Silverlake Axis Ltd

Silverlake Axis is a banking software company. It operates in south East Asia and is one of a few player in the banking software oligopoly. Prior to August 2015 Sliverlake Axis was a star. Than the bombshell dropped, as razor99 accused Mr. Goh (60% shareholder and CEO of Silverlake) that he and Silverlake did dubious deals in related party transactions at the expense of minority shareholder [RAZOR99]. The stock got slaughtered - from 1.20 to 0.55 SGD. In January 2016 Deloitte cleared Silverlake of these accusation [DELOITTE]. Is Silverlake a value buy now?


Can I trust the numbers?

Deloitte Singapore was ordered by Silverlake to investigate razor99 accusations [RAZOR99, DELOITTE]. Deloitte found that for the 3 acquisition in question, the prices 2 had fair prices where 1 was in the higher range of fair. ROI is for the 2 fair acquisitions 10 to 12% whereas the other is about 3%. Today the 3 acquired businesses make up to 85% of revenue. Silverlake today is Silverlake because of the 3 acquisitions. In my opinion razor99 accusations are unfounded and I adopt Deloittes perspective. BUT I will keep my eyes wide open and be cautious. razor99 argumentation is tempting and a good filter on my checklist. [SAIM2016]

On the contrary accusations of anonymous short sellers, like these of razor99, spiked in the advent of August 2015 flash crash and the growing unbalance of indices (a few large caps are up whereas the rest is down; look for FANG stocks versus S&P). These short sellers might provide interesting investments in future after the stock got hammered.

Business Model


Bank software is driven by regulation, customer integration and less technology.

Regulation
Bank software has to respect the regulation of the legislation of its country its operating in. This leads to a couple of conclusion.

First this causes market segmentation by legislation within South East Asia. Because these markets were this small, larger players (Oracle, FIS, ...) have neglected these markets earlier and local players could establish market dominance.

Second the markets are separated by different regulation which requires constant adoption to regulation changes causing constant supply of adoption, maintenance and extension projects.

Third the sales process is driven by the network of the executives to customers which share cultural similarity and similar former positions. Goh Peng Ooi (CEO; Top 10 of the richest Malaysian) and Lin See-Yan (former Malaysian central banker) seem to have a strong network within the banks of the region to which they sold Silverlake’s core banking solution.

Technology
The technology side of banking is quite unimportant. It is technological simple to make bank transfers, support and implement business processes or extract insights out of banking data.

Bank transfer technology is simple but meeting the formal requirements is hard. (Who wants to invest the money to meet the requirements to do what already been done?) I was told that the core of bank transfer technology is 20 years old - never change a running system. The regulative changes require constant adoption of business processes. This requires a project but not R&D. Last but not least I am skeptical that banks will make use of their data wisely (Look for big data in banks - except fraud detection). These require R&D but corporate politics and regulation will prevent creating creative / innovative business processes to make really use of the data.

Once I interviewed a big data researcher (of an university) which told me the following story. He did a research project together with a bank and extracted interesting and counter-intuitive insights out of their banking data. The result was not only ignored by the bank's management but the management even fired the employee responsible for this project. I would have fired the employee, too. I would show my employees what happens if one breaches the one rule of banking: never risk to loose the trust of your customers! But hell, if the damage is already done, why should I not use the insights?

Depth of Moat: Switching Cost of Core Banking IT

Exchanging (parts of) a banks IT system will cause lots of expensive bad surprises - like data loss. Also lots of employees have to be trained on the new software and many business processes have to be changed. Lots of development and project cost are caused by switching parts or the whole core banking system. Any kind of data loss or incompetent looking employees have to be prevented so that no (trusted) customer relationship is at risk. This fear of loosing the customers trust causes the switching cost even more explode. That’s why Silverlake Axis realizes return on sales of >40%. [BARRONS, FOOL, VALUEPOD].

