Hogg Robinson Group — Update 3 August 2016

Technology lies at the heart of HRG. It is key not only to providing its current range of services, but also to extending the range of the services and clients served to exploit fully HRG’s knowledge, relationships and strategic position. It should come as no surprise therefore that HRG’s technology work has led to the development of a software business. Fraedom brings together HRG’s own internally developed products and expertise and Spendvision, an expenses and payment software company that started life in 1999 as mypcard.com and which HRG bought in stages from 2004 to 2012. Fraedom employs 365 staff (mainly in the UK and New Zealand) and in FY16 generated £25.6m in revenues from processing transactions worth £25bn for more than 135,000 organisations across 178 countries.

In 2015 Fraedom was officially launched to provide payments, expenses and travel services for existing and new clients on a software-as-a-service (SaaS1) basis. The Fraedom platform provides a simpler and faster way for companies and their employees to manage expenses, make payments and book and control travel. The route to market is mainly via third-party travel and payment providers, most notably Visa, who see not only direct revenue benefits from the sale but also ongoing benefits from the increased usage of their cards/system that Fraedom can help trigger.

While Fraedom’s roots lie in the corporate travel and expenses arena, it is not aimed solely at travel. Management regards Fraedom as a potential disruptor across the wider payments and expenses management sector, with payments being the area with greatest potential. Management has pointed to Visa and MasterCard’s own research, which suggests that while card transactions account for nearly $2tn of B2B and travel and expenses (T&E) transactions globally each year, the wider B2B transactions market is more than 50 times that size. The major card companies see B2B payments as an opportunity, particularly within the SME market, and Fraedom is eager to work alongside them to address the opportunity, helping to enable the changes in technology and behaviour required for this to happen.

The charts below show the split of revenue generation across the three categories (Expenses, Payments and Travel in FY16) and geographically (FY15).

Roughly three-quarters of Fraedom’s revenues are from usage-related and hosting fees and the remaining quarter consist of development and implementation (D&I) fees. We understand that Fraedom undertakes bespoke work for certain partners to integrate the software with their systems, and this drives the D&I fees. We would expect Fraedom to continue to earn D&I fees as more customers are signed up. Fraedom’s transaction-related revenues depend on the functionality used:

In the traditional software model there is a large upfront payment for a perpetual software licence, with the software running on the clients’ hardware, and typically ongoing revenues for software updates and maintenance. In all but the smallest of enterprises, this is typically accompanied by a significant installation or integration expense and often additional hardware costs for servers, PCs etc. Under the SaaS model the software is paid for on an ongoing subscription basis (usually annually or monthly) and it is run or hosted on the machines of the software company or, as is increasingly the case, the machines of a third-party service provider, such as Amazon Web Services, Google or Microsoft.

These advantages are particularly clear for Fraedom. The logistical and technical challenge of implementing and supporting software for 135,000 organisations would be a huge and costly challenge. Providing access to the software via a handful of hosting locations, while far from simple, makes this challenge readily achievable and allows Fraedom considerable flexibility with regard to increasing numbers of customers served and services offered.

In some cases, customers want the software to run within their own firewalls – in this case Fraedom will host a separate instance; it will still be charged for in the way described above, rather than via a perpetual license model.

The way in which Fraedom reaches end customers/users is crucial to understanding how the products and markets are likely to evolve and why management believes that Fraedom is well placed to enable change in (or in their words disruption of) the B2B arena.

Fraedom reaches end users via both direct sales and partner channels. The vast majority of sales (we believe 80-85%) are via partners and this is likely to continue because Fraedom’s partner channel is not a simple agency fee-based model; partnering with Fraedom and driving its sales can bring significant indirect benefits to partners as well as their customers.

Fraedom’s partners use Fraedom to help them create and, importantly, brand Payment, Expense and Travel products for their business customers. Most Fraedom partners are financial services providers including Visa, BMO, Barclaycard, Lloyds Banking Group and ANZ. The most significant is Visa, which resells the Fraedom technology to approximately 100 banks globally. It is through its financial service provider partners that Fraedom is able to serve over 135,000 organisations. These partners typically see gains on several levels, including uplift in customer card usage and greater levels of integration with reporting and management information systems – with some of Fraedom’s partners claiming 25% uplifts in card usage.

In the direct sales channel, clients buy Fraedom to use in their own business as part of a Payment, Expense and Travel solution. Fraedom’s direct customers include Mitsubishi Motors, De Beers, IMG and Essex County Council.

The Payments element of the platform is principally sold via partners and so we expect to see the proportion of direct sales to continue to decline further over the coming years as Payments outgrows the other applications.

Partners typically sign up for five years; direct customers typically sign up for three to five years. Fraedom has a high retention rate, with the most recent data showing 96% retention by customer and 99% retention by revenue.

We discuss in more detail the functionality and growth strategy for each part of the Fraedom platform.

Within the area of expense management Fraedom gives companies an easier way to manage their non-production related expenses. The Fraedom platform is able to capture the data from card transactions, employee expense claims and receipts and smart scanning and to create a range of reports and statements, helping management to analyse and control expenditure.

This area made up the bulk of the Spendvision business and hence now the Expense application area is the largest for Fraedom at more than two-thirds of revenues. If it grows at the 12% per year rate that management alluded to in the recent Fraedom teach-in (March 2016), then we would expect it to be the largest source of growth for the next few years. As with Travel, improved mobile functionality is seen by management as an important enabler and driver of growth, and Touchless transactions in particular are regarded as a way to capture more spend through the system.

As this function is charged for on a per-user basis, it has a high level of recurring revenues.

