Qualiport

7. A company which has a high return on equity

This is a tricky ratio to calculate for Misys, considering all their previously written off purchased goodwill. Rather than explain that here, follow the link above.

Adding back to shareholders' equity a grand total of £1,075m purchased goodwill, we get a ROE of 12.1%. That is quite low for a company of this nature.

A better calculation is return on tangible assets. This works out to be a far more meaningful 35.9%. The low capital expenditure requirement (see point 6) usually means that a company has a high ROE.

8. A company which is a strong cash generator

Misys passes this one with flying colours. In 1998, operating profit of £97.8m translated into cash from operations of £140.5m. That is an amazingly high conversion rate (144%), courtesy of a sharp increase in deferred revenue. There's no better scenario for a company than receiving cash in advance of work being done. In 1998, Misys achieved this wonderful feat.

Going forward, this conversion rate simply won't be maintained. However, if it can be kept at above 110%, that will still be excellent going.

As at Jan 1999, Misys were in debt to the tune of £111m. For a company capitalised at over £3.1 billion, that is insignificant. Also, consider that they generated £108m free cashflow in 1998. That debt, excluding future acquisitions, could be paid off in a year. The interest bill of £6.1m was covered 10 times by operating profits. That is more than adequate. The company's strong cash generation shows up in its valuation (see point 10 below).

9. A company which has identifiable future growth prospects

Technology is the way forward. One look at the divergent fortunes of companies like British Steel (BS.) and The Sage Group (SGE) gives you an idea of what I'm talking about.

Misys is firmly in the technology business. Its banking software products enable companies to work more efficiently and, hence, more cost effectively. Transaction processing allows other companies to concentrate on their core activities, leaving Misys software and people to do the grunge work. It's a win-win situation. The customer is happy, and so is Misys.

The banking and securities division makes up 71% of Misys' operating profit. In the past couple of years, and particularly in the first half of this year, Misys has benefited from increased spending by customers in advance of the year 2000 (Y2K), and from the introduction of the euro. The company freely admits that the growth rates seen in the recent past will not be matched in the future -- for the half year to January 1999, sales rose 62% and pre tax profit rose 83%.

Misys reckons it can achieve 20% per annum growth in the banking division. Banks have spent the last 2 years preparing for Y2K and the euro, but that has been largely to improve the systems they already have. When the Y2K excitement subsides, banks will start spending on new technology. New entrants to the market, such as Sainsbury's Bank and Egg, mean that traditional banks will want to improve service and/or cut costs. Enter Misys.

The urge to merge amongst banks also tends to benefit Misys. Few companies have compatible computer systems and often prefer to install one new one when they combine systems. Enter Misys.

Misys has already embraced the Internet, courtesy of the Screentrade insurance broking site. Naturally, it is currently losing money, but that's the name of the Internet game at this stage of the cycle. Misys has also publicly stated it is looking for opportunities to use the Internet as a distribution and selling vehicle as the company moves forward.

The company is very acquisitive. Opponents argue that Misys will one day buy the wrong company, or bite off more than it can chew. At the time, the Medic acquisition was supposed to be just one too far, yet results have proven otherwise. Many great companies have grown largely on the back of canny acquisitions. The trick is making money out of them, and Misys has passed with flying colours. Here's a recent quote from Lomax on acquisitions.

"We believe first and foremost in value, and I think there are occasions where we see it and others don't. They might just see the negative parts, whereas we will concentrate on the good bits of the business."

Expect further acquisitions in the years ahead. Expect the share price to fall when they are announced. Based on past record, expect them to be a success.

10. A company which is attractively valued.

This is the final piece of the Qualiport jigsaw.

Misys Snapshot

Recent share price: 560p

Fiscal 1998 Sales: £447.7m Fiscal 1998 EPS: 13.2p

1999 EPS Estimates: 16.7p 1999 EPS Estimates: 20.1p

Market Capitalisation: £3153m Market Capitalisation to Sales: 7.0

Current P/E: 42.4 Forward P/E: 33.5 on 1998 estimates, 27.9 on 1999 estimates

Long-Term Expected Growth Rate: 18%

The 18% growth rate is my estimate. As usual, this could turn out to be conservative.

The following valuations are based on principles laid out in our How To Value Shares series.

Earnings growth rate projections

Assumptions

Earnings growth 2001 to 2009 -- 18% per annum Dividend growth 2001 to 2009 -- 15% per annum Price earnings ratio (P/E) in 2009 -- 25

Total return (including dividends) -- 15.2% CAGR

Discounted cash-flow

Assumptions

Discount factor -- 9% Post 2009 growth rate -- 5% Residual capitalisation rate -- 10% Free cash-flow growth rate 2000 to 2009 -- 14%

Intrinsic value -- £3951m Discount to current market value -- 25.3%

Return on Equity

Not applicable. See point 7 above.

Price to Sales (PSR)

Assumptions

Sales growth 2000 to 2009 -- 18% per annum 2009 PSR -- 3.5

2009 market value -- £11,211m 10-year CAGR -- 13.5%

The above valuations give me sufficient confidence that an investment in Misys will jump our 15% CAGR hurdle. This is dependent on the company continuing to keep executing its business plan. The growth rates, year on year, are quite demanding. As a company gets bigger and bigger, the goals become harder and harder to achieve.

There are, of course, risks involved with any investment. Despite bullish outlook statements, Misys may find that banking customers may considerably slow their IT spending after the millennium has passed. The company may make a poor acquisition, which will weigh the group down for many years. It may lose some of its key management team, especially Mr Lomax. Software companies are very much dependent on their people.

However, these are risks we're willing to take. We've done our homework, and are sufficiently happy that Misys passes the quality company test. The next 10 years will prove whether we are right!

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