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Accelya Kale Solutions

Buy above Rs.690/- 14th Mar, 2013

Find the right auxiliary business

If there is one industry that Warren Buffett has been most critical about it has to be

the aviation industry. The problem with the industry is that there are high fixed costs,

competition is intense and bargaining power with various stakeholders is low. This

results in a cost structure that is very vulnerable to macro headwinds. No wonder

then that historical y, investors have lost a lot of money in the airline industry across

the world.

While airlines may have been a bane for investors, it would be a big mistake to

overlook the fact that aviation has been one of the most important inventions of the

20th century. By providing fast and efficient connectivity across the globe, it has been

a vital aid to globe trade and commerce and has been a catalyst for social and

economic progress. Ever since airplanes came into existence, global passenger and

cargo volumes have grown at a phenomenal rate irrespective of the fortunes of

airline operators.

This is the reason the industry has not just survived but has continuously grown in

size over the last 100 years. What started with one passenger in 1914 has now grown

to over 3 billion annual passengers. In 2013 the total passenger volume stood at

about 3.1 billion. And this is set to grow to 3.3 billion in 2014. Thats a whopping 44%

of the worlds population! Each year, about 50 million tonnes of cargo is transported

by air. This comprises 35% of the value of goods traded internationally (Data source:

IATA).

So if your returns were linked to passenger and cargo growth and not to the

profitability of airline operators, you could have made handsome money.

This reminds of an interesting episode from the past. During the California Gold

Rush that started in 1848, about 300,000 people flocked to California to make

fortunes by mining gold. While few emerged very wealthy, many made little or no

gains out of this gold hunt. But irrespective of whether those miners found gold or

not, pick and shovel suppliers did make a lot of money.

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This brings us to an interesting point. Even within not-so-profitable main industries,

there can be auxiliary ways to build wealth if only you set your vision at the right

opportunity. So how must one go about investing in auxiliary businesses?

Here are some key attributes of fundamentally-strong auxiliary companies:

Products/services of the auxiliary industry must be critical to the main

industry and not discretionary.

Auxiliary industry must have favourable cost structure, strong balance sheet

and bargaining power.

Growth and profitability of the auxiliary industry must be linked to the output

of the main industry and not its profitability.

Auxiliary industry must have a fairly diversified client-base to avoid

concentration risk.

So the airline industry may continue with little or no profitability, but if you find an

auxiliary business with the right attributes, you could be in for some handsome

gains.

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About Accelya Kale Solutions Ltd.

I prefer to stay away from stocks and sectors which suffer from bad economics. Such

investments are unlikely to be long term wealth compounders. This is why I would

never touch aviation stocks even with a 10-feet pole. There is hardly any airline

operator in the industry that enjoys a strong moat and most do not generate

commensurate returns for shareholders.

Accelya Kale Solutions Ltd. (formerly known as Kale Consultants) is a small software

company based in Pune and Mumbai. Incorporated in 1989, the company has chosen

to be a niche IT service provider to the aviation industry. Accelyas competitive

advantage stems from its strong domain expertise and long term track record in the

airline industry. It has developed world class software products for airlines that are

critical for their business. These include products for revenue accounting, billing,

audit, business analytics, cargo handling and early warning systems, among others.

The company markets these products as an outsourced platform based service. This

means that airlines use Accelyas products on a pay-per-use model, while Accelya

handles the back-end services related to the product. This is beneficial for both

parties. Accelya benefits from a stable revenue stream that increases with the

number of passengers. At the same time, the airline is relieved of investing huge

amounts of money on capital expenditure relating to its in-house IT infrastructure.

Accelyas industry expertise and the quality of its products can be gauged by its long-

standing relationships with marquee clients like US Air, Thai Airways, Gulf Air, Air

Canada, Etihad and Cathay Pacific, among others. This is where we believe Accelyas

economic moat lies. As the aviation industry as a whole becomes cost-conscious and

adapts to a low-cost business model, Accelya is very likely to be among the strongest

contenders for handling their software requirements.

