Edelweiss has recommended accumulate rating on Nucleus Software. At the CMP of Rs 991, the stock trades at 21x FY08E EPS of Rs 47 and 14.5x FY09E EPS of Rs 68.1.
Edelweiss report on Nucleus Software:
Increased focus on product business to enhance EBITDA margins
Since inception, Nucleus Software Exports (Nucleus) has focused on the BFSI vertical. With 250+ product implementations, for its flagship product - FinnOne™ - Nucleus has credibly positioned itself as a retail banking packaged software player. As on FY07, 54% of its revenues came from the product segment, which is expected to grow at a CAGR of 64.5% over FY07-09E, contributing 72.6% to total revenues in FY09E. This is likely to result in EBITDA margins expanding from 28.61% in FY07 to 29.9% in FY09E.
ACOM deal – another marquee client on the list
Nucleus has recently won the Rs 1.5 billion ACOM (Japan) deal (1x FY06 revenues), taking its total order book to Rs 3.3 billion (as on FY07). ACOM being one of Japan’s largest consumer finance companies establishes strong franchise for Nucleus. For this deal, Nucleus competed with several companies with strong forte in the BFSI segment. This builds on top of the multi-site execution that Nucleus is engaged in for GMAC. We thus believe that the deal puts Nucleus head-on with companies in the BFSI segment globally.
BFSI segment – multiple growth drivers exist
Over the past decade, the BFSI segment has become increasingly dependent on information technology (IT). IT spending, BFSI’s top priority, is being increasingly directed towards addressing the long-standing issues related to core applications, including achievement of higher operational efficiency, better risk management, regulatory compliance, and enhanced customer satisfaction. Also, with the advent of globalisation, all the global banks are standardising their core systems across multiple countries. These institutions are increasingly looking for complete solutions for business expansion and achievement of cost effectiveness. Gartner estimates demand for BFSI product development industry to grow at 25-30% over the next 3-5 years on the back of multiple growth drivers. This represents huge growth opportunities for companies this segment.
Global retail assets base – a huge market waiting to be addressed
Datamonitor estimates the global retail assets base worth USD 26 trillion (as on 2005) to grow at a 6% CAGR till 2010, to USD 32.5 tn. Of the USD 26 trillion of retail assets, almost 50% comes from the US and 80% are mortgage assets. Nucleus estimates that it services USD 60-65 billion retails assets currently, which represents a quarter percentage of the global retail asset base. We believe this represents huge growth opportunity for Nucleus and other retail-focused players.
Products – In the products segment, Nucleus is totally focused on the BFSI vertical with an IPR-led strategy for a global presence. While offering a full range of products on both assets and liability components of the business to its clients, Nucleus has achieved significant presence in the retail loans segment. Product revenue for Nucleus comprises license fees, revenues from customisation and implementation of products, and technical support.
FinnOne™, Nucleus’ flagship product, is an integrated suite of applications designed to support the typical business offerings of banks and financial solutions companies. Till date, the company has implemented 250+ modules in 22 countries. Originally built on Oracle platform, FinnOne™ is now available on Java J2EE platform. FinnOne™ currently contributes 95% to Nucleus’ total product revenues .
Nucleus’ other products in cash management, internet banking, fraud management, and credit card segments are Cash@will ™, BankONet, FMS, and PowerCard (a distributed product), respectively. During Q307, the company received an order from a large European bank, to implement Cash@will ™ in over 16 countries. During FY07, the aforementioned products contributed 54% to Nucleus’ total revenues, up from 38% during FY06. Going forward, Nucleus plans to introduce more products in BFSI segment, thereby reducing its dependence on one product. We expect revenues from this division to grow at 64.5% CAGR over FY07-09E, contributing 72.6% to the total revenues in FY09E. Projects and services – On the project and services front, Nucleus provides technology and implementation consulting, customised software development and support, and services related to testing and network maintenance. Nucleus has two major clients in Japan and Singapore, which contribute 94% to project revenues. Going forward, Nucleus plans to look for opportunities with large international banks. During FY07, projects contributed 40% to Nucleus’ total revenues, whereas services contributed a meager 6.1%. We expect revenues from project and services divisions to grow at 10% and 7.9% CAGR over FY07-09E, contributing 24 % and 3.3% to the total revenues in FY09E, respectively.
