Nepa: Cost Base Too High to Withstand Challenging Market

Research Update

2023-05-22

07:25

Redeye argues that Nepa’s Q1 report was weak, especially with regard to the company’s cost control. There were however bright spots, and Nepa’s subscription business in Marketing Optimization still delivered decent y/y growth. While Nepa is taking actions towards reducing its cost base, Redeye is unsure whether it is enough, or if more is needed. Redeye lowers its valuation but sees a significant upside if management executes well.

JVK

Jesper Von Koch

Fredrik Reuterhäll

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Poor Q1 topline causing quarterly loss – but Nepa’s golden core delivered solid numbers

Nepa delivered a weak quarter in a very challenging market. Total revenues declined 9% y/y, the gross margin was low (72.7% vs 80% last year), and the cost base is too high – causing a quarterly loss in Q1.

However, looking below the surface, Nepa’s core, its subscription business in Marketing Optimization (MO), delivered a solid +8.5% y/y growth. The weak figure of -1% y/y for Nepa’s full ARR was caused by weakness from the Customer Experience (CX) segment that lost one of its biggest customers.

Cost base is too high and Nepa is taking actions – but is it enough?

Regarding the cost base, it is simply too high to sustain profitability in a weak market. Hence, Nepa is taking further actions to cut costs. The company aims for an annual cost base of SEK220m by Q4 2023. While this is a good step, we doubt that it will be enough, and we would have liked to see even more.

Stupidly cheap stock – but solid execution skills required to extract value

On the back of the Q1 report, Redeye lowers its estimates for sales and raises its estimates for costs, resulting in lowering our fair value range. New Base Case is SEK58 (80), Bear Case is SEK26 (38), and Bull Case is SEK100 (130).

We argue that Nepa is trading stupidly cheap. We think so both with regard to the EV/Sales multiple (0.35), the EV/ARR multiple (0.63, despite ARR only making up 55% of sales), and also in relation to its revenue quality. The reason why is the cost base being too high, causing profitability to be dependent on volatile ad-hoc sales. While we argue that the value of Nepa is much higher than today’s market value, it will require solid execution to extract it.

Key financials

SEKm	2021	2022	2023e	2024e	2025e
Revenues	N/A	N/A	N/A	N/A	N/A
Revenue Growth	14.2%	5.7%	-7.9%	8.2%	8.1%
EBIT	40.0	19.7	-2.9	23.7	30.0
EBIT Margin	13.5%	6.3%	-1.0%	7.6%	8.9%
Net Income	38.6	17.5	-3.4	19.5	24.4
EV/Revenue	4.1	0.3	0.4	0.3	0.3
EV/EBIT	30.1	5.1	-40.7	4.6	3.1
P/E	33.4	9.3	-48.8	8.4	6.7

Review of Q1

Q1 was weak. Low sales, low gross margin cost by low ad-hoc sales, and too high cost base caused a quarterly operating margin of -5%.

Weak revenues – but bright spots exist

Net sales can be divided into two different ways: by revenue type and by segment. Regarding revenue type, around 60% is recurring subscription revenues, and the rest is divided relatively evenly between ad hoc revenues to subscription customers, and ad hocs to others. Nepa has three segments: Marketing Optimization (MO) constitutes around 80% of revenues, whereas Customer Experience (CX) and Innovation Acceleration (IA) share somewhat equally the remaining 20%.

Q1 revenues declined by 9% y/y. Subscription revenues increase by 1% y/y, ad hoc revenues to subscription customers declined by 8% y/y, while ad hocs to non-customers declined by a full 32% y/y.

Nepa: Revenues per type, SEKm

Source: Nepa

Subscription business in Marketing Optimization is core – still doing decent

The golden nugget of Nepa is its subscription business in MO, i.e., its Brand Tracking product. Revenues from this part grew by 8.5% y/y, which we think is decent considering the challenging market.

Weighing on total revenue development, the company's two other segments declined significantly y/y. CX declined by 27% and IA declined by a full 64%. The drop in CX was mainly caused by one of its biggest customers churning. IA is pure ad-hoc consulting projects that is very dependent on the market environment.

