Brady — Positioning for new technologies

Founded in 1985, Brady is a leading provider of trading and risk management software for global commodity markets. The group has 300+ customers worldwide, including some of the largest financial institutions and corporations, which depend on Brady's software solutions to deliver mission-critical business transactions across their global networks. The group employs c 180 people with development centres in the UK (Cambridge and Edinburgh), Norway (Bergen and Halden), Switzerland (Geneva) and India (Bangalore), and commercial offices in the US, UK, Europe and Singapore. Customers include Codelco, Cofco, Gerald Metals, Glencore, Koch Inds, LG Intl, Norilsk, Norsk Hydro, Rio Tinto, Standard Bank, Statkraft, Statoil, Traxys and Xstrata.

A primary focus is to transition the group’s customer base to a recurring rental model. While Brady’s Norwegian energy business operates a recurring onsite rental model, its commodities and energy scheduling units have traditionally operated a term licence model. The near-term focus is to shift this business to recurring rental. Longer-term, the plan is to transition to microservices, which provides a route to more scalable cloud deployment. The group posted an operating loss in FY17, due to disappointing revenues, with projects delayed, and there was an acceleration of the switch to the rental model, which reduces revenue in the short term. Underlying H118 group revenue rose 2% and 74% of revenues were recurring in nature, although this ratio is expected to decline in H2 as licence and service revenues recover. We forecast sales to grow by 6% CAGR organically over FY18-20, with adjusted operating profit recovering to £0.3m in FY18 and to £1.3m in FY19. Brady had net cash of £4.8m at end-H118 and we forecast this to increase to £5.1m at end-FY18 and to £6.8m a year later.

In our view, Brady’s greatest sensitivity, as with a typical enterprise software vendor, is the risk of IT department budget cuts in an economic downturn. It is also exposed to commodity markets, which are cyclical and subject to periods of extreme volatility. We note that the 2015 commodity sell-off, which was related to a Chinese economic deceleration, was persistent and severe, and correlated across asset classes.

The stock trades on a P/E of 206x our FY18 earnings forecast, falling to 55x in FY19e and to 35x in FY20e. The high ratings reflect the depressed profitability, which we expect to improve as the business scales, and Brady should benefit from its streamlined cost base. Alternatively, the stock trades on 1.9x FY19e revenues, which is substantially below the broader sector (see Exhibit 7 on page 14). Additionally, the stock is underpinned by the high level of M&A in the financial software sector and in particular across the commodities software space.

Brady seeks to be the definitive provider of choice for natural resources software solutions. It operates in the E/CTRM (energy/commodity trading, transaction and risk management) software space, supporting the business processes of enterprises that are associated with trading energy and commodities. Brady is the largest Europe-headquartered E/CTRM provider; it is the largest in the metals (a segment within CTRM or commodity trading, transaction and risk management) and the largest ETRM (energy trading, transaction and risk management) provider in Europe. Brady has over 30 years’ expertise in the commodity markets with more than 300 customers worldwide. These businesses rely on Brady’s software solutions to deliver business transactions across their global operations. Brady clients include many of the world’s largest financial institutions, trading companies, miners, refiners, tier one banks and a large number of London Metal Exchange (LME) Category 1 and 2 clearing members, and many leading European energy generators, traders and fabricators.

Over the last few years, Brady has undergone a significant transition into a leaner, more focused business. Costs have been taken out and the recycling business sold, as it did not fit well with the business. A strategic review was initiated by Ian Jenks, chairman, following his appointment in June 2016, and completed in 2017. The group has switched from operating on a divisional basis to global functions, and hence no longer reports results for energy and commodities separately. Staff numbers have reduced by around a third since the peak as a result of the recycling disposal, reduction in headcount in the Bangalore office in early 2018 and cuts from duplication as the group transitioned to operating on global functions basis. We also note that staff turnover was high in 2017 but this has since returned to normal levels. The development team has been unified, and development work is shifting from platforms to ‘microservices’, so that new products can be leveraged across the group and Brady is evolving to a recurring revenue model. An account management function has been created to replace what was previously handled by sales and this has helped drive new sales from existing customers in H1. The focus now is to improve the new sales process to build the pipeline of new customers.

