Expert System — Update 16 December 2015

Expert System has made significant operational performance recently, which should provide it with a solid foundation to achieve further commercialisation of its core Cogito technology in the coming months.

Expert System is making good progress towards achieving its internationalisation strategy. Its H115 earnings release showed growth in the company’s international revenues to 41% from 16% in H114. Growth in the company’s US revenues was particularly strong, up 285% to €1.9m from €0.5m in H114. Including the contribution from the TEMIS acquisition on a pro forma basis, Expert System’s international revenue would have been 65% during H115. The company is now present in Italy, the US, UK, Germany, France, Spain, Canada and Columbia. This shift in the company’s geographic footprint significantly increases its addressable market. It will also enjoy significant tax benefits, as historically its largely Italian business has suffered from an effective tax rate of c 60% in its home market. We expect the group-level figure to come down significantly to c 30% as more favourable international tax rates dilute the impact of the Italian rate.

We expect international revenues to continue to grow ahead of the domestic business on an organic basis, given the relative maturity of the Italian business and the larger addressable market of the international business.

Expert System completed the previously announced acquisition of French text analytics company TEMIS on 23 September 2015. TEMIS operates in the text analytics market, similar to Expert System. TEMIS adds French, German and Canadian geographical exposure to Expert System’s existing footprint and reinforces Expert’s presence in both the US and the UK. TEMIS also serves an impressive number of blue-chip clients in the life sciences, financial and media industries, including BASF, BNP Paribas, Bayer Schering Pharma, Novartis, Sanofi, Thomson Reuters, The McGraw-Hill Companies and Bloomberg BNA.

TEMIS’s flagship platform Luxid identifies and extracts targeted information from bodies of unstructured information. Luxid offers a more structured but less sophisticated solution than Expert System’s core Cogito technology. As a result, Luxid is more standardised and requires less bespoke work than has historically been the case for Cogito. Consequently, TEMIS currently achieves a higher proportion of software sales than Expert System and is complementary to its offering. TEMIS’s offering is also cloud-based, while Expert System’s is server-based. TEMIS achieved revenue of €8.1m in FY14, which management expects to rise to €9.1m in FY15.

The US continues to form an important part of the commercial opportunity for Expert System. Following the completion of the TEMIS acquisition, the company has announced a reorganisation of its US operations designed to enable better focus on its two distinct target markets:

We believe this move is prudent as the two markets have very different sales cycles and product needs. Expert System USA is presently looking to achieve the necessary security clearances required to sell direct to government security agencies, rather than through system integrators. This will give it greater control of its sales channels.

Expert System reduced its stake in its non-consolidated subsidiary ADmantX during September by choosing not to take part in a capital raise conducted by ADmantX. As a result, its stake fell from 69% to 60%. The pre-money valuation of ADmantX valued Expert System’s stake at €10m. This represents a significant proportion of Expert System’s enterprise value, which we believe is underappreciated by the market. The company has stated that ADmantX is no longer a part of its long-term strategic objectives. As a result, we would expect it to continue to reduce its exposure over time.

TEMIS is already profitable and, as a result, we expect the acquisition to be immediately earnings accretive. For FY15 we now expect Expert System to record revenues of €19.0m and EBITDA of £1.3m including the contribution from TEMIS. Based on company guidance, we have reduced our assumptions for FY15 revenue growth for the core Expert System business without the contribution from TEMIS from €21.4m to €16.5m. We note that the company has previously shown a large degree of H2-weighted seasonality due to the contractual timing of some orders, giving us confidence that our revised estimates can be met despite requiring H2 revenues of €10.2m versus the €6.3m achieved in H1. This still equates to growth of 25% y-o-y for the core business. We have incorporated TEMIS from the completion date based on annualised revenues of €9.1m and costs of €7m. We introduce FY16 forecasts assuming 15% organic growth for Expert System and 10% revenue growth for TEMIS.

Expert System executed a successful bond issue over the summer, which raised €5m. The company intends to use the proceeds to continue its international expansion plans, particularly in the US and the UK. The semi-annual bond has a nine-year term that matures in 2024, and an attractive 4% rate of interest. The first payment is due at the end of January 2016.

Taking a full-year contribution from TEMIS and what we believe to be modest growth forecasts, Expert System trades on an FY16e EV/Sales of 2.2x and an EV/EBITDA of 13.8x (the EV is based on H115 reported net debt adjusted for the TEMIS acquisition). There is no directly comparable peer; the closest in terms of products is Nuance, but it is more established and considerably larger and generates a large proportion of revenues from its speech recognition software. Expert System trades at a significant discount to Nuance on an EV/Sales basis (2.2x vs 3.9x), reflecting Nuance’s higher proportion of software sales and hence great current profitability. On an EV/EBITDA basis, Expert System trades at a premium (13.8x vs 11.1x). However, Nuance is a more mature company growing at c 4%. We believe that Expert System should be able to significantly outgrow Nuance as it moves further into markets that are far greater in size than its home market. Moreover, Expert System should see its margins rise as it increases the proportion of its software sales. Consequently, we believe there is strong scope for the company to surprise on the upside in terms of both revenue growth and margins. The fact that TEMIS is already profitable provides further de-risking of Expert System’s investment case.

In addition to the aforementioned valuation catalysts, we believe that the greater US exposure, together with the Google partnership and other third-party relationships that the company is developing, provide Expert System with far greater commercial visibility for its Cogito technology. This increases the possibility of a potential take-out at a valuation well in excess of where Expert System is presently trading, taking completed transactions in the space as guidance, such as the 2014 acquisition of cognitive computing company DeepMind (founded in 2010) by Google for an estimated $400m. While we do not expect a take-out price of that magnitude for Expert System at this stage, it is illustrative of the significant investment and M&A activity in the space at the moment.