I believe, possibilites for other scenarios are positively skewed with more bullish outcomes being more likely than bearish outcomes (vs base).

My bullish case scenario would include a slightly faster recovery and higher growth. Additionally, SAL would profit from higher margins due to more project-based revenues in the near term and longer-term the company profits from higher margins due to operational leverage (scaling).

My bearish case on Silverlake accounts for a slower recovery of project-based revenue and thus lower near-term margins. Further, scaling does not really happen and some investments in new platforms to not pay off, pressuring margins longer-term.

Valuation & Catalysts

The company has a market capitalization of SGD 660m ($ 480m) equating to MYR 2,000m in its reporting currency. Accounting for net cash (see financial position), SAL’s enterprise value or EV is lower than its market cap.

I estimate a fair value of SGD 0.61 per share for my above base case, with return-potential highly skewed to the upside. As of Nov 11th it traded for SG$ 0.26.

• I live in Cologne, and carnival usually starts today! But not with corona. This is very sad 😦

The market might rerate SAL when higher prject-based revenues kick in again or when it wakes up to the high share of recurring revenues. Otherwise, the dividend yield should grow to levels, too high for hte market to ignore.

My conclusion

SALs slogan is ‘symmetry a work’ referring to mathematical principles.
I believe, by investing in SAL today, I can take advantage of an a-symmetrical risk/reward investment profile with limited downside-risk but high potential long-term returns.

I wanted to buy an initial position of SAL shares. My limit buy order was filled Nov 11th.

Update Aug 2021: I got to know about the short report only after buying my position. I read it two times, found some weakensses like all (good) short-reports probably have, some exaggerations etc…. but overall many valid points. I did not like the corporate governance and the structure in the first place (if! I remember correctly). I did not sell immidiately. In the end, I thought, I do not know the probability of if being a (full) fraught, and if my FV estimate is about right it might still be a good bet, but what are probabilities and will it ever trade at FV with eroded trust. There was a pop due to some investment in the holding company, and I sold on Aug 4th at SGD 0.275. There are probabaly better investments out there with less stress involved / better returns on brain-drain.

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I hope you enjoyed this post about a lesser-known company within an interesting business segment. Or what is your take on SAL?

You can make sure not to miss any of my future posts: just follow my blog 🙂

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— Appendix —

Shareholder structures

Goh Peng Ooi, the groups executive chairman and founder of the the Silverlake group in 1989, has (via an entity) a deemed interest of 1,760m shares equivalent to almost 70% of total shares (p78).

A performance share plan (PSP) is/was in place, but in FY 2020 there were no PSP shares awarded. The plan consists of awarding fully paid shares, thus no option scheme.

Treasury shares stood at were bought during FY 2020 in the amount of 55.7m for RM RM 56.8m.

The settlement of the earn-out consideration for SISG will partially (80%) be settled via shares, resulting in dilution (at a rather low share price).

extract from AR 2020, note 45., p 220

Capitalisation of software development exp.

extract from AR 2020 (accounting policies), p 116

Cashflow effects due to the initial recognition of software development expenditures as an intangible asset manyfold: When development expenses occur at the beginning balance sheet life of the intangible asset (t₀) the reported accounting profit will be higher than cashflow (capitalization of expenses). In the following years t_i, cashflow will higher than reported profit, due to (non-cash) amortization of the asset over the period of its expected future benefit (max. of ten years: i <= 10). Other intangible assets as (acquired) purchased and proprietary software as well as customer relationship and contracts are amortized over a max. period of 12 years.

Currently, annual capitalized expenses are much higher than amortization for internally developed software (marked yellow below), resulting in a negative cashflow effect of MYR ~25m. But, (i) this negative gap will shrink in the following years and (ii) other amortization expenses (i.e. proprietary software and customer relationships) lower this gap for a few more years.

• Taking a conservative stance, would result in the assumption of low annual negative cashflow effect for some years

own spreadsheet, data from annual reports

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