In addition to this, the company has a strategic alliance with the International Air

Transport Association (IATA). It has developed products for the airline industry

under this partnership. Accelyas products are used by IATA to settle disputes

between airlines, record customer and flight data, monitor and measure performance

of travel agencies, handle settlements between airlines whenever passengers change

flights on long distance routes and many other applications. This means that Accelya

stands as a neutral third party in the airline industry. This has enabled the company

to develop deep domain expertise as well as to cater to the different needs of many

airlines around the world. The company has successfully used its knowledge to

develop products that have found wide acceptance by large global airlines. This is

amply demonstrated by the fact that the companys revenues are very well spread

out. No single geographical region contributes more than 30% of its revenues.

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To find out more, we met the companys management. The company is owned by

Accelya Holding World SL, a leading airline software solutions provider in Spain,

Europe. The parent company is owned by a private equity firm, Chequers Capital

which specializes in acquiring companies in partnership with its management. The

financial performance of the company has improved significantly since the new

promoters have taken over. The parent company has most of the large airlines as its

clients and this has benefited Accelya Kale. Due to the promoters focus on keeping a

tight lid on costs, the operating margin has improved from 20% in FY11 to 43% in

FY13. The company has paid out more than 100% of its net profits as dividends in the

last two years. The business model of the company is very asset-light, i.e. Accelya

does not need to spend too much on capex or continuous product development. This

will help the company maintain its strong financial health.

Accelyas revenues and net profits have grown at a compounded annual growth rate

(CAGR) of around 23% and 45% respectively over the last six years. The gross

margin has improved from 41% to 61% during this time while the Return on

Invested Capital (RoIC) has grown from 10% in FY07 to 148% in FY13. The

companys balance sheet is very strong. It is debt-free and has a cash balance of Rs

345 m as of FY13. The dividend yield also stands at an excellent 10% on a trailing 12

months basis.

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How Accelya Kale Solutions will improve its fortunes

A well-established presence in a niche market

Accelya Kale Solutions is a company focused on only one industry- Aviation.

It has exited from all other verticals like hospitality and logistics. This has

enabled the company to focus al its resources to develop high quality software

products for its customers. This approach has held the company in good stead.

Its products cater to the entire span of an airlines operations. Accelyas

products have achieved industry leadership positions global y, in the areas of

revenue accounting, streamlining of receivables and payables, audit

operations, card bil ing and cargo handling.

Accelyas clients use these products on pay-per-use or lease basis. This means

that every time a passenger books a ticket, or every time a cargo shipment is

successfully delivered, Accelya receives a small fee. This steady revenue

stream lends stability to the topline. About two-thirds of the companys

revenues come from such annuity-based revenue. This model helps airlines to

significantly cut down on their capex. As airlines around the world operate on

thin margins, Accelyas products play an important role in maintaining their

profitability and competitiveness. Accelya has pioneered this business model.

Around 60 airlines from around the world use Accelyas products.

Strategic partnership with IATA

Accelya has partnered with the International Air Transport Association

(IATA). As per this partnership, the company provides IATA with software

that is used on an industry-wide scale. IATA uses a software platform

developed by Accelya for the settlement of revenues between two or more

airlines on account of changes in the flight plans of customers. Along with

IATA, the company has developed a product for dispute resolution between

airlines. This enables the company to stand as a neutral third party in the

event of a dispute and solve the issue promptly. This is highly beneficial for

the airline industry, as it allows airlines to outsource their entire billing and

settlement process and focus on their core operations.

The partnership has helped Accelya develop an intimate understanding of the

airline industry that other IT companies cannot match. Accelya does business

with most airlines around the world (more than 200) through IATA. Accelya

has successfully made use of its domain expertise to deliver customized

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solutions for global airlines. An example is a product developed by Accelya for

airline managements which enables them to analyse their passenger data in

real time and make critical business decisions. In this manner Accelya adds

significant value to its clients business.

Strong support from parent (EBIT Margin %)

Accelya Kale is owned (74.66%) by Accelya Holding World S.L. which is

headquartered in Barcelona, Spain. The parent company is a leading software

and Business Process Outsourcing (BPO) service provider to the airline

industry in Europe. The original promoters of Kale Consultants sold their

entire stake in the company to Accelya between September 2011 and July

2012. The new management is shareholder-friendly and extremely cost-

conscious. They have increased their stake in the company to the current level

via an open offer and a buyback.

