On August 14th, Origo (formerly Nýherji) announced that the company had entered into exclusive negotiations with the Dutch investment firm HPE Growth Partners for the sale of 33% of the equity of its wholly owned subsidiary, Tempo Software.
The announcement brings more clarity to the actual market value of Tempo Software but Origio first announced its intention to attract a strategic investor to aid the further growth of the company in mid-year 2015. The intended valuation of Tempo Software in the exclusive negotiation is $62.5m. The valuation indicates a transaction multiple of 3 times revenues, which is within the range of the expected Enterprise-Value-to-Revenue-multiple of Tempo Software.
Tempo Exclusive Negotiation Announcement
The market initially reacted favourably to the announcement, with shares moving up about 5% in the first trades of the day. In the day after the announcement, the gain reverted as Origo stock sunk back below the range that Origo stock traded at before the announcement was released.
What this could indicate is that investors and analysts were expecting a higher valuation for Tempo and that the value of Tempo Software was already fully priced in the current market capitalization of Origo. Another potential reason could be that after a disappointing first quarter in 2019, disgruntled investors where waiting for the right moment to exit. The Icelandic stock market lacks liquidity and it can be precarious of big players to move in and out of positions.
In the first quarter of 2018, Origo reported a loss, ending a streak of 16 consecutive quarters of improving profitability. No love was lost between Finnur Oddson, Origo’s CEO and the group of analysts and investors during the Q&A session in the 1Q2018 earnings presentation.
Another potential reason is that the announcement was pretty weak and leaves a lot of questions unanswered:
- Origo state that this is an exclusive negotiation, but make no mention of the commitments. What happens if HPE Growth Partners backs out of the negotiations? Is there a break-up fee?
- The announcement says that there is an intended valuation of $62.5 million. This is a very vague statement and can mean a lot of things. Does this mean enterprise value or value of the equity?
- Will this be a secondary offering where Origo sells existing shares to HPE Growth Partners or is it a primary offering whereby Tempo Software issues new shares to HPE Growth Partners?
- On what terms are HPE Growth Partners entering into the transaction? Are they strictly buying common shares? Or are they getting preferred shares or even some other sort of hybrid securities? Will they receive any other rights, such as registration rights or redemption rights?
Origo will announce its second-quarter earnings on the 22nd of August. Hopefully, the management will add more colour to the potential transaction with HPE Growth Partners as well as clarity on operational improvements from last quarter.
Origo Business Segments
In 2017, Origo generated revenues of ISK 15 billion (just under $138 million). Thereof, about ISK 10 billion (~$92 million) of revenues were generated by IT-products and related services in the Icelandic market. The remaining ISK 5 billion (~$46 million) came for software solutions, including the Tempo Software and Applicon AB subsidiaries.
Reading the Origo 2017 Annual Report, you will find that the report really is a tale of two businesses. On one hand, Origo is a legacy IT products and related services business, selling anything from hardware to consumers to insourcing the IT infrastructure for companies and organizations. It’s a low-margin business, that consumes significant amounts of capital.
The other business is a collection of mostly Software-as-a-Service businesses. These business units are relatively capital-light but generate substantial cash flows in relation to the capital deployed to these operations.
Origo IT-Products and Related Services
This business is asset heavy and even though it is generating two-thirds of Origo’s revenue, the business segment is not even producing its cost of capital. In its current state, the IT-segment could be described as a capital-intensive charity, catering to Icelandic consumers and businesses alike.
There are two lines of business that belong to Origo’s IT-related operations:
- Consumer Solutions: Origo is an official dealer of brands such as Lenovo, Bose, Canon, NEC and Sony in Iceland. The company sells those products direct to consumers in retail stores as well as online. About 45% of the IT related revenues come from this segment.
- IT-products and outsourcing solutions to Enterprises: Origo sells IT products as well as outsourcing solutions to Icelandic companies. About 55% of revenues come from this segment.
Even though the IT segment of Origo generates more than ISK 10 billion in annual revenue, the EBITDA margin of the operations came in at 2,55% and 4.66% in 2017 and 2016 respectively. Capital expenditures have tracked depreciations pretty closely and as such, the free cash flow to the firm should be quite close to the EBIT numbers.
Just under ISK 5 billion of operating assets are attributed to the IT-segment according to the 2017 Annual Report, which indicates that the Return on Operating Assets of the IT-segment was less than half a per cent in 2017.
Simply put, based on these numbers, the IT-related operations of Origo are currently far from earning their cost of capital.
Origo Software Businesses
The software operations of Origo consists of solutions targeting the Icelandic market, Tempo Software, a project and portfolio management solution for software companies and Applicon AB, which offers consulting services to the banking and finance companies in Sweden. The solutions for the Icelandic market can be broken down into ERP solutions and Digital Services.
Even though less than one-third of Origo’s operating assets are allocated to the software business, this segment is generating a great majority of the company’s total EBITDA with EBITDA-margins north of ten per cent over the last two financial years.
As capital expenditures are much lower than the depreciation rate, the free cash flow generation to the firm is relatively high (pre-tax and pre-interest). Based on the figures provided in the 2017 Annual Report, the software segment has been generating more returns on operating assets between 25-30% over the last two financial years.
What the financial reporting of Origo lacks, is a break-down between different segments of the software operations. With the impending sale of a part of Tempo Software to a third party, Origo will likely have to break this down in more detail in their reporting.
According to the Annual Report, just under ISK 3 billion of revenues came from Tempo and Applicon in 2017. This means that around ISK 2.7 billion were attributable to the Icelandic software services. Thereof, the split between ERP solutions and Software Applications was just about split in half.
Origo has made public the revenues from both Tempo Software & Applicon AB in 2017. Using the average exchange rates of both the US dollar and Swedish Krona from the Annual Report, we see that about two-thirds of the ex-Iceland revenues came from Tempo Software.
Origo Sum-of-Parts valuation
Using the Tempo Software valuation from the announcement and applying a more conservative EV/Revenue multiple of 2 for Applicon AB and the other software services, the total value of the software segment of Origo exceed ISK 14 billion in value.
With long-term debt of about ISK 1.6 billion and a current market capitalization of ISK 9.7 billion, one can make the argument that the market is applying a negative value to the IT-related segment of about ISK 3 billion.
Now, let us purely for the purpose mental exercise image that the valuation ISK 14.4 billion ($132 million) for the software arm of Origo would hold true in reality. Furthermore, let us imagine a scenario were the Origo management would simply hand over the keys to the IT operations for a token amount of a single Icelandic Krona.
Assuming that there is no excess cash on the balance sheet and subtracting interest-bearing debt of ISK 1.6 billion, that would leave shareholders with net assets worth ISK 12.8 billion. There are 465.152.326 shares outstanding, which would correspond to ISK 27.5 per share. This would be a 24% discount to the current share price of ISK 20.9.
It is not likely that the management would give away a business consisting of two-thirds of Origo’s revenues, even if it would benefit shareholders. It is also not that hard to imagine a scenario where the IT-segment continues to underperform, not earning the cost of Origo shareholders’ capital.
It is, nonetheless, foreseeable that the software segment of Origo will, year-by-year, become an ever-increasing share of Origo’s revenue. For shareholders, this may come sooner than later.
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