Qualiport

Buy Report

By Bruce Jackson (TMF Googly)

Kilburn, London -- In accordance with the Fool's trading policy, the Qualiport proudly announces the purchase of £2000 worth of Misys (MSY) shares. Using real money, some time in the next 5 trading days we will buy shares in this Information Technology company.

Please don't try this at home. The Motley Fool is not a tip sheet. We aim to educate and empower individual investors so that they may take control of their own finances. We have learnt about Misys and are happy investing in this somewhat complicated company. More importantly, we know the risks. This is our money, and we're prepared for anything and everything. The Qualiport's preferred holding period is 10 years. Time is on our side!

The Buy Report

"The Group's philosophy is based on enhancing shareholder value, measured by growth and stability of long-term cash flows. Misys' progress has been achieved through committed and experienced management, proven financial controls, substantial ongoing investment in product development and selective investment in well positioned businesses."

As company mission statements go, that is one of the best I've seen. You will note that nowhere does it mention what the company does, and I think that's a good thing. The "committed and experienced management" ought to know what the company does and where it is going. That everything they do is focussed on "enhancing shareholder value" is good enough for me. Too many companies forget that shareholders pay their wages.

About a year ago, I set out its criteria for the ideal Qualiport company. There were 10 points, and I thought it was doubtful that any company would pass them all. Misys is no exception, but it gets quite close. I will soon be updating the text of the criteria, but the message will remain basically unchanged. This, like all future buy reports, will measure the company against these criteria. Here goes.

1. A well managed company

This is the great intangible, yet is deliberately number one on the list. How do you define good management?

Kevin Lomax is the Executive Chairman and a founder of Misys. He is the acknowledged driving force behind the company. Before Misys, he worked at Hanson (HNS), the acquisitive conglomerate, and at 25 he was the youngest managing director -- of a subsidiary -- the company had ever had. Hanson taught him how to run a business effectively and how to get the best out of a company's assets. It also no doubt gave him an eye for an acquisition. All these qualities have been seen in action at Misys over the past 20 years.

Lomax believes that the management team has very much been behind the success of the company. Good people are promoted to areas of responsibility at an early stage, echoing his upbringing at Hanson. Many employees are also shareholders, through their share option scheme, and this has created about 50 paper millionaires. Whilst some may question the future motivation for these people, think of the incentive the other 5000-odd employees will have to emulate the financial success of their colleagues.

A well managed company is a successful company. The best and most tangible way to measure that is to look at the company's past performance. You can't argue with the facts.

2. Strong, and ideally increasing, margins

Operating margins give an indication of a company's competitive advantage. At the lower end, we find supermarkets, with operating margins in the region of 5.5%. At the top end, we see some of the monopoly utilities and the big pharmaceutical companies, with margins in the region of 33%.

Misys is in the top echelon of companies, with an operating margin of 22.6% for the 6 months ended January 1999. This is up from 19.3% in 1994, and 16.6% in 1995, from whence it has increased every year.

High operating margins are usually considered a good thing, because each pound of sales translates into higher profits. Rivals of Misys complain that these sort of margins are too high for a software company, hoping that somehow there is something fishy within the company's accounts. However, as we shall see later, the accounting profits are being translated into cash profits, and the bank balance never lies.

As we move forward, depending on future acquisitions, we shouldn't be surprised to see these margins fall a little. However, as long as sales growth continues at a good clip, so should profit growth.

3. Strong brand name and competitive advantage.

Misys is the biggest IT company in the country, capitalised at over £3.1 billion. That in itself is good exposure for the company within the industries it operates. You may never have used Glaxo Wellcome's (GLXO) products, but you probably have heard of that company. That is courtesy of its pure size. Granted, Misys has a long way to go to catch Glaxo, but you hopefully get the drift. As we're not talking about a consumer goods company here, brand name is arguably less important. I'm not going to go to the chemist to order "a Glaxo" just like I'm not going to ring up Misys and ask for "a Misys."

The company's banking and securities division is the world's largest independent supplier of software products to the sector. That doesn't happen by accident. Word quickly gets around that the product obviously does the trick, and others but it. The success of SAP, the German Enterprise Resource Planning (ERP) company, came primarily on the back of word of mouth recommendations. Big and successful companies can easily become bigger and more successful without having to do an awful lot of direct selling. Let the current customers do the selling for you!

Misys has a number of products in a number of sectors, none of which are household names. However, as long as the brand names are known and successful within the markets where they operate, that's the main thing.

As we saw above, operating margins of above 20% give a good indication as to the company's competitive advantage.

4. A company which you understand, and which has predictable earnings.

Here's the first gong. For me, Misys is not the easiest company in the world to understand. The 1998 annual report, which is very good, goes into some detail about the company's various products and trading activities. However, never having witnessed any of these products in action, it is difficult to get a handle on things.

I feel a little uncomfortable about investing in a company I don't fully understand. If the investment goes belly up because of this fact, I'll only have myself to blame. I know it is a risk, but because of the other positives, it's one I'm willing to take.

Misys is split into two key market areas -- financial services and healthcare.

Financial Services

In banking, Misys supplies software solutions and services to over 1600 customers in 100 countries. Products include systems for treasury, portfolio valuation, risk management, regulatory reporting, cheque processing, mortgage lending and electronic banking. In insurance, Misys provides a raft of software and related services and transaction processing. It also continues to develop its own Internet based direct insurance site at www.screentrade.com (external link).

Both the banking and insurance industries are rapidly consolidating. The urge to merge is done almost exclusively to cut costs. IT systems such as the ones Misys provides to those sectors have the same effect -- to enable companies to do basic functions better and more efficiently. The end result should be reduced costs and higher profitability, something the banking and insurance industries are constantly striving to achieve.

Healthcare

This division sprang to prominence following the acquisition of US medical software company Medic for £573m in 1997. Its core software product is focussed on the billing and administrative functions of primary care and specialist physicians. Misys is the largest vendor of IT in this market. The challenge for Misys is to sell its three main products into the growing managed healthcare market.

Misys has very visible future earnings. When a customer buys software, it also enters into a maintenance contract, which effectively licenses the customer to use Misys software. The customer pays a recurring license fee for this annual contract, and this makes up 27% of the company's total revenue. Transaction processing, a large part of its insurance division, has a large recurring and ongoing element to it. Deferred income as at the end of January 1999 was £123.8m on an annualised sales base of £558m, meaning 23% of future sales have already been booked. Not bad going.

5. A company with a proven past growth record

We've already partly looked at this when we considered Misys' operating margins. However, here's some idea of the Compounded Annual Growth Rate (CAGR) of the company over the past 4 years to May 1998.

Sales +48% CAGR EPS +51% CAGR Dividend +16% CAGR Share price +43% CAGR to present -- approximately 5 years

Hard to argue with.

6. A company with minimal capital requirements

Software companies are traditionally lean and mean fighting machines. The up-front development costs can be significant, but once the product is selling, the production costs are minimal. This is reflected in the Misys gross margin of 60%.

Also, there's no plant and machinery involved to produce the software goods. This is outsourced to third parties. From 1998 operating profits of £98m, just £10m was spent on fixed assets. Lean companies have more cash to invest in the business to fuel future growth.

Continued on next page.