Brady combines fully integrated and complete solutions supporting the entire commodity trading operation, from capture of financial and physical trading, through risk management, handling of physical operations, to back office financials and treasury settlement for energy, refined and unrefined metals, soft commodities and agricultural products.

Brady has a particularly strong position in metals and a smaller presence in agriculture and softs. The main solutions include Trinity, FinTrade and Aquarius. Trinity is the group’s original solution while FinTrade was acquired with Viveo Switzerland in 2010. Trinity’s functionality includes trading and risk management from physical contract positions to hedging and derivatives trading activities, notably for precious and base metals. FinTrade is a physical and financial solution for all metals, agriculturals & softs and bulk energy commodities, and has an accounting module called FinAccount. The functionality of the group’s concentrates solution has recently been built into FinTrade, while a handful of customers continue to operate the legacy Aquarius solution.

Primary solutions include Energy Trading and Risk Management (originally Elviz), Energy Data Management (originally Navita) and Energy Logistics (originally Syseca). The solutions cover the following energy products: power, electricity, gas, emissions, renewables, LNG and LPG. Functionality covers physical trading, power generation, scheduling and nomination, cross-border trading, and financial trading and risk management. The bulk of Brady’s ETRM customers are in Norway and other Nordic countries, for the trading/risk and EDM solutions. The Nordic energy margins are going through significant changes – energy data are being centralised, but with different standards in Norway, Sweden and Finland. This creates an opportunity for Brady.

The group has made some small ETRM sales in other European countries, and a significant power scheduling deal with EirGrid, the Irish state-owned transmission system operator (TSO) that manages and operates the transmission grid across both the Republic of Ireland and Northern Ireland. This solution has been built to manage scheduling for I-SEM (Integrated Single Electricity Market), the new wholesale electricity market arrangement for Ireland and Northern Ireland, and this relationship has helped Brady win additional I-SEM-related business in Ireland. The Irish business development and support is handled from the group’s Edinburgh office.

Brady Credit Risk is a global limits management and credit exposure measurement application that was built for the energy markets. Brady Credit Risk interfaces with multiple systems across front and back offices, allowing credit risk exposures to be measured and policed on a global basis. The solution was acquired as energycredit and Brady intends to target the solution at the broader commodity markets.

Brady listed on AIM in 2004. At that time, its core competence was in the metals markets, and it was typically winning one to three new contracts per annum. A new management team joined in 2007, which sought to use the public listing to broaden the group’s exposure across the commodities spectrum. In 2009, Brady acquired Comsoft to expand into concentrates. The acquisition of Viveo Switzerland in early 2010 added exposure to soft commodities and agriculturals, while also strengthening its position in metals. The first significant exposure to energy (ETRM) markets came with the acquisition of Viz Risk Management, a Norwegian business, later in 2010. This was strengthened via the acquisition of Navita, the major competitor of Viz in Norway, along with Syseca, a small Swiss business that has provided the foundation of the group’s energy scheduling business. The Norwegian businesses were streamlined with customers transitioned to go-forward platforms. SAI, a software provider to the scrap metals (recycling) industry, was acquired in 2012, which was strengthened via the acquisition of ScrapRunner in mid-2015. These businesses were sold in January 2018 following the strategic review, because the recycling industry is a challenging end-market, and the recycling software platform was not suited to the transition to microservices. The group’s credit risk product was acquired in 2016 (energycredit).

This first set of numbers since last year’s restructuring reveals a stabilising revenue base, growing recurring revenues, rising gross margin and falling operating costs. While Brady is still running at a loss, there is less risk in the business due to the significantly reduced cost base and management is in a significantly better position to scale the business. Further, the group retains a strong balance sheet with net cash and no financial debt. There was £2.8m of new bookings, including £2.3m of from existing customers and £0.5m from two new energy customers. The bookings from existing customers included £1.2m of new business (new user licences and additional modules) and £1.1m of renewals, with the latter reflecting a 100% hit rate as four customers renewed their term licences. The group ended the period with cash of £4.8m and has no debt. A final payment of £1m for the recycling business is due to be received in FY19.

