value and opportunity

DISCLAIMER: The stock discussed in the following post is a very illiquid French small cap. The author might own the stock. Please do your own research. Do not blindly follow recommendations neither on this blog nor anywhere else.

Sometimes investment ideas are created from quite random events. I was looking into my database for interesting French stocks (as always). Out of interest, I thought that I want to tackle a French software stock next.

Among the few software stocks I just picked randomly the company called “IGE + XAO SA” because of its strange name. And guess what ? This company is creating CAD software for electrical installations with Gerard Perrier, my last stock pick as one of the major clients.

So despite the rather expensive valuation numbers, I decided to dig a little bit deeper.

“Tradition” Valuation metrics:

P/E Trailing 14.2
P/B 2,9
P/S 2.6
EV/EBITDA 5.1
Dividend yield 1.8%
Market cap EUR 61 mn

Not so exciting at first. However, when I ran IGE through my checklist, it scored very high (20 out of 27), at par for instance with Vetropack and AS Creation mostly due to the following facts:

– great free cashflow generation (FCF on average 1.2x Earnings !!!)
– rock solid balance sheet with ~15 EUR net cash per share
– Management owns 20%+ of company, CEO & founder still on board
– company started to significantly repurchase shares again in 2012 (Sharecount decreased by 20% since 2008)

If I would take into account net cash and the share repurchases, IGE would even met my P/E and dividend criteria, scoring 22 out of 27, equal with Tonnelerie.

So the result from the checklist is clear: Dig deeper !!!!

Business model / “Scuttlebutt”:

The company is mainly a Software company which, according to their Webpage offers the following products:

The Electrical CAD Software Specialist and you….
For over 26 years, the IGE+XAO Group has been a software publisher designing, producing, selling and ensuring the maintenance of a range of Computer Aided Design software (called “CAD”). These CAD software products have been designed to help manufacturers in the design and maintenance of the electrical part of production processes. This type of CAD is called “Electrical CAD”. IGE+XAO has built a range of Electrical CAD software designed for all the manufacturers, which functions either with an independent computer or with a company network.

So this is a very specialized “niche”. If I search for the German “Elektro CAD” in Google, it is already clear that IGE is not the only one offering this kind of Software.

The first question I would ask myself: “General” CAD Software is used everywhere, so can’t just the general CAD packages take over this job ? Well, according to this site ( a competitor) , this doesn’t seem to be so easy.

There seems to be also some competing products, for instance I found this German discussion board where different E-CAD or CAE systems are discussed. One of their main products, CADdy seems to be based on a old German DOS program and has been developed further by IGE.

Overall, I think that with specialised software like this, one should see quite significant network effects, i.e. if one product gains dominance, than this will be self-sustaining as there is little incentive to use different programs of that complexity for instance when you switch firms. I browsed a little bit in CAD forums and this has been confirmed quite often, for instance here. So once a program in this area is used and people are educated on this program, they will want to use it further on. What I found interesting is the fact that in this forum, A German IGE +XAO employee actively moderates everything which has to do with their products.

I think this is also the reason why they have 70% market share in France according to their 2011/2012 investor presentation. Which, of course, makes gaining market shares in other countries quite difficult.

This 70% market share might also explain the nice margins the company is enjoying. 20.9% Operating margin and 18.4% net margin are clearly not something one finds easily, not even with software companies.

ROE looks OK with 20%, however we should not forget, that basically all the equity is basically net cash and only a small part of that is really needed.

Those margins are on par or even better as heavyweight software champions like SAP or Dassault or CAD expert Nemetschek. Teh only difference is that those companies are much more expensive

As it looks for now, their business isn’t subject to the overall slow down in the French economy. In their latest half year report from the beginning of April, they still show solid growth rates of 5%. Net income didn’t grow due to higher tax expenses, but that should be a one time effect.

Net profit margin development

One thing that puzzled me, was the development of net margins. We can see that with one exception (a jump in 2008), Net margins increased steadily from 7.4% in 2002 to a fantastic 18.4% in 2012.

	NI margin
31.12.2002	7.4%
31.12.2003	7.6%
31.12.2004	8.3%
30.12.2005	8.5%
29.12.2006	10.4%
31.12.2007	11.8%
31.12.2008	15.3%
31.12.2009	12.6%
31.12.2010	14.1%
30.12.2011	16.2%
31.12.2012	18.4%

In my opinion, this creates a series of questions:

– how did they achieve this ?
– are those margins stable ?
– do we have to expect reversion to the mean at some point in time ?
– what would be the “Mean” for margins ?

