Tap into a prodigious cash generator

You are unlikely to see a more impressive blue-chip client base than the one offered by Aim-traded financial software provider Arcontech (ARC:160p). The roll call of blue-chips includes Barclays, Citi, JPMorgan, Lloyds, Morgan Stanley, Santander and Bank of England. These financial organisations generate recurring licence fees that equate to 90 per cent of the company’s annual revenue, offering investors a stable income stream.

Arcontech makes its money by providing software products and bespoke solutions for the collection, processing, distribution and presentation of time-sensitive financial markets data. It is a software house as it doesn’t deliver any market data, but provides the means for clients who are in the main large banks to do so. The company is therefore independent of market data vendors (such as global giants Refinitiv or Bloomberg), but at the same time partners with them to ensure its software integrates with vendor data and systems as well as clients' own data and systems.

Product suite delivers tangible benefits

Arcontech’s major product offering is its Excelerator Real-Time Excel Add-in solution, which has 1,410 users who use it to import, calculate and publish market data in real-time both internally and externally. It has a compatability mode that enables them to use existing spreadsheets from other software providers in Excelerator. Importantly, the solution is compliance friendly with data access controls of systems such as Refinitiv/Thomson Reuters and Bloomberg.

Other products include its CitiVision Server-Side platform business, which enables organisations to receive, process and transmit a wide range of market data in real-time. The aim is to integrate clients’ internal systems into the market data vendors’ platforms so that the client can receive data from multiple sources, process it across a range of operating systems, and then transmit the data to multiple destinations (including vendor contribution). The market data platform offers dealing desk display and real-time streaming web updates. The solution offers four specific benefits to clients:

■ Compliance. Financial institutions can control which end users can access which data, and therefore ensure compliance with market data vendors' restrictions and other regulations.

■ Reliability. Arcontech’s server-side platform offers an automatic failover to a standby platform, thus enabling seamless access in the case of a server failure. This is a critical requirement for financial institutions.

■ Integration. The solution integrates with a range of vendor platforms, direct data feeds from brokers and exchanges, and external and internal sources of data to enable end users access to the market data they need.

■ Monitoring systems performance. Financial organisations can monitor the status of their systems using Arcontech’s own solution or third-party monitoring systems. In response to client demand, the company developed its user interface to assist administration by raising alerts when issues occur rather than when reported, thus reducing risk for the organisation.

Barriers to entry

The clear benefits of the product suite to clients aside, other reasons for Arcontech’s high recurring revenue stream are the high switching costs and the economies of scale it generates. Sales cycles are long and complex, which discourages clients from switching to another provider, and means that the company’s revenue stream has strong defensive qualities.

Indeed, when pitching for a new contract, Arcontech has to demonstrate: the potential cost savings of its solutions; how the company can replicate the functionality of the clients’ existing products, and deliver new benefits in a seemless manner to minimise disruption; and provide the support to the organisation when required. As a result, Arcontech usually wins small contracts initially which then scale up, so generating organic growth in future years.

High margins

Arcontech has a relatively fixed cost base, so operating profit is highly operationally geared to new sales wins, one reason why adjusted operating profit margin has almost trebled from 12.2 per cent to 35 per cent in the past five financial years as revenue increased from £2.1m to £2.95m.

Revenue growth prospects

Admittedly, annual revenue for the current financial year to 30 June 2021 is expected to increase modestly to £3m, but this is because the Covid-19 pandemic has resulted in limited customer contact due to remote working practices. However, what doesn’t show up in the figures is that two sales recruits have been working on growing the list of prospective new clients. This augurs well for when lockdown ends, and sales teams can convert leads into orders. The incremental operating margin on new sales is around 60 per cent, so any new contract wins have an accentuated impact on profits.

True, Arcontech’s sales teams are unlikely to have greater access to financial institution customers until later this year, but there is undoubtedly an opportunity to exploit. That’s because many financial institutions will now be taking a very close look at their cost bases to make savings as they streamline their operations. Unbundling current arrangements with market data providers is one easy way to make material cost savings. Bearing this in mind, Arcontech’s product suite still offers the same data quality as other premium service providers, and is highly regarded in the industry. Indeed, the company has built up a reputation for software quality and reliability in this niche market over several decades, one reason why it has only lost three clients in the past seven years.