Traxys is a privately owned physical commodity trader and merchant in the metals and natural resources sectors. Its logistics, marketing, distribution, supply chain management and trading activities are conducted by over 400 employees in over 20 offices worldwide, and its annual turnover exceeds $6bn. With a Luxembourg HQ, Traxys is active in a range of non-ferrous metals, ferroalloys, minerals, industrial raw materials and energy-related commodities. Traxys serves a broad base of customers and suppliers and offers a full range of commercial and financial services.

Traxys grew through a series of acquisitions, which resulted in multiple trading systems and different processes across its global businesses. In 2011–12, Traxys implemented one common global accounting system. In 2013, it set out to replace all of its trading systems. Traxys had three trading systems ranging from a 20+ year-old custom build to one more modern platform and a very large number of spreadsheets. Its primary objective was to end up with one global system and one set of global processes. The greatest challenge in selecting a system for Traxys was the range of products it trades and there was no single system on the market that handled all its products.

Traxys selected Brady’s FinTrade solution for the following reasons:

Traxys has successfully gone live with FinTrade in a number of its divisions, including the base metals business (globally in five locations, 100% live) and Industrial Minerals (50% live globally). User feedback has been positive overall and the system is seen as a significant improvement in control and efficiency.

There were challenges with the project, with development timelines stretched out and project budgets overrun, and there has been high turnover of resources. However, the changes at Brady in the past year have restored confidence and the product has seen ongoing improvements. Traxys is now deeply invested in Brady and has confidence in a successful project completion and long-term relationship. The roll-out is expected to be completed in mid-2019.

Ian Jenks joined Brady in June 2016 as a non-executive chairman. Mr Jenks hired external consultants to review the business. In September 2016, it was announced that Gavin Lavelle, CEO, was leaving the business and Mr Jenks took over as executive chairman on an interim basis. The company is looking for a new CEO who has a strong sales focus, after which Mr Jenks will return to the non-executive chairman role.

A new senior management team has now evolved:

Head of value enablement – Scott Hestenes: Mr Hestenes joined Brady when it acquired Navita in 2012. He is responsible for all sales and marketing activities.

Head of product – Libby Koehn: Ms Koehn is responsible for all product development. Ms Koehn spent her career in the software industry and joined Brady in 2017 from Sage, where she was VP of product for the company’s enterprise software business.

Head of business enablement – Martin Thorneycroft: Mr Thorneycroft joined Brady in 2014 and is responsible for finance, HR and legal. He was previously finance director of AIM-listed Patsystems from July 2004.

Further biography details are on page 15. A new layer of team leaders has been established under the operating board.

The initial priority is to complete a number of legacy contracts which, once completed, will free up resources to focus on new projects.

We highlight the following points on the group strategy:  

In January, Brady sold its US-based recycling business to AMCS Group, an Irish software company focused on the waste and recycling sector, for an initial c £3.3m with a c £1m balance in 18 months. The disposal included Systems Alternative International, which Brady acquired in November 2012 for an initial £3.9m, along with ScrapRunner, which Brady acquired in July 2015 for c £1.3m. The recycling business provided software to the metals recycling industry, and the bulk of its sales were in North America. Brady chose to sell the business as the recycling industry is a challenging end-market, and the software platform was not suited to the transition to microservices.

Gross R&D remains at elevated levels, at c £6m or c 25% of sales in FY18, down from £7m or c 30.5% of sales in FY17. The company is going through a major refresh of its product portfolio, which in H1 included additional functionality for the concentrates solution and a tolling module for FinTrade. The FinTrade solution has been significantly enhanced. A new front end has been developed for Brady Credit Risk, which gives it much deeper insight and will enable it to be sold to a broader customer base, outside its traditional energy target market.