Nepa: Revenues per segment, SEKm

Source: Nepa

Nepa provided SaaS metrics for the first time – but we want MO to be separated

In the quarter, Nepa started to provide SaaS metrics for its subscription business. While we think this is good, we would have wanted to see the metrics for MO separately. The reason why is that we believe its SaaS metrics are strong – something that today’s share price does not give Nepa credit for.

Nepa revealed an average Net Revenue Retention (NRR) since Q1 2020 of 99.9%, and quarterly average churn of 1.0%. We are certain of MO having performed better than this, while CX has surely weighed on these numbers. Should Nepa reveal these metrics for MO separately, we think investors could better assess the quality and value of Nepa.

Solid but not great for MO as a whole

Looking at the y/y comparison of MO, Q1 was still OK. See below:

Nepa: Marketing Optimization, y/y comparison, SEKm

Source; Nepa

Low ad-hoc revenues caused low gross margin

The gross margin in Q1 was low – landing at 72.7%, compared to last year’s 80.0%. The reason for the low gross margin was the low share of ad hoc revenues, especially within Innovation Acceleration (IA).

Nepa: Gross margin

Source: Nepa

Current cost base is too high – causing quarterly loss in Q1

Nepa’s cost base stood at SEK60.5m in Q1 if including “other operating costs”, and SEK59.3m without.

Nepa: Cost base, SEKm

Source: Nepa

With low revenues, especially from the high-margin ad hoc revenues from Innovation Acceleration, the gross profit simply was not high enough to balance the company’s high cost base. Hence, EBIT margin landed on -5% and the underlying free cash flow margin (EBITDA less investments in intangibles) was -10%. This makes it obvious that the company’s cost base is simply too high to carry.

Nepa is taking actions to decrease cost base – but is it enough?

In the Q1 report, Nepa stated the following “The previously announced cost saving programs were projected to save SEK 31.2 million of personnel costs and other external costs on an annual basis from the cost base in place before the programs, in October and November 2022. But, given the weaker than expected market in the short-term, the savings are materializing too slowly. Therefore, we are aggressively accelerating actions to fully realize the targeted cost savings and reach an annual cost base (personnel and other external costs) of SEK 220 million by Q4 2023.”

This statement surprised us in two ways. First, we had calculated the cost base after the savings to be less than SEK220m. Second, the CEO appears to insinuate that total cost savings will now exceed SEK31.2m but still results in a higher cost base than we had previously estimated.

Considering the weakness of the market, we are not sure if an annual cost base of SEK220m will be small enough. The last twelve months, the cost base has been SEK235, making the maths hard to get correct considering that Nepa appears to think cost savings of SEK31.2m is not enough.

Nepa: LTM cost base, SEKm

Source: Nepa

Finishing thoughts

We are still certain that Nepa has a solid core business that is worth considerably more than what is today priced in the share price. However, Nepa has put itself in an awkward position and needs to take firm action to turn its business around. While we argue that there is a substantial upside to the share price if Nepa succeeds, management needs to show that it is capable of running a stable business with profitable growth.

Changes to financial estimates

Reducing estimates on sales by 4-6% for 2023-2026e

Reducing estimated gross margin by 1-2 percentage points for 2023-2026e

Increasing estimated cost base by 10% for 2023e, and by 2-3% for 2024-2026e

The resulting estimated EBIT is cut by c40% per year

Nepa: Estimate changes

SEKm	2021	2022	Q1 23	Q2 23E	Q3 23E	Q4 23E	2023E	2024E	2025E	2026E
Total net sales	295	312	73
New				74	65	76	288	311	336	361
Old				78	68	79	301	324	353	386
Change				-6%	-3%	-4%	-4%	-4%	-5%	-6%
Gross margin	78%	76%	73%
New				73%	72%	72%	72%	74%	75%	75%
Old				75%	75%	75%	75%	75%	76%	77%
Change				-2%	-2%	-2%	-2%	-1%	-1%	-2%
OPEX	181	205	54
New				51	45	49	198	192	206	220
Old				45	39	46	178	188	200	216
Change				13%	14%	8%	11%	2%	3%	2%
EBITDA	50	31	-1
New				3	3	5	10	38	46	51
Old				13	11	13	46	55	68	79
Change				-81%	-76%	-59%	-78%	-30%	-32%	-36%
EBIT	40	20	-4
New				-1	-1	2	-3	24	30	33
Old				10	8	10	32	40	52	59
Change				-107%	-107%	-77%	-109%	-41%	-43%	-45%
EBIT (%)	14%	6%	-5%	0%	0%	0%	0%	0%	0%	0%
New				-1%	-1%	3%	-1%	8%	9%	9%
Old				13%	12%	12%	11%	12%	15%	15%
Change				-14%	-12%	-10%	-12%	-5%	-6%	-6%