Although not the largest revenue source at present (making up just over quarter of FY16 revenues), Payments is the fastest growing of Fraedom’s applications and, management believes, the one with the greatest growth potential (c 25% pa). Management believes this lies principally in the growth in the use of cards and other such systems for non-personal business-to-business (B2B) payments. As previously discussed, financial institution partners are keen to offer this service to their customers to promote the use of their cards.

The first stage of the Fraedom Pay offering brings together a range of card and payment technologies within an authorisation, payment, receipt and reporting system. This is regarded by management as, in itself, disruptive. For the second generation of Fraedom Pay, anticipated over the next two to three years, management plans to bring together a far wider range of payment methods, including lodge cards, cheques and e-transfers and to not only combine authorisations, payments, receipt and reporting but also to select the best payment method for each transaction (“intelligent payments”). For virtual cards, management wants to be both scheme and commodity agnostic, ie capable of servicing Visa, MasterCard, Diners and AmEx cards, and for any type of expense.

Payment by card is the norm in travel and general expenses, but as the size of purchases becomes larger and more B2B in nature so the structure of billing, payment and pricing changes. Within T&E markets the vendor anticipates the use of card and will factor in the c 2% card processing fee accordingly. However, in the mainstream B2B purchases/payments area the fee is not factored into vendors’ calculations and so can be seen as an unwelcome hit to profit margins. Fraedom’s payments functionality will be able to take into account the full range of payment methods available to a customer, and assess which is most appropriate for a specific payment, taking into account working capital requirements, supplier preferences, the cost of the transaction and any available discounts.

The primary objective in the travel area is to give the corporate user better and faster ways to find, book and manage their travel. Although travel is Hogg Robinson’s core business, Travel accounts for only a small proportion of revenues within Fraedom (<5%). The disclosed revenue figures do not include provision of software to the wider Hogg Robinson group.

The new Fraedom Travel is aimed at the SME sector in combination with expense and, ultimately, payment. Unlike HRG Travel, Fraedom's own OTE (Online Travel & Expense) does not manage travel and expense policies in support of large organisations. The complex large corporate tool is sold by HRG Travel.

Management suggests that medium-term growth percentage in this area could be in the high single figures per year over the short to medium term. This is not as rapid as the Expense and Payments applications but is still, in our view, attractive. A key driver to this growth is expected to be the increased mobile functionality and ‘Touchless Transactions’ that Fraedom is developing. As Spendvision’s roots were in the Expenses business, Fraedom is now looking to sell the Travel component to the existing Expenses customer base, representing another source of growth.

Hogg Robinson Group is far from alone in seeing the value in developing travel, expenses and payments software but management believes it is uniquely placed with regard to the range of services it can combine, particularly in the payments space. The diagram below sets out how management regards the market. The closest competitors are US-based Concur, acquired by SAP in 2014 for $8.4bn, and KDS, a privately owned French business. Management is of the view that neither of these businesses possesses the payments integration that Fraedom is able to offer and that management regards as crucial to disrupting and capturing the value of the payments market.

Looking at the purchase-to-pay software market and the invoice networks that link buyers and sellers for B2B payments (eg Ariba, Basware), most software providers support the purchasing process as far as payment authorisation, but do not actually provide the means to make payment. Fraedom sees itself as able to provide the final step in this purchase-to-pay cycle.

Exhibit 5 summarises Fraedom’s financial performance since FY13. Fraedom has shown consistent revenue growth over the period, and operating margins exceeded 20% for the first time in FY16.

Based on management indications of the revenue split for FY16 and targeted growth rates by function, we estimate that Fraedom revenues could approach £40m in three years (CAGR c 16%).

The current underlying operating margins are now at a similar level to traditional software vendors. Looking at quoted SaaS businesses, although 30-40% operating margins are often talked about as achievable in the long term, very few are yet to reach this level and many are in fact still loss-making.

The impact of Fraedom on Hogg Robinson Group in terms of valuation is difficult to quantify. Although established, Fraedom clearly has some way to go before it can claim to have reached its goal. Furthermore it remains a core part of the group and, we believe, that much of what it does is intertwined with HRG. It is clear to us, however, that despite its present small size, Fraedom is currently of significant value and has the potential to be of considerable value.

We do not have sufficient detail on the Fraedom financials to undertake detailed DCF-based valuation calculations. We can, however, look at the valuations of listed entities within similar markets or with similar dynamics and we can consider prices paid in corporate transactions.

The most notable transaction in recent years was the purchase by SAP of Concur for $8.3bn equivalent to an EV/Sales (trailing) multiple of approximately 12x. Serko is the only listed focused competitor for Fraedom (NZX-listed, market cap NZ$44m), trading on an EV/sales (trailing) multiple of just under 3x and still loss making. There are no direct UK comparators, but Craneware (AIM-listed, market cap £229m) is an interesting example of a service business that has evolved into a subscription-based software business, in its case in US healthcare billing, and its shares stand on a forward EV/sales multiple of 5.8x and P/E of 29.9x on a forecast operating margin of 29%. In the procure-to-pay software market, AIM-listed Proactis (market cap £49m) trades on a forward EV/sales multiple of 2.2x and P/E of 17.1x at a forecast operating margin of 18%.

Based on the assumption of c 14% revenue growth in FY17 at a 20% operating margin and 20% tax rate, we calculate the value of Fraedom on a range of EV/sales multiples and calculate the implied EV/NOPAT multiple.

Looking at the valuations of peers above, a valuation range of £75-105m would not be unreasonable for Fraedom. It compares with Hogg Robinson’s current total EV of £251m.