Moreover, even though the disruption caused by the Covid-19 pandemic has slowed Arcontech’s sales growth, the company has still been landing new contracts. For instance, it won two contracts worth £100,000 in annual revenue last autumn, one of which was with a new Tier 1 bank client for its Multi-Vendor Contribution System, which enables organisations to contribute data automatically to multiple destinations, including Refinitiv, Bloomberg, IDC and Telekurs. It is an important relationship with a Tier 1 global institution that should scale up over time.

Increasing regulatory compliance requirements should also support new contract wins once lockdown restrictions end and sales teams have face-to-face access to decision makers at financial institutions. That’s because financial market participants have to ensure any data sent to the market is managed and recorded for audit. Arcontech’s software enables its clients to do this by consolidating the data so it is known exactly what is being sent to whom as well as to monitoring the data flow. 

Half-year results

The cost of the investment in additional sales staff explains why Arcontech’s pre-tax profit slipped 8 per cent to £506,237 on modestly higher revenue of £1.54m in the six months to 31 December 2020. It’s worth noting though that the company is still on track to hit house broker finnCap’s relatively flat full-year pre-tax profit and earnings per share (EPS) estimates of £1.05m and 8.2p, respectively. That’s still a decent outcome.

Admittedly, finnCap cautiously reined back revenue forecasts by 6 per cent for the 2021-22 financial year, predicting another flat year, but these forecasts are supported by 90 per cent recurring income, which significantly de-risks the investment case, and means any new contract wins will result in a material earnings upgrade.

A prodigious cash generator

Arcontech is a prodigious cash generator, a reflection of a high-margin asset-light business with relatively low capital requirements that generated a post-tax return on equity of 26 per cent in the last financial year. Free cash flow has been consistently on an upward curve for the past five years. The directors fully expense all research & development (R&D) spend through operating expenses, and depreciation and amortisation charges account for less than 1 per cent of annual sales.

Arcontech’s R&D tax credits relate to its current spend on qualifying R&D expenditure. In addition, the company has £7.4m of historic income tax losses to offset future corporation tax liabilities. After taking into account tax credits, net profit has exceeded reported pre-tax profit every year since 2015. As a result of the buoyant free cash flow generation (9p a share in the 2020 financial year), net cash has been increasing sharply.

In fact, net funds have trebled to £5m in the three financial years to 30 June 2020, and house broker finnCap is pencilling in a further increase to £5.6m (42p a share) at the 30 June 2021 financial year-end. Shareholders are benefiting from Arcontech’s bumper cash flow genaration as the payout has been hiked from 1p to 2.5p a share in the past three financial years and analysts are predicting a further 10 per cent increase to 2.75p a share this year.

Modest rating and potential bid target

Arcontech’s shares are priced on a prospective cash-adjusted price/earnings (PE) ratio of 14, and offer a forward dividend yield of 1.7 per cent. The modest valuation compares favourably with larger software peers, being less than half the forward PE ratio of finnCap’s Aim Technology 40 Index. It also compares favourably with the mega-cap financial software providers (FactSet, Moody’s, MSCI, S&P Global and Thomson Reuters) which are trading on average forward PE ratio of 27.

The valuation discrepancy also highlights the takeover potential for the company by a larger rival. For instance, Thomson Reuters, FactSet, CME and ION Investment Group have all been acquisitive in recent years, and in some cases have pursued acquisitions of a similar size to Arcontech. It’s even possible that a private equity player could be tempted to bid for the company given Arcontech’s forecast free cash flow of £1.16m in the 2021/22 financial year equates to 7.4 per cent of its £15.7m enterprise valuation, and 5.5 per cent of the company’s market capitalisation of £21.3m. The prospective free cash flow yield is more than double the 2.5 per cent average of the finnCap’s Aim Technology 40 Index.

Target price

I suggested buying the shares at 167p in my my October Alpha Report and view the pull-back from the subsequent 210p high as a repeat buying opportunity, targeting fair value at 220p. Please note this target price doesn’t factor in a bid premium in the event of corporate activity materialising. From a technical perspective, the 14-day RSI on the shares has a heavily oversold reading of 19.4. The shares have rallied hard three times in the past year once the 14-day RSI dropped to 20. Buy.

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