Clearly, I wasn't the only one thinking this way as shares in the Alternative Investment Market (Aim)-traded company have risen 30 per cent since publication of that article ('Follow the smart money', 27 February 2017). I have a feeling that investors are likely to warm to another small-cap that I have monitoring for some time, too - Lombard Risk Management (LRM:9p). The company is a leading provider of collateral management and regulatory reporting software products, which automate tedious and expensive tasks of regulatory reporting and optimisation of collateral management in order to reduce the costs, complexity and constraints of trading in financial markets.
Founded in the late 1980s, the company employs 378 staff and offers software solutions to more than 340 corporations, including 30 of the top 50 global banks, as well as hedge funds, asset managers and other institutions. This is a good time to be servicing their needs given these institutions have been slammed with over $200bn (£164bn) of fines for their previous misdemeanours during the light touch years in the run up to the 2008 global financial crisis, and are now facing an unprecedented wave of new regulations to keep their operations in check. At the same time, the top brass of these global banks prefer to source vendor software solutions rather than self build to comply with banking regulations, having slimmed down their IT departments in cost-cutting measures since the financial crisis.
Moreover, irrespective of whether the new Republican administration decides to pander to the needs of the Wall Street banks and ease some of the more onerous conditions placed on their activities by the Dodd-Frank Act, which was passed by the Obama administration in 2010 in direct response to the financial crisis, a host of new directives covering their trading activities, risk management, conduct and reporting compliance of financial institutions are forcing a major overhaul of their IT requirements.
And this sea change can be seen in a raft of contract wins for Lombard, which delivered record revenues of £15.2m in the six months to the end of September 2016, up by 41 per cent on the same period in 2015, and posted a 35 per cent rise in the closing contracted order book to £9.2m. Software license sales more than doubled in the six month trading period and, importantly, recurring revenue now accounts for over 40 per cent of total revenues, so covering a chunk of the fixed cost base.
Contract momentum building
A raft of recent announcements suggest that contract momentum is building, too. For instance, at the end of last year, the company signed an agreement with Atos, an international leader in digital services, to facilitate the delivery of Lombard Risk's award-winning collateral management solution, COLLINE®, to the German market from early 2017.
In layman's terms, collateral management helps to reduce counterparty credit exposure, and is normally used with over-the-counter (OTC) derivatives such as swaps and options. When two parties agree to collaterisation, they execute a collateral support document with terms and conditions. The trades are regularly marked to market, net valuations agreed and the party with the negative mark-to-market liability on the trade delivers collateral to the party with the positive one. By providing a single platform, COLLINE® delivers more efficient collateral optimisation, and provides clients with the capability to manage liquidity and trading book capital.
Bearing this in mind, Atos has an established client network across Germany, including major corporations across the manufacturing, banking and financial services, energy, insurance and public sectors; all of which need collateral management solutions. Financial services firms in Germany, like the rest of the world, are under increasing pressure to cut costs while upgrading their legacy systems and ensuring compliance, so tapping into this market through Atos' client network is smart business.
The software is proving very popular in North America as a key take in the company's recent trading update has been "the substantial growth of Lombard's client base and major new product additions", with the directors adding that COLLINE® has been delivered to a "record number of clients across both the buy and sell side in the US and Canada, with five major clients going live in the current quarter".
Product innovation is playing a part, too, as the launch of a new exchange traded derivative (ETD) module means that COLLINE® has extended its reach to all asset classes and products, covering activities in OTC, ETD, exchange traded funds, repo and securities lending. Lombard is converting a growing number of opportunities in the pipeline, having just extended its global strategic partnership with Societe Generale, one of the largest financial services groups in the world. Indeed, analysts Paul Hill and Hannah Crowe at equity research firm Equity Development informed me that "Lombard's sales force is presently enjoying 70 per cent hit rates on qualified leads".
