Seamless Distribution Systems: Important quarters ahead

Research Update

2024-02-20

07:20

Redeye revises its estimates and valuation on the back of the Q4 2023 report, which came in below our expectations. While the company continues to replace low-margin sales from SDD with recurring revenues, the financial leverage remains on the high end.

Anton Hoof

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Q4 – below expectations

Net sales amounted to SEK58m in Q4 2023, 20% below our expectations, primarily due to lower recurring revenues and a weaker quarter for SDD. On a positive note, margins held up impressively, and EBITDA margin increased from 20% in Q3 to 28% in Q4. EBITDA amounted to SEK16m, compared to our estimate of SEK22m, and EBIT landed at SEK6m compared to our estimate of SEK9m. The deviation is explained by the lower sales, while underlying Opex came in lower than expected.

Financial situation – still uncertain

Although SDS almost achieved its 2023 targets, weaker-than-expected cash flow and an uncertain financial situation persist. New bond terms allow a Net debt/EBITDA of 7x as of 31 December 2023 and 6x thereafter. With a year-end ratio of 6.8x, SDS faces tight financial headroom. To meet covenants ahead, improved cash flow in H1 2024 is crucial.

Valuation

Following the report, we have made a downward sales revision, lowering sales by 11% in 2024e and 8% in 2025e-2026e, primarily due to lower recurring revenues and sales in SDD. While the company continues to replace low-margin sales from SDD with recurring revenues, the financial leverage remains on the high end. Our new base case stands at SEK16 (SEK19), and the fair value range is SEK6-27 (SEK9-36).

Key financials

SEKm	2022	2023	2024e	2025e	2026e
Revenues	279.2	290.9	254.8	270.8	279.0
Revenue Growth	-8.0%	4.2%	-12.4%	6.3%	3.0%
EBITDA	9.8	62.0	80.0	92.5	95.8
EBIT	-48.6	17.0	43.0	58.1	59.6
EBIT Margin	-19.8%	6.4%	16.9%	21.4%	21.3%
Net Income	-75.4	-16.0	12.0	26.5	28.4
EV/Revenue	0.7	1.1	1.2	1.1	0.9
EV/EBITDA	18.6	5.3	3.9	3.2	2.7
EV/EBIT	-3.8	19.1	7.3	5.0	4.4

Q4 numbers – Below expectations, margins holding up

SDS reported net sales amounted to SEK58m, below our expectations of SEK70m. Regarding the sales mix, New sales landed on SEK17.2m compared to our estimate of SEK18m, Recurring revenues amounted to SEK33.6m compared to our estimate of SEK38m, and Re-occurring revenues amounted to SEK7.6m, below our expectations of SEK14m.

Looking at the profitability, SDS’s EBITDA landed on SEK16.1m, below our expectations of SEK22m. EBIT was SEK6.2m, lower than our estimate of SEK9m. The deviation is explained by the lower sales, while underlying Opex came in lower than expected.

Cash flow from operations amounted to SEK-5.5m, compared to SEK-5.8m in Q4 2022. The operational cash flow was negatively affected by working capital changes of SEK-27.6m. The cash position was SEK3.7m at the end of the quarter.

SDS Group: Forecast deviations
0.00	#REF!	0.00	0.00			Actual	Estimate
SEKm	Q3 22	Q4 22	Q1 23	Q2 23	Q3 23	Q4 23	Q4 23e	Diff (%)
Recurring - SDS	31	30	35	36	38	34	38	-14%
New sales - SDS	23	-12	17	20	11	17	18	-5%
Reoccurring - SDD	22	19	17	17	15	8	14	-82%
Net sales	76	37	69	73	64	58	70	-20%
Growth YoY (%)	-3%	-52%	10%	6%	-16%	56%	88%	-32pp

Gross profit	48	15	49	52	44	50	51	-2%
Gross margin (%)	64%	40%	70%	71%	69%	86%	73%	13pp

EBITDA	19	-34	14	19	13	16	22	-34%
EBITDA (%)	25%	-91%	20%	27%	20%	28%	31%	-3pp

D&A	-12	-23	-11	-12	-12	-10	-12	25%

EBIT	7	-57	2	8	1	6	9	n.m.
EBIT (%)	9%	-152%	4%	11%	1%	11%	13%	-3pp

Net finance	-7	-7	-7	-7	-8	-9	-8	4%
PTP	0	-64	-4	1	-8	-3	1	n.m.
Net income	0	-66	-5	0	-8	-3	1	n.m.
Source: Redeye (estimates), company data (historicals)

All in all, we consider the quarter rather soft, with both sales and cash flow falling short of expectations. However, we are impressed by the margins, which held up remarkably well despite the lower sales. This is primarily due to the lower sales in SDD, which is a lower-margin business, but also due to solid cost control. Despite a decline in recurring revenues from Q3, following three consecutive quarters of q/q growth, the management expresses confidence in returning to growth in 2024. We think the highlight of the report is the announcement made earlier in the week regarding the initiation of a strategic partnership with Emida Technologies to enter the Latin American market. This move aligns with the CEO’s goal, set since joining the company in 2023, to expand into the Latin American market.

