Qualiport

[ August 2, 2000 ]

Uncomfortable With Misys

By Maynard Paton (TMFMayn)

Rochester, Kent -- Qualiport member Misys (LSE: MSY) reported its full-year results last week. Following on from Monday's divisional review of the numbers, today I'll focus on the weaker aspects of the financial performance. In a nutshell, a deterioration of cash flow, further acquisitions and an optimistic share price makes the Qualiport feel rather uncomfortable holding Misys shares.

Cash Flow

A strong cash flow has historically been a great financial characteristic of Misys. The way the company sells its licence fees usually meant large surpluses of operating cash. However, this enticing operating feature has lost its shine in recent years. The reconciliation of operating profits to operating cash flow tells the story.

                                    Year ended 31st May
                                 2000        1999       1998
                                 (£m)        (£m)       (£m)

Operating Profit                102.5       132.2       99.7
Depreciation and amortisation    27.3        11.5        7.0
Change in stocks                  2.5         2.7       (1.8)
Change in debtors                11.4         3.8       (6.0)
Change in creditors               1.6         5.5       16.9
Change in deferred income       (22.2)       (4.5)      27.2
Other                            (1.8)      (11.1)      (2.5)
Operating cash flow             121.3       140.1      140.5

If we ignore depreciation and goodwill amortisation, the last two years have not seen profits fully converted into cash. This 100% conversion was once a regular and welcome feature of the Misys accounts. The blame can be laid firmly at the door of the deferred income account.

Deferred income represents payment received by Misys for its services that have yet to be "earned". A typical example would be the client paying upfront for an annual software licence. The proportion of that licence payment extending past the balance sheet date is accrued in the balance sheet as deferred income. The deferred income then filters through the profit and loss account during the following year.

From an investor's point of view, the beauty of deferred income is the visibility of forthcoming revenues. Significant changes in this respect can be a forewarning of near-term sales difficulties. Here's how deferred income has altered in the past two years.

                                      Year ended 31st May
                                   2000        1999       1998
                                   (£m)        (£m)       (£m)

To be recognised within one year:
Recurring licence fees             57.1        53.3       43.9
Other income                       33.5        50.8       68.4

To be recognised after more than
one year                           13.0         7.6       12.1

Total Deferred Income              103.6      111.7      124.4

So on the face of it, a worrying trend. The total has dropped from £124m to £104m in two years, the cause being the decline in "other" deferred income. This "other" figure represents initial software sales and consultancy services that have been invoiced but have yet to meet revenue recognition criteria. To a certain extent, the 1998-2000 comparison is a little unfair. The build up of one-off Euro and Y2K-related work peaked during 1998 and no doubt generated a fair chunk of that year's £68.4m deferred contribution.

What does concern me is comparing "other" deferred income at the latest full-year stage (£33.5m) to that reported at the previous interim point. At the end of November 1999 (with the Y2K "lock down" underway), other deferred income stood at £35m. It's unnerving that this figure should be higher than that declared at the end of May 2000, given the subsequent (and supposed) unbottling of post-Y2K demand for software and services in the meantime.

Although deferred revenue from recurring sources continue to make progress, this whole aspect of the Misys accounts needs to be monitored very carefully. The current situation could indicate near-term revenue troubles. But the effect of the Y2K slowdown hampers the reaching of any definite conclusions.

Acquisitions

I'm always wary of companies following a growth-by-acquisition strategy. Firstly, it gives an impression of a lack of "management creativity". Secondly, it clouds the financial picture. Unfortunately, Misys have a long record of substantial acquisitions and the group continued the corporate activity during fiscal 2000. I sighed at the analysts' results briefing last week when Chairman Kevin Lomax stated that "we intend to remain a highly acquisitive company".

The latest year's acquisitions are listed below. Consider, too, that the group made an adjusted post-tax profit of around £85m during the year.

Date                   Acquisition                Cost (£m)

June 1999              Group SIP                      5
July 1999              Data Counsel                   1
August 1999            Financial Options Group       40
October 1999           RSA Sales Force                5
March 2000             Synopsys                       1
April 2000             CDS                            3
May 2000               i.e. group                    28

Total consideration                                  83
Fair value of assets acquired                       (17)
Goodwill capitalised                                100

Essentially, Misys reinvested all of its profits into purchasing other companies. Hardly the sign of the entrepreneurial spirit that drives most businesses to long-term success. With the year's acquisitions not up to optimum profitability and a Y2K-inspired decline in earnings, return on equity calculations aren't going to reflect a true profit reinvestment performance. But I will again reiterate my lack of enthusiasm for the long-term incremental return on equity accomplishments of Misys.

The company has spent £1b on acquisitions to generate an additional £78m of earnings in the eight years to May 2000. Although recent acquisitions have yet to get up to speed, that performance is mediocre. Indeed, this state of affairs warrants an article all of its own. In the near future, I'll look at the acquisitions, goodwill and the resulting return on equity at Misys in much more detail.

Valuation

The average of the two forecasts published since last week's results produce earnings-per-share (EPS) estimates of 16.2p and 20.7p for the years ended May 2001 and 2002 respectively. Using a normalised EPS figure of 15.1p for fiscal 2000, those figures equate to earnings growth of 7% and then 27%. At the current share price of 665p, Misys sits on a prospective price-to-earnings ratio (P/E) of 41, declining to 32 for 2002. By no means cheap, given the recent financial performance. Overvalued? Probably. Grossly overvalued? Not yet, I think.

There's a lot of expectancy that Misys will, in their own words, "progressively return" to their long-term 20% growth rate very soon. The questions on my mind concern the undisclosed timetable of that return, given that Misys are not out of the Y2K woods yet, and the possibility of expensive and chunky acquisitions fuelling that performance.

Overall, nothing from the full-year results has changed my mind towards Misys. On a valuation, prospects and financial performance mix, Misys still ranks near the bottom of the current Qualiport constituents. Given the cloudy performance caused by the Millennium, it's prudent to postpone any clear-cut financial judgement until the next set of interims. In the meantime, I remain uncomfortable holding Misys at the current share price levels and I'll have no hesitation in selling should they ever become "grossly overvalued".

Where Next?

• Review the divisional performance from Misys' annual results.
• Then visit the Misys discussion board | website