Wideness of Moat: Long Lifetime of Core Banking IT

I estimate the replacement cycle of core bank IT between 10 and 30 years [COMPWEEK, SAOCBC]. Planning and implementation can take up to 10 years, whereas the productive use is a multiple of that [BBG]. Because of these long time frames (for IT standards), a bank will bet on established players, like Silverlake Axis. This will keep non-established competitors out of the market and away from Silverlake’s cash-rich castle.

Growth
Marc Faber assesses the economic progress of the world mostly done in South East Asia, primarily in Vietnam, Malaysia, Indonesia, Philippines and Thailand. In all of these markets Silverlake is a dominant player. All these economies are heavily impacted on the slowdown growth of China, but on long-term he is still optimistic. [MFABER]
Over the long-term Pat Dorsey expects that the increasing economic growth in South East Asia, will lead to over-propositional growth of the financial sector [BARRONS]. I agree with his assessment, as the economy grows, the population accumulates money and needs to store it in financial institutions. These use the money to invest it in the country. On the other hand as the bureaucracy matures (legal certainty) in developing countries, these economies attract outside capital which need a financial sector so that the money can be allocated efficiently.

As a side note Silverlake acquired SunGard Ambit Retail Banking which is active in Europe, on the Indian subcontinent and the Middle East, too. For Indian subcontinent and Middle East I expect long-term growth to close the gap to the West. I see the possibility of war in that region which will hurt its growth. Silverlake is mostly active in the growing Eastern Europe. I do not see major risks there. If there is a major war in that region, than NATO and Russia are likely to be pulled in, in which case I do not worry about my Silverlake investment anymore. I see the acquisition as an option of having the foot in the door to sell other Silverlake software to former SunGard customers. [SUNGARDAMBIT]

M&A
Looking at the latest deal, Silverlake paid 17m SGD for SunGard Ambit Retail Banking which SunGard paid in 2006 120m SGD for [SUNGARDAMBIT]. In my opinion Silverlake unlikely did overpay but got a lot of optionality to expend in other geographical markets which otherwise would have cost a lot more. Vice versa, I guess the Ambit product maybe at the end of its life cycle so it might not create lots of future cash flow any more (this is a speculative thought). I believe it’s a lottery ticket for international expansion at a cheap price.

Competition
As shown below, Silverlake has (at least) an oligopoly in South East Asia core banking applications. (I will try to get market share information.)


Silverlake Competitors by Country in 2016 [SA2016Q2]
The main competitor are FIS and Oracle. FIS acquired SunGard in 2015. Interesting is the Silverlake acquisition of SunGard Ambit Retail Banking, which might have been done with FIS support. If that is the case than FIS decision not to compete with Silverlake underpins its moat in that region [SUNGARDAMBIT]. On the other hand software companies have a coopetion (cooperation-competition) love-hate relationship with each other. Basically cooperate in one market and fight to death in another market.

Competition through Fin-Techs?
Another source of competition are today's Fin-techs. In my opinion most of them are not innovative. They basically clone already known ideas of each other. For example direct sales of finance and insurance products eliminating bank "consultant" intermediaries is nothing new - just look at decade old direct banking. Banks try the direct way of sales because they have to make their cost structure lean because of 0 or negative interest rates. And now Fintech think they can capture the revenue of banks which are them self-struggling. It’s like selling to homeless people - even if they like the product they cannot pay much. And of course block chain based stuff. Cloning bit coins block chain for asset transfers or cloning bit coin directly to replace it as digital currency by larger players like Goldman Sachs. In my opinion a very crowded space which does not leave lots of space to grow a company. In my assessment core banking IT is unaffected by fin-techs [COMPWEEK].

Most of fin-tech ideas are straight forward, their future market is crowded and therefore low ROI should be expected. I would bet on really strange fin-tech ideas if I have to bet. In general I have the feeling that most of the fin-techs only exist because investor’s money was easy to get. But I keep my eyes wide open - ignorance is deadly in technology business.