The companys revenues have increased by 37% in the last two years. At the

same time, the employee costs have remained stable resulting in the

improvement in gross margin to 61% in FY13 from 41% in FY11. On

operating cost front, the company has cut back significantly on non-productive

expenses and is focusing on increasing its spending in areas that really matter.

The spending on sales and marketing as well as software development and

research has more than doubled in the last two years. The operating margin

has expanded from 20% in FY11 to 43% in FY13. During the same period, the

net profit has risen over four times. However the biggest improvement is seen

in the productive al occasion of capital by the management. This is reflected in

the steady improvement of the return on Invested Capital (ROIC) which now

stands at a staggering 148%.

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More about Accelya Kale Solutions

Accelya Kale is an integrated software solutions provider to the global airline

industry. It develops software products which cater to the entire lifecycle of processes

involved in the operation of an airline. The company has pioneered the software

product-based outsourcing model in the airline industry. It is also the primary

strategic software partner to the International Air Transport Association (IATA). The

company has well-established products, an extensive track record, a competent

management and a geographically well spread out revenue profile. The company is a

recognized leader in the space that it operates.

Key Management Personnel

Mr. Philippe Lesueur, Chairman, is also the Chairman of all Accelya Group

companies worldwide. He has over 30 years of experience in the airline industry. He

is a well-known and respected authority in the airline industry and has worked in

various capacities in leadership roles in the Accelya group.

Mr. Vipul Jain, CEO and MD, holds a B.Tech degree from IIT, Kanpur and a Post

Graduate in Management from IIM Ahmedabad. He had promoted the company

along with Mr. Narendra Kale. He has held several positions in the company and has

handled the critical responsibility of marketing the companys products.

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Key challenges for Accelya Kale Solutions

Loss of large clients to competition

Accelya Kale derives about two-thirds of its revenues from the lease of its

products. This revenue increases in line with the increase in the number of

airline passengers. This part of the revenue is stable and linear. However, it

will grow at a slow rate which necessarily means that the company has to keep

on adding new airline customers every year to maintain its growth. In FY13,

the company was successful in adding 13 new clients which led to a big jump

in revenues of nearly 40% YoY. Unfortunately, this works both ways.

The competition that Accelya faces from global and Indian IT firms is intense.

If a large client were to leave, then the revenues for that year would not grow,

despite the addition of new smaller clients. This is exactly what happened in

FY12. In fact in FY14 also, the sales growth is likely to be impacted for the

same reason. The possibility that a few large clients may end their relationship

with the company has already been factored in our estimates. However, this

risk cannot be wished away.

Aviation sector risk

It goes without saying that out of the 230 airlines around the world (as per

IATA) most are not in a good shape financially. Their need to cut costs and

improve efficiency will certainly lead to more outsourcing. At the same time,

their ability to spend large amounts of money on IT infrastructure will be

impacted, when they are under financial stress.

When I met the management of Accelya Kale, they were of the opinion that

the best way for the company to handle this situation was to focus on its own

strategy rather than worry about the fate of the aviation sector. While this is

fine, the investment risk does remain. Any recession in the developed world

would severely impact the airline industry and possibly Accelya Kale as well.

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Risk Analysis

Regulatory Risk

Some businesses are subject to regulations by external government agencies.

These companies are subject to regulatory risk since they do not have the

liberty to operate in a free environment. Excessive regulations can create

bureaucratic hassles and impede growth. Thus, higher the regulation, higher

is the risk for any business. Though the regulatory framework in India is

conducive for IT companies, however the companies are subject to the

regulations in their client countries. As seen in recent times, most of the

changes in regulations in the client countries have had an impact on the

Indian IT companies.

Cyclicality Risk

A business cycle is characterized by alternating periods of expansion and

contraction. Businesses whose fortunes typically swing with industry cycles are

known as cyclical businesses. Cyclical businesses do well during an industry

upturn and vice versa. On the other hand, there are some businesses that are

not very cyclical. These businesses are more immune to changes in industry

cycles in the sector and have less risk. In short, if the business is cyclical, the

risk is higher. Given that the IT sector is not a cyclical business, we assign a

low risk score of 8 to the company on this parameter.