Nepa: Financial estimates

SEKm	2021	2022	Q1 23	Q2 23E	Q3 23E	Q4 23E	2023E	2024E	2025E	2026E
Net sales	295	312	73	74	65	76	288	311	336	361
- Recurring	148	170	43	44	45	45	176	192	212	233
- Ad hoc	76	67	17	17	10	17	61	65	68	70
Gross Profit	231	236	53	53	47	55	208	230	252	271
EBITDA	50	31	-1	3	3	5	10	38	46	51
EBIT	40	20	-4	-1	-1	2	-3	24	30	33
EPS (SEK)	4.9	2.2	-0.6	-0.1	0.0	0.2	-0.4	2.5	3.1	3.3

Recurring as % of total	50%	54%	59%	59%	68%	60%	61%	62%	63%	64%
Sales growth (%)	14%	6%	-9%	-15%	-6%	0%	-8%	8%	8%	7%
- Recurring sales growth	6%	15%	1%	-2%	9%	8%	4%	9%	10%	10%
- Ad hoc sales growth	29%	-12%	-8%	-16%	-1%	-10%	-10%	7%	5%	3%
EPS growth (%)	194%	-55%	-157%	-105%	-106%	-138%	-119%	-681%	26%	6%
Gross margin	78%	76%	73%	73%	72%	72%	72%	74%	75%	75%
EBITDA margin (%)	17%	10%	-1%	3%	4%	7%	3%	12%	14%	14%
EBIT margin (%)	14%	6%	-5%	-1%	-1%	3%	-1%	8%	9%	9%

Valuation

Assumptions, fair value range
	Bear Case	Base case	Bull case
Value per share, SEK	26	58	100

2023e-2027e
Sales CAGR	3%	8%	11%
Total sales 2027	327	389	437
Avg EBIT margin	4%	7%	9%
EBIT margin 2027	6%	9%	14%
EPS CAGR	14%	13%	25%

2027e-2031e
Sales CAGR	3%	8%	9%
Average EBIT margin	6%	10%	16%
EPS CAGR	3%	18%	15%

Terminal EBIT margin	8%	14%	20%
WACC	11.0%	11.0%	11.0%

Investment thesis

Case

Sticky, recurring software revenues with pending margin expansion

Having completed its turnaround in 2020, closing unprofitable business units and migrating customers to its new software platform, Nepa stands on a solid foundation. Its recurring revenue base (60% of the total) is very sticky and has close to no churn – even in difficult times. After poor cost control in 2022, profitability has come down and investors' confidence in Nepa is currently at bottom lows. This provides a good foundation for an interesting opportunity, we think. The company's savings program will start to be realized in Q1 and fully realized in Q4 - setting the scene for yet another margin expansion. Nepa is targeting a minimum 20% EBIT margin by growing recurring software revenues without expanding its workforce meaningfully. While we expect 2023 growth to be negative, we then expect Nepa to return to solid growth from 2024. We estimate sales growth of 2023e–2027e CAGR of 8%. At the same time, we expect earnings per share to grow even faster (2024e–2027e CAGR of 13%) thanks to the company’s scalable business model and high operating leverage.

Evidence

Customers migrated to highly automated platform – scalability and pricing power

The completion of the platform migration implies two factors that are likely to improve margins: 1) The new platform is more automated, meaning some reports that previously required employee time to complete are now generated by a simple click, meaning less human resources are required. Moreover, the employees required for certain tasks previously were expensive hires with PhDs, but these tasks can now be performed by more junior colleagues. 2) Less manual work means less room for human error, with the elimination of previous, time-consuming mistakes, reducing the required personnel. As customers have moved to the new platform, Nepa has introduced price increases for recurring subscriptions as of Q1 2022. These will be almost fully implemented in Q1 2023, we believe. Despite the price hikes, no customer has been unwilling to switch, indicating a solid value proposition and good pricing power.