Under the terms of the contract, Societe Generale will use Lombard's award-winning COLLINE® solution to centralise and automate its cross-product collateral management operations across various business lines in order to deliver a more robust system that enables higher volume and also enables the bank's clients to post a wide range of collateral. Interestingly, Lombard's product director Helen Nicol notes that: "We are seeing this as a new trend in the marketplace as banks are recognising the benefits of centralising collateral management onto a single platform." This trend is well worth noting.
Funded for profitable growth
The reason why Lombard has been on my watchlist for some time is because I wanted to see whether management's optimism was well placed after the company raised £8.3m at 8.75p a share last summer through a placing and open offer. The proceeds are being used specifically to accelerate investment in Lombard's product offering and IT infrastructure in order to take advantage of the anticipated increase in demand driven by the regulatory requirements being placed on both existing and potential clients. Clearly, the raft of contract wins since last summer supports their optimism and the implementation of a £7.5m investment programme funded by the proceeds of last summer's equity raise.
It's also reassuring to see that the insiders have been backing themselves: chief executive Alastair Brown purchased 540,540 shares at 9.25p last autumn to raise his stake to 1.68m shares, or 0.42 per cent of the share capital, and that's after buying 1.14m shares at 8.75p in June's placing; finance director Nigel Gurney purchased 342,000 shares in the placing and a further 168,961 shares at 9p subsequently to lift his holding to 622,829 shares; and chairman Phillip Crawford purchased 1.15m shares in the placing to take his stake to 6.7m shares, or 1.69 per cent of the share capital. In other words, all the directors have significant skin in the game.
Of course, there is execution risk here, but given the current sales momentum, analysts' predictions that Lombard's revenues will rise by a third to £31.75m in the 12 months to the end of March 2017, ramping up to almost £40m and £49m, respectively, in the next two financial years doesn't seem unreasonable to me. The point being if Lombard's management team achieves this level of top-line growth then expect a small loss on a cash profit basis in the current financial year to reverse into a hefty underlying cash profits thereafter as the benefits of high operational gearing, a growing recurring income stream and gross margins of 99 per cent hugely benefit the bottom line.
To put this into some perspective, analysts at Equity Development export Lombard to make cash profits of £6.4m in the 2017-18 financial year, surging to £11.8m the following year. On this basis, expect pre-tax profits of £1.6m and EPS of 0.37p in the 12 months to the end of March 2018, rising to £5.9m and 1.3p, respectively, the year after. All these forecasts are stated on an underlying basis before capitalisation of software investment. In the first half to the end of September 2016, Lombard capitalised £2.8m of software development spend as part of the aforementioned investment programme.
The other important point worth making is that as cash profits ramp up, so too will the company's cash generation and this will drive a major cash build: analysts at Equity Development predict net funds bottoming out at £1.4m at the end of this month, before quadrupling to £5.6m by March 2019, and doubling the year later if all goes to plan. I would also flag up the benefit of £11m of accumulated UK tax losses, which can be offset against future corporation tax when the company turns profitable, thus helping to support the sharp rise in EPS as analysts predict.
Management team
The quality of leadership is key in hitting revenue and profit forecasts, so it's well worth pointing out that 47-year old chief executive Alastair Brown was former divisional chief investment officer and digital leader at Royal Bank of Scotland (RBS) prior to joining Lombard in December 2015. He has extensive experience in major transformation programmes, both as a veteran of the NatWest and ABN AMRO integrations with RBS, having led migrations to new back office platforms for the Fixed Income, Lending and FX businesses. Leading such initiatives from inside a major bank is invaluable experience and one reason why Lombard is now winning so many contracts from financial institutions.
Another key member of the senior management team is Tina Wilkinson, who joined Lombard a year ago as Global Head of Product, having previously held leadership positions as head of the retail and offshore asset management business at insurer Allianz, as well as investment bank BNP Paribas. She has extensive product development and investment management experience in her 30 years in the industry, and previous roles in both the front office and in running back office operations provide her with a unique insight into institutional clients' needs.