Competition Risk

Every industry is characterized by competition. However, some industries

where entry and exit barriers are typical y low have higher competition risk.

Low barriers means more players can enter into the industry thereby

intensifying competition. The competition in the IT services sector is intense

and global in nature.

Sales Growth

Over the eleven year period (actual history of past 5 years and explicit

forecast for the next 6 years) we expect sales CAGR of around 16.4%.

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Net Profit Growth

Over the eleven year period (actual history of past 5 years and explicit forecast

for the next 6 years) we expect a net profit CAGR of around 22%.

Operating Margin

The operating margin is a measurement of what proportion of a company's

revenue is left over after paying for variable costs of production such as raw

materials, wages, and sales and marketing costs. A healthy operating margin is

required for a company to be able to pay for its fixed costs, such as interest on

debt. The higher the margin, the better it is for the company as it indicates its

operating efficiency. Accelyas average operating margin over the eleven year

period (actual history of past 5 years and forecast for the next 6 years) stands

at 34.2%, which is very good.

Net Margin

The net margin is a measurement of what proportion of a company's revenue

is left over after paying for all the variable and fixed costs inclusive of interest

and depreciation charges. Net margin is the final measure of profitability. It

reflects the total profits the company takes home. Higher the margin, better it

is for the company as it indicates better pricing power and effective cost

management. For Accelya Kale, the average net margin over the eleven year

period (actual history of past 5 years and explicit forecast for the next 6 years)

stands at 21% which is good.

Return on invested capital (RoIC)

RoIC is an important tool to assess a company's potential to be a quality

investment by determining how well the management is able to al ocate

capital into its operations for future growth. A RoIC of above 15% is

considered decent for companies that are in an expansionary phase. The

average RoIC over the eleven year period (actual history of past 5 years and

explicit forecast for the next 6 years) for Accelya stands at a very impressive

104.1%.

Earnings quality

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This measure helps us assess the quality of earnings reported by the company.

For instance, some companies may follow aggressive accounting practices and

recognize revenues earlier than warranted. Earlier recognition of revenues

boosts profits. However, at the same time they do not generate sufficient

operating cash flow (OCF). This signifies debtors are not liquidated on time as

sales were booked in advance. Such companies face working capital issues and

their quality of earnings is poor.

I assess earnings quality by dividing operating cash flow to net profits. Higher

the ratio better is the quality of earnings. For Accelya the average OCF/net

profit ratio over the eleven year period (actual history of past 5 years and

explicit forecast for the next 6 years) stands at 1.27 which is healthy.

Transparency

Transparency is the key to any business. Transparency can be gauged by

assessing the past dealings of the company with various stakeholders, the way

it displays its financial information and the frequency of management's desire

to communicate with external shareholders whenever some unfortunate

incident happens. The easiest way to gauge the same is checking the level of

disclosures in the company's quarterly financial updates and annual reports.

Transparent managements would get a higher rating. In my view, the

companys level of disclosures is not up to the mark, as per industry standards.

Capital allocation

Apart from transparency, capital allocation skills are equal y important in

assessing management quality. By capital allocation I mean how the

management chooses to deploy capital in the business. There are many

instances where growth is given priority over returns on the investment. This

results in a company with larger size but with poor returns. Managements are

enticed to increase the size since their compensation is tied to the size of

organization they manage.

Also, they sometimes destroy shareholder wealth by making expensive

acquisitions or by diversifying into unrelated areas. Hence, capital al occasion

skill s assumes great importance in gauging management quality. Capital

allocation skills are good when return ratios depict resilience. In short, more

stable/higher the return ratios better the capital al occasion skills. Accelyas

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return ratios have not only been good but have also improved significantly

over the years.

