Since not living far from the company's headquarters, regularly playing tennis across the street from it and having had this company on my watch list for quite a while, I wanted to take a closer look at Frequentis and its business model. It's a great honour, that Stefan Marin, the Head of Investor Relations at Frequentis took his valuable time to talk to me about important questions that arose after having analyzed the half-year report of 2021 and the annual report of 2020.
Regarding sales development
Revenue growth has been really impressive over the last 20 years. As I understand it, a large part of the growth was based on successful M&A activities, as also shown on investor presentations. Do you think this assessment is correct?
Mr. Marin: Our industry grows at 3 to 5 % annually. We managed to grow 6% or more throughout the last years. Partly, yes, this was influenced by our acquisitions. However, the major part of our growth stems from organic growth.
I gather from your IPO plans that the additional capital raised through the stock exchange should primarily be used for growth investments in the form of M&A activities. The acquisition of the L3Harris spin-off was a hit. Are there specific transaction goals being pursued here? What investment framework are we talking about here in the medium to long term in the planning?
First, I would like to make clear that we do not acquire companies for the sake of revenue growth. We acquire to extend our product offer. I would say that we agree on the target to only acquire companies that contribute 10% to our revenues at maximum. What's more is that we focus on acquiring 51% of the target's shares. We extensively focus on successfully integrating acquired businesses so that we merge the company culture of both companies. This is crucial for us. And one way we make this happen is by keeping the old business as they were so take both sides profit most from this acquisition.
Comment to Mr Marin's answer: This answer deeply impressed me. It is not by any sense usual to have such a strong normative view on strategic questions related to short-term developments for a stock-listed company. Mr Marin clearly states that Frequentis wants to grow steadily and does not focus on short-term issues. One reason for this could be Frequentis' shareholders. With a share of 68%, the owner's family still has decisive control of the company's evolution. 10% of the shares are in the ownership of B&C, probably the most important (stock-investing) foundation in Austria.
According to the annual report 2020, 90% of the customers are regular customers, the current customer portfolio could result in further attractive opportunities for growth: What potential do you see in the existing customer portfolio through cross-selling and price increases organically on the basis of the current figures?
In some contracts we have clauses that say that the prices of our services are tied to an index that should decrease negative affects from inflation. In case of other contracts we renegotiate prices for maintenance to keep price levels attractive. Generally, we do not focus on cross-selling in its purest sense. We concentrate on the tendered projects. Our most successful example of cross-selling has happened in Norway. We started with a project at a volume of 10 EURm for the police. Since then, we have acquired a project volume of 120 EURm for the rescue, fire brigade and sea rescue services. Usually, tenders are offered with many additional services included so that the authorities are not obliged to further tenders as they are expensive.
Comment to Mr Marin's answer: What a story! From this answer we can learn that organic growth will mainly stem from new project acquisitions.
Despite the low dependence on the economic cycle mentioned in the annual reports, the type and duration of the tender procedure is extremely expensive, lengthy, resource-consuming and jeopardizing success, especially in transactions with the public sector: Are you heavily dependent on public approval and tendering procedures in your operational activities? How long does this decision-making process for the company's products take on average?
Our products are critical for official authorities. There are also laws that tell authorities what regulations they must comply with. These are updated regularly for the public cause. So, authorities do not really have a chance to not comply. Tenders do usually have a range of 2 to 6 years. So, I would not expect us being that dependent from the tender procedure.
Comment to Mr Marin's answer: Clearly shows in which protected situation Frequentis is with its products. Great sign for investors.
Regarding operating (cash flow) return
The ATM segment has 60% share of sales and is therefore decisive for the profitability of the (entire) company. Due to the high barriers to entry, one could position oneself with particularly high margins. What is the reason behind this business segment performing weakly on profit margins? Are these long-term or short-term circumstances?
Throughout the last years, the ATM segment experienced four acquisitions. We had some extraordinary costs for integration of these new businesses and had an impairment of business value that contributed negatively. The ATM segment's profit margin is not as high as the PST's segment margin. Despite our four acquisitions, we do not plan to increase our revenue share weighting of 60% of the ATM segment.