In May, Brady launched a new hosted cloud version of its physical trading and risk management solution for metals (FinTrade), which employs out-of-the-box, preconfigured settings that make it usable from day one. Brady plans to roll out further quick-start solutions for other commodities. It has found that many aspects of an installation can be standardised and this new approach simplifies the typical installation and hence reduces installation time and cost.

Microservices are core to the development strategy, as they provide a more efficient approach to software development. Microservices enable large software applications to be broken down into multiple services. Each microservice can be employed independently, acts as a single business function and enacts only that business function. Brady has several platforms and there are a number of overlaps, so developing a microservice allows the company to improve efficiencies. Also, Brady can offer the microservice on a standalone basis to customers. Ultimately, microservices provide Brady with a method to build a cloud platform without having to develop a new one from scratch.

The E/CTRM software segment supports the business processes of enterprises that are associated with trading energy and commodities. The E/CTRM market is divided into ETRM for the energy markets and CTRM for agriculture, metals and other commodities. The ETRM market began in the early 1990s, inspired by regulatory changes, with the establishment of the first ETRM vendor in 1992, which was focused on the natural gas markets. The ETRM market was expanded into power in the mid-1990s and crude oil products in the late 1990s. The CTRM market was slower to take off, and did not gain significant traction until the mid-noughties. Prior to the advent of E/CTRM vendors, participants had to develop their own in-house systems, typically developed from spreadsheets.

Brady’s traditional market was metals (CTRM) and it expanded by acquisition into soft commodities and power (ETRM) spaces. Its areas of strength are in metals (number one globally) and power (number one in Europe). The company lacks exposure to the petroleum markets which is a highly competitive area. Brady intends to expand its portfolio, with a focus on soft commodities/agriculture. Brady already has a presence in cotton, sugar and coffee and it intends to expand its capabilities in these areas.

ComTech Advisory sized the E/CTRM market at $1.65bn in 2016, and forecast it to grow by 6% CAGR over 2016-2020e to $2.06bn. We estimate that Brady has 1.2% of this market. In our view, the total market opportunity for Brady is significantly larger, after taking into account the fact that a large component in the market still operates on spreadsheets, particularly at the lower end, and management believes the market remains poorly severed. Further, there is an opportunity to extend into adjacent areas, eg logistics.

The market has undergone significant consolidation in recent years. Most notably, ION Trading has acquired the two leading pure-play E/CTRM participants – OpenLink and Triple Point – while also acquiring Aspect Enterprise Solutions, a smaller E/CTRM player that operates a cloud computing business model. This makes ION by far the largest player in the space. The accumulation of such high-quality assets looks daunting, especially since ION also owns a range of other solutions in the value chain following the acquisitions of FfastFill, Patsystems and, most recently, Fidessa.

However, there are a number of reasons why this situation could benefit Brady:

Additionally, FIS acquired SunGard, the financial software giant, in 2015. Smaller independent players include Allegro, India-based EKA and AIM-quoted MicroGen (Cortex). Further down the hierarchy, the commodities software market remains highly fragmented with a large number of small specialist players. Small participants do present a competitive threat to Brady in that they can win niche, standalone services that enterprises can stitch together.

In the credit risk space, the main competitor is CubeLogic, which was taken private from OpenLink in 2016.

A primary focus is to transition all the group’s customers to a recurring rental model. While Brady’s Norwegian energy business operates an onsite rental model, the group’s commodities and Switzerland-based energy scheduling unit have traditionally operated a term licence model. The aim over time is to switch these customers to a rental model. The company is also progressing in making installations more efficient, which will require a lower level of services. Over time, the evolution of microservices and cloud will add further efficiencies.