In order to understand better the increase in margins, I compared 2002 with 2007 and 2012 in the following table:

	2012	in % of sales	2007	in % of sales	2002	in % of sales
Total sales	24.2		20.7		15.7
external costs	-5.4	-22.1%	-5.5	-26.5%	-5.4	-34.6%
salaries	-12.3	-51.0%	-10.7	-51.7%	-7.1	-45.4%
other cost	-0.6	-2.6%	-0.5	-2.4%	-0.5	-3.1%
Depr.	-0.5	-2.1%	-0.7	-3.5%	-0.8	-5.1%
Operating result	5.4	22.2%	3.3	15.8%	1.9	11.8%
Net interest reslt	0.3	1.4%	0.3	1.4%	0.0	0.2%
EBT	5.7	23.7%	3.6	17.3%	1.9	12.0%
Tax	-1.5	-6.1%	-1.2	-5.7%	-0.7	-4.5%
Net result	4.3	17.6%	2.4	11.6%	1.2	7.5%

The interesting thing here is that the improvement in the margin can almost be fully attributed to the decrease in percentage points to the decrease of external purchases / services. To me this looks like the typical “economies of scale” at a software companies. Once you have written the code, selling additional licenses increases the margin.

Competition

I found an interesting interview in French from 2009 where the CEO has been asked the question. His answer was (my translation):

– in everything related to aerospace etc., there are only Japanese and American competitors which do not seem to cross borders
– for industrial installations, there seem to be local competitors in each country
– in everything which is related to buildings, Autodesk is considered the main competitor

I think there competitive position is quite good. Their current niche is still to small to really interest a large player to enter on a “green field approach”.

Stock price

Looking at the stock price alone makes me ask myself why I didn’t discover the stock already last year when it was really really cheap. On the other hand, the more important point will be: What is the intrinsic value now ? Is there still enough upside ?

Management

As a hobby investor, I do not have access to management, However i watched on Youtube some interviews with the CEO (for instance here. The general impression was quite good. The only thing that I noticed is that the CEO is also active as the head of the local commercial chamber as well as some function at the local airport. This might lead to additional business contacts on one side but maybe distract him from the companies at other times.

Picture of the CEO:

Renumeration for the CEO was 250 k in total for 2012, that is quite OK for such a succesful year. Compared to the value of his shares (~7 mn EUR), I think the interest is quite well aligned with shareholders.

Shareholder structure:

A few words here because for a small French company, the shareholder structure is rather unusual. There is no majority shareholder.

The 2 top shareholders

Irdi Midi Partners 14.1%
Odysee Ventures 12.3%

are French private equity companies which ahve reduced their stakes lately. On the other hand, Amiral, the well known French value investment firm has recently increased their stake from ~3% to 9%.

That means howver that in theory the company would be “available” for a competitor to buy. Maybe this explains the quite shareholder friendly policy of the company which is ussual for France.

Edit: Longer term shareholders seem have double votes, so the Management plus IRDI might still have the majority, but how long ?

Valuation

Comparables: Just for fun, lets look at some other Software companies. I picked out 5 others:

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Name	Rev – 1 Yr Gr	OPM	EBITDA Mrgn	3Yr Avg ROE	R&D/Net Sales:Y	EV/EBITDA T12M	EV/T12M EBIT
IGE + XAO	4.8%	22.9%	23.9%	18.2%	25.0%	6.8	7.1
PSI AG	6.7%	6.3%	8.6%	11.4%	9.6%	14.0	18.7
NEMETSCHEK AG	6.8%	16.8%	23.0%	20.2%	25.1%	10.0	14.3
DASSAULT SYSTEMES SA	13.8%	24.7%	29.3%	14.6%	18.1%	16.8	20.0
AUTODESK INC	4.4%	15.1%	20.7%	14.2%	25.9%	14.7	20.0
SAP AG	14.0%	25.5%	30.8%	23.8%	13.9%	16.7	20.5

Although its maybe not really fair to compare them, people pay for the same kind of profitablity aroound twice or three time as much for the larger companies.

This could be clearly also a function of better growth prospects, on the other hand it could also indicate what a potential buyer could be willing to pay.

Risks
As a French company, IGE is clearly subject to a worsening of the situation in France. With 73% of sales in France, there will be clearly problems if France goes into a real deep depression.

Another risk as with all cash rich companies could be that they use their cash for expensive acquisitions. So far, they haven’t done it but one never knows.

Summary

Overall, I think IGE + XAO makes a compelling investment case:

+ high margins and return on capital, rock solid balance sheet
+ capital light software company with good local competitive postion
+ for a French company surprisingly share holder friendly
+ potential target for buy out or take over

The major risk is of course the overall developement of the French economy. Nevertheless this is also the reason why one can buy this excellent company at a very attractive price.

I will therefore add IGE & XAO to my portfolio. I assume that I could have purchaes ~300 k EUR of shares over the last 6 weeks since I follow the company at ~42.50 EUR per share, making it a 2% position in my virtual portfolio.

Final remark on sizing /portfolio risk

The 2% portfolio weight might look a little bit small compared to the enthusiasm of my review. On the other side, my total French exposure now has hit 20% gross (~18.5% net of hedge). This is of course a quite conncentrated bet on France not going down the drain. So I try to limit my exposure within this concentrated bet on France by having a kind of “basket” approach and spread to different companies. Let’s see how this one works out…