Currency Risk

Silverlake Axis uses in Malaysian Ringgit but books 80% of its profits in Singapore Dollar. Long-term the Singapore Dollar strengthen against the Euro (more) and US Dollar (less). I believe that over the long-term the SGD will keep its value against Euro and US Dollar. Also I like to keep some of my assets geographically diversified.

Valuation
Silverlake is worth about 2.02 to 2.22 MYR (current price: 1.82 MYR; SG$ 0.75) at lower bound, with upside potential through faster than expected growth. I like these kind of lottery tickets which pay them self.

Here is my valuation on Google drive: https://docs.google.com/spreadsheets/d/1gotdrNCB3MxnV0vqHD6-a3HAbBFbv22rq0Vdx_CmoWY/edit?usp=sharing

Otte
The Otte valuation method uses return on sales (very stable metric), and simple growth and discount rate assumptions to estimate the value of the earnings of a company. I named to the guy who made me a value investor. Prof. Dr. Max Otte is one of the few professional value investors in Germany. The whole idea of Otte valuation is getting the first question out of the way, is that company cheap and worth diving deeper? According to this valuation the intrinsic value is about 2.22 MYR (SG$ 0.75).

My discount rate is 15% because it is my hurdle rate. The idea is, if an investment earns 15%, is safe and no better alternative is likely to be available, I make an investment. According to DCF risk should determine the discount rate. But this idea is flawed in my opinion because it assumes a thin tailed distribution of risk (so that the average of all risks converges to the median of the risks), but in real world risk is accelerating and skewed towards one direction (average and mean do not converge) [FATTAILS]. In my opinion its better to put risk into the cash flows and keep the discount rate constant across the investments. For me it is just a discount factor of my personal time value.

I assume growth at 10%. Some of this nominal growth is caused by inflation 3-5% and real company growth 5-7% (see above growth discussion). Estimating long term inflation at 3-5% at nearly deflationary levels at the moment is a gamble on my side. in As I mentioned earlier, I can expect that the currency to my local currency exchange rate should be stable or even yielding in my favour so that I do not take that into account here (and I diversify my assets around the globe).

I do not do a complicated DCF model with future projections of cash flows because they are projections, which look precise but are fantasy. More important is to see that the process of how the company makes money is stable and having a lower bound / conservative estimation of its worth.

Owner Earnings
Similar to Otte but using Buffett’s Owner Earnings valuation method. Owner Earnings = Net Income + non-cash flow influencing charges - CapEx - M&A. I get an enterprise value per share at 2.04 MYR. The difference is caused by the M&A charges.

I added M&A as kind of capex cost because software companies can acquire proprietary technology through M&A - similar to mine companies which buy machinery. I used 2 years average to smoothen these M&A cost, but partly these M&A increasing the company size so they should not be included fully. I want to be conservative, so I subtract nearly all M&A costs like it is capex (150M MYR of 170M MYR of M&A).

The SunGard Ambit deal increased top line by 40-50M MYR this Q2 of FY2016. I think I should not treat the 50M MYR of acquisition cost as kind of R&D expenses. But estimating the proportion I should charge is hard. I will charge nearly all this year so that I know I error more on the conservative side.

Hurdle Rate
The idea is to check for sanity in my valuations above. I want to have 15% return, where does it come from? 6% net income related to current stock price + 3-5% inflation + 5-7% growth. As Silverlake is operating in emerging markets the economy is likely growing >3% per year long term (catching up to developed word) and the financialization is likely to grow faster than that [BARRONS].

Risk
The main risks in my opinion are Chinas economic slowdown will slow down south east Asians economies, slowing the financial sector growth or even shrinking it for some time giving Silverlake’s Customers a hard time. US, Europe or a Global slowdown will effect Asia for sure in similar ways and cause similar problems for Silverlake.

A second financial crisis like 2008 which leads to a Global financial meltdown, stop of international trade and the collapse of banks around the world and bankruptcy of some of Silverlake’s customers.

Razor99 allegations are true and Deloitte did a miserable job.