Supportive Analysis

Before 2021, Nepa had practically no dedicated salespeople, but it still grew its sales. In mid-2021, Nepa conducted very basic tests with marketing that showed strong results, prompting the company to establish a simple marketing plan that included targets for what would be sold to whom, and how. Although basic, it is more than the company had previously worked with. It has chiefly used LinkedIn ads with targeted campaigns to carefully specified target groups, which have yielded overwhelming results for Nepa. Thanks to this initiative, it has received interesting pilot projects with some of the world’s most famous brands. Nepa will continue expanding its efforts in sales and marketing.

Challenge

Scaling the business in a recession – but the company will cut cost base by almost 15%

Nepa is now moving into the second phase of its strategy: Expansion. Here, much more emphasis is placed on marketing and sales efforts. The additional sales personnel have naturally added to the company’s cost base. The company has also expanded its R&D efforts, further adding to its cost base. As the recession became obvious in Q4'22, the company announced cost savings of SEK31m per year, equivalent to almost 15% of its cost base. From this cost base (cost saving to be fully realized starting in Q2), Nepa aims to improve profitability by increasing its revenues while keeping its cost base relatively stable (two-thirds of cost base is scalable. While Nepa has a long and robust growth history, as the economy now appears to be heading into a recession, growth will naturally become more challenging. While we think the market is currently not anticipating the cost-saving program to bear any fruit, we think it will.

Valuation

Scalable software priced as a poorly run consultancy

In our Base Case, we estimate a 2023e–2027e sales CAGR of 8%, with the EBIT margin expanding from 6% in 2022 to 9% by 2027e. Using a DCF model, we value Nepa at a Base Case of SEK58, corresponding to a P/E ratio of 18x for 2025e. Our Bear Case is SEK28, and our Bull Case is SEK100. We believe the stock market’s perception of Nepa is far from ours. We see Nepa as a reasonably fast-growing (except for 2023), scalable software company on the verge of a long and strong margin expansion. In our view, the stock market prices Nepa as a poorly run consultancy.

Quality Rating

People: 4

Nepa is still run by its founder and main owner, Ulrich Boyer, who still owns 19.0% of the capital and votes in Nepa. Boyer has founded more than 10 companies (all linked to marketing) and has 20+ years of experience as a CEO. While we think Boyer does a good job as CEO, he is now 60 years old and says that he wants to step down in a few years when a good successor has been found. Thus, Nepa is only half-searching for a new CEO. However, once a new CEO is installed, Ulrich Boyer will likely return to his role as chairman of the board.

Former CEO P-O Westerlund resigned in 2021, citing personal health reasons, and still retains his 5.4% ownership stake. After initially having remained on the board of directors, Westerlund is no longer active in Nepa. The second largest owner is Elementa Fonder – a hedge fund with 17.4% of the shares. Elementa is quite active as an owner. In terms of institutional ownership, several well-known Swedish funds are found amongst owners.

Business: 4

Around 66% of Nepa’s revenues are recurring, and the remaining 33% are ad-hoc. However, customers with ongoing subscriptions occasionally order ad-hoc projects. Thus, revenues from customers with ongoing subscriptions constitute more than 80% of total revenues.

Historically, Nepa has had a very low and almost non-existent client churn. In the spring of 2020, during the outbreak of the pandemic, a few tourism-related customers paused their subscriptions. However, these customers quite quickly returned to normal subscriptions – even though their respective industries (and the companies themselves) were still severely hurt. We think this is a strong indication of the high stickiness of Nepa’s revenues.

Nepa enjoys market leadership in its core market, Sweden, where it has a ~50% market share for its core offering, i.e., its brand-tracking software. When it comes to procurements where Nepa is up against competitors, Nepa usually wins a very large percentage of these (as much as 90%, we have heard).

Nepa can grow with its customer in several dimensions – new markets, new modules, new customer groups, and new brands. The company aims to grow geographically along with its customers.

Financials: 3

Since its foundation in 2006, Nepa has had a long history of strong and consistent growth – except for 2009 and 2020, in which sales declined by 1% and 2%, respectively. 2009 was impacted by the financial crisis, whereas 2020 included Nepa completed a big restructuring program to improve profitability. Nepa has a solid sales CAGR of around 10% independent of which time period of the last ten years we measure.