Promoter pledging

Promoters typical y pledge their shares to take a loan which is generally

infused in the company. This exercise is generally resorted to when al other

sources of external liquidity dry out. The risk with this strategy arises when

share price falls. This triggers margin calls. If management is unable to

provide some sort of a collateral to the lending party from whom the money is

borrowed that party may sell the shares to recover its money. This accentuates

the share price fall. Hence, higher the promoter pledging higher is the risk

Debt to equity ratio

A highly leveraged business is the first to get hit during times of economic

downturn, as companies have to consistently pay interest costs, despite lower

profitability. We believe that a debt to equity ratio of greater than 1 is a high-

risk proposition. The D/E ratio for Accelya over the last five years has stayed

low. The average D/E ratio over the eleven year period (actual history of past 5

years and explicit forecast for the next 6 years) stands at 0.1.

Interest coverage ratio

The interest coverage ratio is used to determine how comfortably a company

is placed in terms of payment of interest on outstanding debt. It is calculated

by dividing a company's earnings before interest and taxes (EBIT) by its

interest expense for a given period. The lower the ratio, the greater are the

risks. Given the low debt levels and strong cash flows of Accelya Kale.

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Financial at a glance

Consolidated (Rs. In m) FY13 FY14E FY15E FY16E FY17E FY18E FY19E

Sales 3038 3190 3669 4219 4852 5580 6417

Sales Growth (%) 39.80% 5.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Operating Profit 1304 1271 1467 1693 1953 2252 2596

Operating Profit margin (%) 42.90% 39.80% 40.00% 40.10% 40.30% 40.40% 40.50%

Net Profit 844 787 908 1057 1229 1427 1655

Net Profit margin (%) 27.80% 24.70% 24.70% 25.10% 25.30% 25.60% 25.80%

Balance Sheet FY13 FY14E FY15E FY16E FY17E FY18E FY19E

Current assets 1348 1118 1487 1922 2425 3007 3678

Fixed assets 346 373 402 434 471 512 558

Others 607 607 607 607 607 607 607

Total Assets 2302 2098 2496 2963 3503 4126 4843

Current Liabilities 1144 1201 1381 1588 1827 2101 2416

Net worth 1020 759 976 1237 1538 1887 2289

Loan funds 0.04 0 0 0 0 0 0

Others 138 138 138 138 138 138 138

Total Liabilities 2302 2098 2496 2963 3503 4126 4843

Valuation (in Rs. m) FY13 FY14E FY15E FY16E FY17E FY18E FY19E

Net Sales 3038 3190 3669 4219 4852 5580 6417

PAT 844 787 908 1057 1229 1427 1655

No. of shares 14.9 14.9 14.9 14.9 14.9 14.9 14.9

EPS (Rs.) 56.5 52.7 60.8 70.8 82.4 95.6 110.9

Price to Earning (x) 12.2 13.1 11.4 9.8 8.4 7.2 6.2

Price to Sales (x) 3.4 3.2 2.8 2.4 2.1 1.8 1.6

Price to book value (x) 10.1 13.6 10.6 8.3 6.7 5.5 4.5

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Conclusion

The software sector is very dynamic in nature. The valuation of companies in this

sector depends on macro as well as company specific factors. The macro factors

include economic growth in the clients countries, the latest trends in software

technologies and the performance of the respective sectors that the IT firms cater to,

among others. The company specific factors also play an important role in

determining the valuations of an IT company. The managements integrity, foresight

and competence rank right at the top. Others are domain expertise, employee

productivity, return ratios, the scale and type of the services offered and the

competition.

Most IT firms operate with little debt and have a low capex requirement. Therefore

the Enterprise Value (EV) method is not useful in valuation. Also, due to intense

competition, uncertainty surrounding the economic conditions in the western world

as well as the dynamic nature of the sector, there is a high probability of volatility in

the earnings of IT firms. Thus using the Price to Earnings

Growth (PEG) ratio is also not very useful. We therefore value IT firms based on the

price/earnings (P/E) ratio. Over the years, Accelya Kale Solutions has traded at a P/E

of 3 to 8 times trailing twelve months (TTM) earnings. The companys fundamentals

are strong and it is a niche player in its industry. We believe that the lower end of the

valuation band should be higher than what has been observed in the past. However, it

faces stiff competition from Indian and global IT firms. Also the airline industry

itself faces severe headwinds. This is why we believe that the upper end of the band

should not be much higher than the past. Therefore, after considering all the above, I

assign a P/E band of 6-9 times to the stock.