Competitors may start cut throat completion making selling of new software solutions hard and only at price discounts. Most of Silverlake’s revenues are maintenance / extension projects of products with decade long life cycles so that competition needs many years of completion to real steal market share from Silverlake’s core market, but market share in their "marginal" markets will be hurt and would make Silverlake’s expansion costly.
John’s cake is awesome.
Legal environment might get uncertain through internal political instability or protectionism of Asian countries.

War in the south china sea, dragging major regional powers and major nuclear powers into.

A conflict between countries politics and the management of Silverlake.

The loss of Mr. Goh as leader of Silverlake.

Investment Thesis
I expect that Silverlake will grow fast the next years but paid "only" for 5-7% growth. Even if Silverlake does not grow, it pays a good dividend which makes waiting pleasant.

Most growth comes from marginal markets, which drives down Silverlake’s gross margin but increases revenue (see SunGard Ambit acquisition). This leads to an overall increase in owner earnings. Early indicator of growth is the sale of software licenses which causes a series of future maintenance and extension projects. The project revenue is recurring and predictable.

M&A on a regular basis are expected and should be made at reasonable prices, like in the past.

The banking IT market is conservative and even disruptive technology will need a long time to disrupt Silverlake’s core market. I have to keep my eyes open! If that hypothesis breaks, Silverlake is in danger of being disrupted away.

In the short term I expect that software licenses revenue increase / normalize as razor99 allegations are proven unfounded and banks award contracts again to Silverlake.

Disclaimer
This post represents an opinion and does not imply any investment advice. The author may own stock in this company.

Sources
[BARRONS] http://www.barrons.com/articles/pat-dorsey-follows-buffetts-lessons-to-pick-stocks-1436587387
[BBG] http://www.bloomberg.com/enterprise/blog/banks-too-slow-to-modernize-core-systems/
[COMPWEEK] http://www.computerweekly.com/news/2240227318/Banks-are-not-contemplating-core-system-replacement 
[DELOITTE] http://www.thestar.com.my/business/business-news/2016/01/13/silverlake-cleared-of-dubious-deals/
[FATTAILS] http://www.fooledbyrandomness.com/FatTails.html
[FOOL] https://www.fool.sg/2013/10/14/the-aura-of-a-sustainable-competitive-advantage/
[MFABER] http://www.theprospectgroup.com/marc-faber-on-growth-in-southeast-asia-the-economic-future-of-malaysia-thailand-81806/ 
[RAZOR99] http://www.valuewalk.com/2015/08/the-unbelievable-financial-alchemy-of-silverlake-axis-razor99/
[SA2016Q2] http://silverlakeaxis.com/img/pdf/Corporate%20Presentation_Q2%20FY2016.pdf 
[SAIM2016] http://silverlakeaxis.com/investor-relations/investor-and-stock-information/news/jan2016_InvestorInfoMeeting.html
[SUNGARDAMBIT] http://www.fiercefinanceit.com/story/sungard-sells-ambit-core-banking-technology-silverlake-axis-12-million/2015-09-22
[SAOCBC] http://silverlakeaxis.com/ecosystem-partnerships/casestudy-OCBC_A_Truly_World-ClassCoreBanking.html
[VALUEPOD] http://www.valuepodcast.com/435 Pat Dorsey mentions Silverlake Axis at the end of the Podcast.

Kommentare

  1. Your articles don't come frequently, but when there is a new one, it is usually quite interesting. I like that because I know that you don't produce "mass", but think before you post. Thanks for the insight into banking software and Silverlake.

    And I like your inclusion of M&A into owner earnings. This probably makes a lot of sense.

    Tom

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  2. Thanks a lot! It is very hard to condense down all the thoughts into one article. The writing itself helps to clear my thoughts on an investment thesis like a fantasy filter. If the argumentation is not clear, than I did not understand the company. I really appreciate the compliment of you, fellow blogger!

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  3. Der Kommentar wurde von einem Blog-Administrator entfernt.

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