The Norwegian energy business operates an onsite rental model with professional services to support customers. The group’s commodities and energy scheduling unit have traditionally operated a term-licence model, normally for five years. There is an annual 20% support and maintenance fee on top, along with services, which could potentially double the licence fee. The default delivery is a hosted cloud offering, which involves a recurring annual hosting fee. Clients that are renewing their contracts are encouraged to switch to rental, but the latest batch of renewals all chose to stick with term licences. While it is easier to encourage new customers to choose the rental option, there will always be some that insist on a term licence. The financial benefits of the switch to rental are relatively small, eg a £300k term licence generates £600k of revenue over five years, including support; on a rental basis, this would convert to £125–150k per annum, including support.

A typical traditional term licence is in the £300k–350k range, while recurring energy deals are much smaller. A smaller value licence might take one to two months to implement and cost £100k to £150k. Larger deals typically have more complex services requirements, might cost more than £750k and take six to 12 months to implement. Following the signing of a new deal, Brady proceeds to implement the software, charging for professional fees. Annual support and maintenance is 20%, paid annually in advance, and the company also offers consultancy and development services. The company has a conservative revenue recognition policy, only recognising the licence revenue when the customer has the ability to go live. Brady has a hosting partnership with Rackspace and the hosted cloud offering saves the customer hardware and internal IT support costs, and hence has a lower total cost of ownership. The price of the cloud offering is dependent on the level of application uptime that is guaranteed in the service level agreement (SLA), and the highest level can potentially double the cost of the licence. As Brady grows its hosting revenues, the gross margin from the partnership increases.

Q4 is typically the busiest quarter, followed by Q2 and Q3, with Q1 the quietest. Q4 and Q2 are boosted as some customers use up their remaining IT budgets in purchasing additional modules and user licences.

Group revenue slipped by 1% to £10.5m, but on a constant currency basis it rose by 2%. Cost of sales fell by 7% (4% at constant currencies) and hence the gross margin rose by 300bp to 55%. Recurring revenue represented 74% of the total, but this is expected to ease to c 70% in the full year, due to an expected increase in licence and services revenue in H2. Operating costs fell by 7% (11% at constant currencies) and consequently the operating loss (Brady method) slipped by £0.8m to £2.3m. While there were no exceptional items, £150k of redundancy costs were put through operating costs. There was £2.8m of new bookings, including £2.3m of from existing customers and £0.5m from two new ETRM customers (Ustekveikja Energi and AES). The bookings from existing customers included £1.2m of new business (new user licences and additional modules), which reflected the increased focus on account management. Additionally, there were £1.1m of renewals, reflecting a 100% hit rate as all four customers that came up for renewal renewed their term licences. All of these renewals were in the form of term licences. The group capitalised £1.2m on development expenditure in H1, which related to additional functionality for the concentrates product and a tolling module for FinTrade. The group ended the period with cash of £4.8m and has no debt. A final payment of £1m for the recycling business is expected to be received in FY19.

The group has implemented IFRS 15 for FY18 and restated its FY17 accounts for the new accounting standard. Under IFRS 15, FY17 revenues were 3% lower than previously stated, while EBITDA (Brady methodology) was £0.5m lower and net assets fell from £24.1m to £21.8m. The fall in revenue is due to slower revenue recognition from software licence and services elements of contracts with multiple performance obligations as the revenue is recognised at the point the customer has the ability to go-live rather than on legal acceptance of the software, as the work is performed or on a percentage-of-completion method.

The group’s pension deficit dipped from £2.5m to £2.0m. We note that Brady has no defined benefit schemes (where the company takes on the investment risk). The deficit relates to two Swiss defined contribution pension schemes, which it is required under IFRS to account for as if they are defined benefit schemes because Brady guarantees them. However, they are insured with Zurich Insurance. Hence we have not included the deficit in our adjusted debt numbers.

Brady says that it expects FY18 results to be in line with market expectations. Consequently, management expects revenue growth of 3-4% in FY18, in relation to the old (ie pre-IFRS 15) FY17 numbers. The group has visibility of 95% of FY18 revenues, largely due to the ongoing work on legacy contracts that will involve significant licence and services in H2, and this will help to bring the recurring revenue level back to c 70%. Any new licence sales achieved in H2 will see minimal revenue recognised in FY18, but there are typically additional user licences sold in Q4.