In contrast, the Public Safety & Transport (PST) division is profitable and has attractive margins (due to 15% EBIT return). What are the long-term plans for the distribution of sales in the future? Are there special investment or acquisition plans in one of the two business areas?
Besides the acquisitions in the ATM segment, we also acquired two businesses for the PST segment. This does not imply any specific focus. We try to keep the revenue shares quite equal and do not want to be dependent from one segment only.
What is the target return for both businesses?
We have a target EBIT margin of 6-8 % for both segments combined.
Comment to Mr Marin's answer: I appreciated Mr Marin's clear answers. EBIT margins of 6-8 % are not high per se, especially in an industry that is protected from competition. Having been in this industry for 60 years, Frequentis knows what's possible in terms of margins. So, I think we have to understand these margins levels in this context.
Although the dependence from economic cycles is classified as low in the annual reports, it can be observed that the return has fluctuated considerably in recent years - especially with regard to the digital (network) solutions on offer. However, I see (A) enormous potential for returns and (B) high margin stability that competitors in the software or SaaS market achieve. In the case of the OCF return, the values fluctuate between 2% in 2018 and 18% in the past financial year. In terms of the free cash flow return, ranges between the slightly negative return in 2018 and the record margin of 17% in the past financial year can be seen. Where do you see the reason for the cyclical operating margins, both in terms of net sales and operating cash flow and free cash flow yields?
We do not define ourselves as software company. We offer hardware which contributes around 10% to our sales, we offer services, maintenance and training. You are true that these numbers vary. This could be caused by prepayments for our services which we have agreed on for specific countries like Venezuela - but, generally, we cannot plan payment streams of customers. Sometimes authorities pay their bills in the fourth quarter having some (excess) budget left. There is no key reason for this. For the last two years, as you've probably seen in the reports, we have had exceptional FCF figures.
What are the target returns for OCF and FCF if economy and businesses are in normal condition?
We do not have any specific focus on cashflow levels, although they show the truth. We focus on our liquidity with working capital and EBIT margins.
Comment to Mr Marin's answer: Unfortunately, Frequentis does or cannot offer any focus on cashflow levels or margins. This makes us depend on past FCF and OCF margins as a valuation basis.
Regarding Usage of Free Cashflow in the Future
In the 2020 financial year, 0.12% of the share capital was bought back for the first time. The entire authorized capital for the share buyback was thus exhausted. Since your company is perfectly positioned and highly attractive (formerly owner-operated) and, moreover, was previously an owner-operated family business that could multiply its market value through intelligent use of FCF, I wanted to ask you what the company's plans are for FCF in the future to use:
How does the company plan to use your FCF for dividends and share buybacks over the long term?
With the buybacks that we introduced in 2020, we have not used all the resources granted from shareholders for share buybacks. We do have the allowance to repurchase 10% of the issued number of shares. But we do not focus on buybacks. We prefer to use our resources for R&D expenses and attractive acquisition targets.
Comment to Mr Marin's answer: Buybacks of 10% would be insane but I am confident that Frequentis will not utilize them for stock repurchases. Although stock repurchases are an essential criterion for our stock selection, we are conscious that stock repurchases are seldom in the German-speaking area. We have not found out why this is the case. However, we can conclude from the previous answers that the company uses its capital wisely and in a focused manner.
How would you rank the prioritization between M&A, dividends and share buybacks here?
Actually, I would say, you can stay with this ranking. 20 to 30% of our net income should be used for dividend payments and we invest 12-20 EURm in R&D. It's important to not neglect that.
Finally, I would like to mention how excited I am about the fact that the company's Goodwill ratio is so outstandingly low (intangibles ratio of 4% in 2020) and net cash of EUR 77m. These two facts underline great financial policies.
Thank you for these kind words. Customers ask for net cash. They have to face a situation in which they are dependent from us for 20 to 25 years. They ask for 100% reliability of our business. This can be guaranteed with net cash. We plan to stay net cash every year.
Thank you very much for the chance to talk to you and your valuable time talking to me! As you might have seen, I have made lots of notes from the learnings I've experienced from our great conversation.
Sure. Sometimes questions arise, that's no problem. Next time you have questions, do not hesitate to ask me.