GMAC deal - a big break-through
GMAC is one of the world's largest auto finance companies with businesses such as automotive finance, commercial and residential mortgages, and insurance. During September 2004, Nucleus won an order worth USD 12 million from GMAC to roll out the loan servicing and collection management modules of FinnOne™ at its international locations across 37 countries in Asia Pacific, Europe, and Latin America. Spread over a four-year period (beginning 2005), this is the biggest rollout in the banking space by any Indian company abroad. Nucleus had already implemented the FinnOne™ modules for GMAC in India and several other Asian locations like Taiwan, Indonesia, Thailand, and China over a period of four years before this deal. The GMAC deal has taken contribution from Europe to 11% of total revenues in FY06 from 5% in FY05. Moreover, the GMAC order has opened up avenues for further penetration in the European and US markets. The GMAC deal, involving the multi-site implementation of its flagship product, has been a strong reference point to bid for business from other retail lending institutions globally. During October 2004, Nucleus acquired 25.1% strategic stake in GMAC Financial Services India Ltd (the Indian automotive finance operation of GMAC) for Rs 136.8 million; the remaining 74.9% stake is with GMAC, earlier subsidiary of General Motors. This indicates the company’s commitment to built long-term relationships with its clients.
During January 2007, Nucleus bagged another big deal worth Rs 1.5 billion, surpassing the GMAC deal from ACOM Co. Ltd (ACOM), the second largest consumer finance company in Japan. Nucleus was working on this deal from the past three and half years and would be replacing certain IBM systems in this assignment. The deal involves implementation of FinnOne™ and PowerCARD, and offshore development service offering from India over next two years, followed by technical support for five years from India. Revenues from this deal have started flowing from Q4FY07 onwards. The project would go live by Q1FY09 with 100-200 people working on the deal at any point of time. The scope of the project involves end-to-end IT transformation of ACOM’s consumer finance operations across all its branches and networks. We believe that order demonstrates Nucleus’ capability of winning big orders in the future and gives it significant revenue visibility over the next two years.
Client concentration across various geographies
Nucleus currently has clients across 22 countries. As on FY07, top five clients contributed 63% to revenues. The graph below shows the revenue concentration over the past four years in various geographies.
Change in the license fee structure in the offing Historically, Nucleus charged a one-time license fee, which is a function of number of countries/sites, and number of users. In the developed markets, the trend is however charging license fees per transaction on a per account basis. Nucleus has made a beginning in this direction recently and for two new customers (apart from the upfront license fee) they have built-in additional fees based on the size of portfolio. Initially, the license fee for Nucleus used to be around 40% of the order value, which it claims to be currently in the range of 50-60%. Huge cash and investments – building a warchest for acquisition As on FY07, Nucleus has cash and investments to the tune of Rs 819 million which are expected to go up to Rs 1.5 billion by FY09E.We believe that the company is preparing itself for acquisitions going ahead. Capacity expansion - on the cards Nucleus has five development centers globally, with state-of-the-art development center at its five acre campus at Noida. The other centers include Singapore, Delhi, Chennai, and Pune. During the second phase of development at Noida, Nucleus has added 800 seats by FY07 end, at a cost of Rs 160 million; it will add another 800 seats in the third phase by the end of FY08 at Rs 200 million respectively. Besides this, the company is also looking at buying another piece of land by FY08E end, at an estimated cost of Rs 200-400 million. The entire expansion would be funded through internal accruals. Nucleus has 1532 employees (globally including the subsidiaries) as on FY07, of which 1305 people are in the technical department. There is core team of 160+ people out of 1305, dedicated for product development and product management. We estimate Nucleus to add 460 people in FY08E and 310 in FY09E, taking its total employee strength to 2289 in FY09E. Continued investments in new product development and upgrades Nucleus intends to invest 10% of its total revenues in R&D every year, towards new product development and upgrading the existing products suite. During FY07, Nucleus has launched a new product module in FinnOne™, “FinnForecaster”, which is a decision driver for predictive analysis and data modeling. By June 2007, a new product release for Cash@will ™ is scheduled. This commitment augurs well for sustainable future growth of the company.
Nucleus operates among the fastest growing segments of the product development industry that has a huge addressable market, along with multiple growth drivers. Further, it is also one of the most challenging segments to be in, as the product acceptance takes a longer time. This is evident from the fact that the Nucleus had been working on the ACOM deal for almost three and half years. Given Nucleus’ strong focus in the BFSI vertical, high pedigree management, strong client list and excellent return ratios, its prospects appear bright. However, we believe that the stock appears fairly priced at current levels and further upsides to estimates are possible as and when Nucleus bags new orders. We expect Nucleus’ revenues and profits to grow at 42% and 41% CAGR, respectively, between FY07 and FY09E. At the CMP of Rs 991, the stock trades at 21x FY08E EPS of Rs 47 and 14.5x FY09E EPS of Rs 68.1. We thus initiate coverage with an ‘ACCUMULATE’ recommendation.
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