Regarding new orders, at the end of January, SDS announced a new order worth SEK8.8m from an existing customer in Oman. The order includes the development of software and services, and revenue is expected to be recognized when the services have been implemented by the customer, which is expected to be in Q2 2024.

Recurring revenues give stability in turbulent times

SDS's recurring revenues have stabilized at around SEK30m per quarter since Q3 2021, and for the full year of 2023, they amounted to SEK143m, representing approximately 54% of the company's total sales and up from SEK121 in 2022 (a y/y growth of 18%). Our understanding is that the higher recurring revenues stem from a heightened focus on supporting fees for new contracts, alongside a general increase in new sales. This could also indicate that the implementation of the new strategy, focused on offering more standardized products, is proving to be successful. However, after having three consecutive quarters with q/q, recurring revenues declined by 11% compared to Q3.

As the interest in Riaktr's products, Smart S&D, and Smart Capex continues to grow, along with continued New sales, we anticipate that recurring revenues will increase and make up a larger proportion of total revenues. As SDS's revenues increasingly shift towards recurring revenues, we expect to see improved margins and enhanced stability, which will make SDS a more attractive investment opportunity moving forward.

Entering Latin America

Earlier this week, SDS announced a new collaboration with Emida Technologies. This strategic partnership signifies SDS’s entry into the Latin American market, a goal SDS’s CEO has aspired to achieve since joining the company. Emida Technologies has maintained a presence in Latin America for over 20 years, and the shared objective of both companies is to enhance customer value by combining their knowledge and products. Overall, we think it makes sense to enter the Latin American market by collaborating with an existing player. However, we think we need more information before having a strong opinion about the partnership. For instance, we need more details on the incentives driving Emida Technologies to collaborate with a former competitor and the actual timeline for the expansion.

Slightly below 2023 targets

After the Q4 report, we can conclude that SDS reported net sales of SEK208m (excluding SDD) and an EBITDA of cSEK62m for the full year of 2023, somewhat lower than its 2023 targets of SEK216m in net sales and SEK72m in EBITDA. These targets were communicated during talks with bondholders and shareholders in March 2023, which also led to changes in bond terms. Considering the expected variability in SDS's business, where order intake can fluctuate between quarters, we believe the small deviation is of minor importance.

Financial situation

While SDS came close to meeting its 2023 targets, the cash flow has been somewhat weaker than expected, and the company's financial situation remains uncertain. The new bond terms mean that SDS can have a leverage ratio of 7x EBITDA, excluding capitalized costs, as of 31 December 2023 and 6x thereafter. For the full year of 2023, SDS's EBITDA was SEK32m (excluding capitalized costs), resulting in a ratio of 6.8x by the end of December, leaving little room for error. Additionally, SDS has exercised its right to defer two interest payments on the bond loan in the second half of 2023, incurring an interest rate of 2% on the deferred amount. These deferred payments can be repaid in conjunction with the bond maturity in May 2025.

To meet its covenants going forward, there is a need for an improvement in cash flow during H1 2024. We anticipate this improvement, considering the working capital that has been built up since Q2 2023. Additionally, it is crucial for both sales and EBITDA to remain solid throughout 2024.

Financial forecast

On the back of the report, we have made adjustments to our sales estimates, lowering sales by 11% 2024e and 8% 2025e-2026e. The downward revisions are primarily due to lower recurring revenues and sales from SDD. Given that we pencil in lower sales for SDD 2024e-2026e, we also expect a higher gross margin going forward. Regarding costs, we are making minor revisions. In total, we have lowered our EBITDA estimates by 5% for 2024e and by 3% for 2025e-2026e, respectively.

Forecast adjustments
SEKm		2024e	2025e	2026e
Net sales	Old	285	294	305
	New	255	271	279
change (%)		-11%	-8%	-8%
EBITDA	Old	84	95	98
	New	80	92	96
change (%)		-5%	-3%	-3%
EBIT	Old	44	56	59
	New	43	58	60
change (%)		-2%	3%	1%
Source: Redeye

Although the growth rate for 2024e-2026e may appear conservative, it is largely influenced by the anticipated negative growth in the SDD business. However, we expect the growth in the SDS business to offset this decline. While SDD operates with relatively low margins, we anticipate that the sales from the SDS business will contribute to overall margins and offer scalability. As a result, we expect a gradual improvement in margins in the coming years, even with a flat top-line growth.

SDS Group: Financial forecasts
SEKm	2022	2023	Q1 24e	Q2 24e	Q3 24e	Q4 24e	2024e	2025e	2026e
Recurring - SDS	121	143	37	39	42	42	160	179	190
New sales - SDS	40	65	16	18	16	19	69	70	71
Reoccurring - SDD	84	56	8	7	6	5	26	22	19
Net sales	245	265	61	64	64	66	255	271	279
Growth YoY (%)	-15%	8%	-13%	-12%	-1%	13%	-4%	6%	3%

Other income*	34	26	0	0	0	0	0	0	0
Total revenue	279	291	61	64	64	66	255	271	279

COGS	-97	-72	-12	-12	-11	-11	-47	-46	-44
Gross profit	149	193	48	52	52	55	208	225	235
Gross margin (%)	61%	73%	79%	81%	82%	83%	82%	83%	84%

Personnel	-84	-84	-19	-20	-20	-21	-80	-83	-88
External	-64	-43	-12	-12	-12	-12	-48	-50	-52
Other costs*	-24	-29	0	0	0	0	0	0	0

EBITDA adj	10	62	17	21	20	22	80	92	96
EBITDA adj (%)	4%	23%	28%	32%	32%	33%	31%	34%	34%

Non-recurring	0	0	0	0	0	0	0	0	0

EBITDA	10	62	17	21	20	22	80	92	96
EBITDA (%)	4%	23%	28%	32%	32%	33%	31%	34%	34%

D&A	-58	-45	-9	-9	-9	-9	-37	-34	-36

EBIT	-49	17	8	11	11	13	43	58	60
EBIT (%)	-20%	6%	13%	18%	18%	19%	17%	21%	21%

Net finance	-24	-31	-7	-7	-7	-7	-28	-25	-24
PTP	-72	-14	1	4	4	6	15	33	36
Net income	-75	-16	1	4	3	4	12	26	28

EPS	-7.2	-1.0	0.0	0.2	0.2	0.3	0.8	1.7	1.8
EPS, diluted	-7.2	-1.0	0.0	0.2	0.2	0.3	0.8	1.7	1.8
Source: Redeye (forecasts), company data (historicals)
*Other income/costs consists of exchange gains/losses.
*Redeye do not factor in any potential impact from exchange rate fluctuations in our forecasts.

Valuation

We derive our fair value range from a fundamental DCF framework for three scenarios, base case (most likely), bear case (pessimistic), and bull case (optimistic), using a WACC of 13% across all scenarios.

SDS Group: Base Case sensitivity

				WACC
	15.7	14.5%	13.5%	13.0%	12.0%	11.0%
	25%	7	9	10	12	14
	30%	9	11	12	14	17
Terminal	40%	12	14	16	19	23
EBITDA-m	45%	13	16	18	21	26
	50%	15	18	20	24	29

Source: Redeye

Bear Case: SEK6(9)

Sales CAGR 2023-2027e of -1% and 2027e-2032e of 0% (3%)
Avg. EBIT-m 2023-2027e of 13% (10%) and 2027e-2032e of 13% (20%)
Terminal growth of 2% and a terminal EBIT-m of 25%
WACC: 13%

Base Case: SEK16(19)

Sales CAGR 2023-2027e of 1% and 2027e-2032e of 3% (4%)
Avg. EBIT-m 2023-2027e of 17% and 2027e-2032e of 22% (25%)
Terminal growth: 2% and a terminal EBIT-m of 29%
WACC: 13%

Bull Case: SEK27(36)

Sales CAGR 2023-2027e of 6% and 2027e-2032e of 4% (7%)
Avg. EBIT-m 2023-2027e of 22% (18%) and 2027e-2032e of 27% (30%)
Terminal growth: 2% and a terminal EBIT-m of 35%
WACC: 13%

Investment thesis

Case

Expanding within the installed base

Thanks to current challenges, both market sentiment and investor confidence have soured, and the share is trading below our bear case. However, despite these obstacles, we acknowledge a compelling long-term case where the current depressed share price presents an attractive entry point. We anticipate a gradual improvement in margins as the company executes its strategy of prioritizing standardized product offerings. This strategic shift will enhance the scalability of the business, ultimately leading to a more efficient and profitable operation. Additionally, we expect recurring revenues to continue their upward trajectory, thereby augmenting the overall stability of the business. This positive trend in recurring revenues is likely to mitigate risk and reduce the associated risk premium, ultimately enhancing the investment proposition.

Evidence

Proven playbook for growth

SDS gained its first contract from MTN Group (Africa’s largest mobile operator group) in 2006 and currently serves 18/20 of its operators and MTN has become SDS’s largest customer. Therefore, we think SDS has a proven playbook for this type of expansion. This should come in handy when increasing sales to more recent customers such as Telenor, Vodafone, and Orange – all won or acquired in recent years.

Supportive Analysis

The global prepaid and top-up market is worth around USD600bn, fueled by Africa's exceptional prepaid penetration rates (>90%). This large and growing market is set to benefit from population growth, improved connectivity, and user penetration in Africa. The digitalization of Africa enables SDS to launch additional and more advanced services and solutions.

Challenge

Slow-moving customers with bargaining power

We assume the size of SDS’s customers – some of the largest mobile operator groups in Africa and the Middle East – give them the natural upper hand around the negotiation table. Moreover, we anticipate bureaucratic and long purchase processes and scepticism towards new and innovative products thanks to their size. This could hamper topline growth.

Challenge

Higher interest rates

SDS issued a SEK200m bond in 2021 to finance the acquisition of Riaktr and replace existing loans. The bond has an expected maturity of three years and carries a three-month STIBOR plus 8.75% interest. Standalone, the 8.75% gives rise to annual interest expenses of SEK17.5m. In this higher interest environment, each 1%-point STIBOR increase incurs an additional SEK2m in expenses.

Valuation

Forecasting improved margins

Our DCF analysis indicates a Base Case of SEK16 per share (Bull: SEK27; Bear: SEK6) based on a 2% sales CAGR during our forecast period (2021-2034e) and a 29% terminal EBIT margin.

Quality Rating

People: 2

The high CEO turnover incurs a negative effect on this rating. However, most of the management team has stayed in the company for an average of more than five years and appears to have relevant skills and sector experience. We appreciate a sound long-term growth strategy and believe the latest acquisitions have strengthened the core offering. Moreover, we think the board appears to be objective and practical and is composed of shareholder-oriented directors. Last, we believe the company lacks a firm controlling owner, which also hampers this rating.

Business: 3

The business model is repeatable and scalable, and the company has a history of successful expansions into new markets. We believe the company operates in favourable market structures, which provide a meaningful runway for growth. However, we are a little uncertain regarding the underlying market’s profitability due to lacking data. SDS’s products offer great customer value and solve a genuine need for a focused customer group: mobile operators in emerging markets. We think SDS currently enjoys market leadership and has a moat built-in to its business model: switching costs. However, this rating is hampered by high customer concentration and exposure to emerging markets.

Financials: 1

While the company is currently unprofitable and facing some financial uncertainty, there are some positive developments to note. Specifically, the company is in the process of transitioning towards a business model that emphasizes recurring revenues with higher margins. This shift should help to support more sustainable profitability over the long term. That said, to score higher in our rating, the company will need to address its financial situation and work towards achieving greater stability in its operations.

Financials

Income statement
SEKm	2022	2023	2024e	2025e	2026e
Revenues	279.2	290.9	249.5	260.7	273.8
Cost of Revenue	96.8	71.9	46.8	44.6	43.2
Operating Expenses	172.6	157.0	127.8	133.0	139.7
EBITDA	9.8	62.0	74.9	83.1	91.0
Depreciation	3.2	3.9	1.7	1.8	0.00
Amortizations	51.6	37.0	32.7	30.0	35.6
EBIT	-48.6	17.0	37.9	48.7	55.4
Shares in Associates	0.00	0.00	0.00	0.00	0.00
Interest Expenses	23.5	30.9	35.2	35.2	35.2
Net Financial Items	-23.5	-30.8	-35.2	-35.2	-35.2
EBT	-72.1	-13.8	2.7	13.5	20.2
Income Tax Expenses	3.3	2.2	0.54	2.7	4.0
Net Income	-75.4	-16.0	2.2	10.8	16.2

Rating definitions

The team

Disclosures and disclaimers

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