Gross margin is high at almost 80% and has been slowly but steadily increasing for the last five years.

Before Nepa’s IPO in 2016, the company operated with a slightly positive EBIT margin. After the IPO, the company expanded unsuccessfully into the USA, which made Nepa unprofitable. In 2019, Nepa initiated a cost-cutting program and completed its turnaround in 2020. In 2021, profitability further improved – but mainly because Nepa didn’t invest in anything. The only focus was cutting costs and becoming a leaner organization. From 2022, investments have increased to enable platform migration and some new development. While the future profitability f looks bright, the company needs to prove its profitability for several years in order to gain a higher score.

Financials

Income statement
SEKm	2021	2022	2023e	2024e	2025e
Revenues	N/A	N/A	N/A	N/A	N/A
Cost of Revenue	64.1	76.0	79.4	80.9	84.1
Operating Expenses	181.1	205.3	198.3	192.3	206.3
EBITDA	50.3	30.9	10.0	38.1	46.1
Depreciation	10.2	0.00	0.00	0.00	0.00
Amortizations	0.00	11.2	12.9	14.4	16.2
EBIT	40.0	19.7	-2.9	23.7	30.0
Shares in Associates	0.00	0.00	0.00	0.00	0.00
Interest Expenses	2.3	2.7	0.60	0.00	0.00
Net Financial Items	1.6	2.1	0.04	0.80	0.80
EBT	41.6	21.8	-2.9	24.5	30.8
Income Tax Expenses	3.0	4.2	0.46	5.0	6.3
Net Income	38.6	17.5	-3.4	19.5	24.4
Balance sheet
Assets
Non-current assets
SEKm	2021	2022	2023e	2024e	2025e
Property, Plant and Equipment (Net)	0.83	0.91	0.81	0.70	0.58
Goodwill	0.00	0.00	0.00	0.00	0.00
Intangible Assets	30.8	46.9	60.0	72.3	80.2
Right-of-Use Assets	0.00	0.00	0.00	0.00	0.00
Other Non-Current Assets	0.91	1.1	1.1	1.1	1.1
Total Non-Current Assets	32.6	48.9	61.8	74.1	81.8
Current assets
SEKm	2021	2022	2023e	2024e	2025e
Inventories	0.00	0.00	0.00	0.00	0.00
Accounts Receivable	79.1	76.3	63.3	68.5	74.0
Other Current Assets	0.00	22.1	20.1	18.7	20.2
Cash Equivalents	85.1	63.8	44.5	54.9	71.8
Total Current Assets	164.1	162.2	127.9	142.0	166.0
Total Assets	196.7	211.1	189.8	216.1	247.8
Equity and Liabilities
Equity
SEKm	2021	2022	2023e	2024e	2025e
Non Controlling Interest	0.00	0.00	0.00	0.00	0.00
Shareholder's Equity	102.8	109.7	106.3	125.8	150.2
Non-current liabilities
SEKm	2021	2022	2023e	2024e	2025e
Long Term Debt	0.00	0.00	0.00	0.00	0.00
Long Term Lease Liabilities	0.00	0.00	0.00	0.00	0.00
Other Long Term Liabilities	0.00	0.00	0.00	0.00	0.00
Total Non-Current Liabilities	0.00	0.00	0.00	0.00	0.00
Current liabilities
SEKm	2021	2022	2023e	2024e	2025e
Short Term Debt	0.00	0.00	0.00	0.00	0.00
Short Term Lease Liabilities	0.00	0.00	0.00	0.00	0.00
Accounts Payable	23.5	27.6	25.9	28.0	30.3
Other Current Liabilities	70.4	73.8	57.5	62.3	67.3
Total Current Liabilities	93.9	101.4	83.4	90.3	97.6
Total Liabilities and Equity	196.7	211.1	189.8	216.1	247.8
Cash flow
SEKm	2021	2022	2023e	2024e	2025e
Operating Cash Flow	2.0	15.9	6.6	37.0	40.8
Investing Cash Flow	-10.6	-27.5	-25.9	-26.6	-23.9
Financing Cash Flow	0.00	-9.7	0.00	0.00	0.00

Rating definitions

The team

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