Finance director Nigel Gurney has had main board experience at stockbroker WH Ireland (WHI:135p) and financial services group Merchant Securities, and has also worked in the software industry, so has relevant sector experience. The same is true of chairman Phillip Crawford who brings a wealth of expertise, having held a number of senior positions in software, hardware and services companies, including senior vice president of Oracle Corporation, with membership of the executive board. He has been putting his high profile contacts to good effect as the company has teamed up with Oracle whereby the software giant is licensed to sell Lombard's AgileREPORTER and regulatory reporting templates to integrate with its Oracle Financial Services Data Foundation. AgileREPORTER is now part of the Oracle Regulatory Reporting Solution offered to banks globally to manage end-to-end reporting to regulators.
Understanding the risks
Of course, no investment is without risk and Lombard is only a £36m market-cap company operating in a global market, so the business could be squeezed by larger rivals such as FIS (formerly Sunguard) and Smartstream on the collateral management side, or Moodys Analytics in regulatory reporting. Staff retention can be an issue in the cutting edge financial technology sector, but the senior management team is well incentivised and have skin in the game, so have an added financial incentive to stay onboard with Lombard.
Furthermore, given that between £10bn and £20bn is being spent in the UK on compliance alone, and in the US the six largest banks were spending an eye-watering £10bn each on average in this area in 2013, the latest year that figures are available, the target market for its products is clearly large enough for the company to make decent inroads into.
Economic risk should not be overlooked as companies always rein in expenditure in downturns and Lombard is not immune to this risk given the nature of its financial services client base. Indeed, there is potential for an economic downturn resulting from uncertainty surrounding the UK's exit from the EU, or an additional renegotiation and a further referendum.
Mergers in the sector could pose a risk, too, as it reduces the universe of potential clients. That said, the trend towards the demerger of operations from existing banks and the granting of new banking licences seems to have materially reduced the level of this particular risk as far as Lombard is concerned.
Finally, volatility in foreign exchange markets is worth considering given that more than half of Lombard's revenues are generated overseas, the flipside being that with sterling so weak the company is enjoying a strong currency tailwind right now, and one it's exploited as the raft of contract wins highlights.
Compelling investment case and target price
Clearly, all the above risk factors are worth taking into account, but even after doing so the investment case is pretty compelling to me: Lombard is a £36m market-cap company predicted to generate underling cash profits north of £6m next financial year; its investment programme is fully funded and already delivering the seismic shift in sales that management predicted at the time of last summer's fundraise; the regulatory environment and implementation of new directives in the financial services industry is set to drive even more interest in Lombard's products; and the directors have heavily backed the company with their own money. I am also comforted by the fact that regarded fund management companies - Fidelity, Ruffer, Herald Investment Management and Liontrust Asset Management - all appear on the share registrar.
In the circumstances, I am initiating coverage with a buy recommendation and 18p target price which lies midway between the 16.5p target of analyst Lorne Daniel at broking house FinnCap, and the 20p discounted cash flow valuation of analysts Paul Hill and Hannah Crowe at Equity Development.
My target is based on an enterprise value to cash profit multiple of 11.5 times for the 2018-19 financial year using the aforementioned profit estimates, and reflects a forecast PE ratio of 14 for the same 12-month period. If anything this could prove conservative if the opportunity for Lombard is as large as recent trading would suggest.
For good measure, the technical set-up looks very promising, too, as the share price appears to have bottomed out last autumn, and a close above last November's intra-day high of 10.4p would be a major buy signal and one pointing to a likely rally and test of the April 2016 high of 13.3p. Beyond that the all-time high of 15.75p dating back to March 2015 will come into play, and one I fully expect to be tested in due course operationally all goes to plan.
Offering 100 per cent share price upside, and ahead of what I expect to be a bullish pre-close trading update released next month, I rate Lombard's shares a strong buy on a bid-offer spread of 8.75p to 9p. Buy.
Finally, I have a results call booked with the directors of cash-rich financial services group STM (STM:40p) on Friday and will be discussing how they intend to mitigate the financial impact of the new QROPS tax as outlined in the recent Budget. The shares have lost a fifth of their value since the chancellor's unexpected announcement, and as soon as I have had that conversation I will publish an update.
MORE FROM SIMON THOMPSON...
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