We have maintained our revenue forecasts, while we have adjusted the balance between underlying operating costs and share-based payments, increasing the former while reducing the latter by an equivalent amount. This reduces our profitability measures. However, EBITDA (Brady methodology) remains unchanged on our forecasts as it includes the share-based payments charge. We have also made other minor adjustments including to R&D, interest and FY18 depreciation.

Licence fees: this includes licence sales (excluding software rentals), along with additional modules and user licences, which typically represent half of this revenue category. We forecast licence revenue to jump by 38% to £3.5m in FY18, reflecting the revenue from legacy contracts. We forecast licence revenue to decline thereafter as the focus shifts to recurring revenues.

Recurring fees: this includes annual support and maintenance, software rentals (mainly in the energy business) and cloud revenues. We forecast recurring fees grow by 2% in FY18, then by 16% in FY19 (helped by support revenues from FY18 licence sales) and by 8% in FY20. This results in recurring revenues dipping to 67% of the total in FY18, then rising to 75% in FY19 (as licence revenue falls back) and to 77% in FY20.

Services: this includes software implementation, consulting and development revenues. While we are forecasting a rebound in H2 as work progresses on legacy contracts, this will not be nearly enough to reach our previous forecasts. We also note that the new FAST START implementation requires fewer services, hence our services forecasts come back by 30% in FY18 and by 29% in FY19 and FY20.

Cost of sales: cost of sales includes software delivery (consulting, implementation and development services) and R&D (some of which is capitalised), as well as hosting costs. R&D was c £7m in FY17, representing 30.5% of sales. We forecast R&D to decline to £6m in FY18, representing c 25.4% of sales which we assume will ease to 25% in FY19 and to 24.5% in FY20. We assume 52% of R&D, or £3.1m, is capitalised in FY18, which is well above traditional levels, reflecting a number of specific development projects. We forecast this to fall to 36% in FY19 and to 31% in FY20. We assume capitalised development costs are amortised over the subsequent five years, resulting in an amortisation charge of £2.1m in FY18, rising to £2.3m in FY20. We forecast that gross margins continue to advance, reflecting the improved scalability of the business. This includes more efficient installations, with the introduction of the FAST START programme, which will result in lower implementation services.

Operating costs and margins: we assume that selling and administrative expenses dip by 7.5% in FY18 reflecting the recycling disposal, remain broadly unchanged in FY19 (noting the minor redundancies in Q118 that were included in opex) and rise by 2% in FY20. We forecast an operating margin of 1.5% in FY18, which rises to 5.0% in FY19 and to 7.8% in FY20.

Taxation: the company benefits from a favourable R&D tax environment. We assume an effective tax rate of 20% in FY19, 22% in FY20 and 24% in FY21.

Commodity markets are cyclical and subject to periods of extreme volatility. However, while falling commodities prices hurt producers, they are beneficial to manufacturers, which also purchase the group’s software, while traders can benefit from increased volatility. Further, falling commodity prices can force producers to drive through efficiencies, which can involve them upgrading or replacing their in-house software with Brady’s software. The 2015 commodity sell-off, which was related to the Chinese economic deceleration, was persistent and severe, and correlated across asset classes. This forced restructurings across the commodity trading sphere, with players deferring deals to conserve cash. Nevertheless, target commodity customers (producers, fabricators, traders, etc) are generally well capitalised, dealing with high volumes, yet are significantly underinvested in IT trading platforms. Strong regulatory and compliance drivers are also pushing demand for improved IT systems.

We highlight the following sensitivities:

The stock trades on c 55x our FY19e earnings. Alternatively, the shares trade on 1.9x our FY19e sales and 30x EBITDA (Edison method). As the company is undergoing a transition, the shares do not look appealing on near-term traditional valuation metrics. However, there are a number of reasons why we believe investors should take a longer-term view.

We highlight the following points on the group’s valuation: