Lectra develops specialized software and cutting systems (CAD/CAM equipment) and provides associated services to customers in the fashion (apparel, accessories, footwear), automotive (car seats and interiors, airbags), and furniture industry. The software is used for design and production. The cutting systems are fully automated cutting fabric at high-speed with optimizing material usage. Though a French company, they generate 90% of its revenue outside of France and 53% outside of Europe. Management holds 38% of the shares outstanding.
The company has a very strong position with a market share of 25% – 30% resulting from high R&D expenses and an extensive sales and services network which enables the company to generate more than 90% of its revenue directly. Lectra serves approx. 23,000 customers in more than 100 countries. Dependence from single customers is relatively low. In 2012, no customer represented more than 6% of revenues and the ten largest customers combined accounted for less than 20% of revenues.
Approx. 58% of revenues are generated from recurring revenues, consisting of maintenance and support. This is good to have as visibility of this revenue stream is highly predictable. The gross profit generated by recurring revenues alone covers more than 75% of annual fixed overhead costs. The remaining revenue is coming from new system sales (software and CAD/CAM equipment).
Before I go into further detail, I should mention, that the information I am using is mainly coming from the very good company’s annual reports.
Lectra claims to be the technological leader in its market. Most of their customers come from the fashion and automotive sector. The company’s high end products help its customers to optimize material usage, reduce time-to-market, improve quality and satisfy the demand for mass-customization leading to high level of productivity and cost savings for the customers.
In the fashion sector (49% of revenue), Lectra profits from demand coming from luxury and fast fashion companies. The luxury sector is growing due to increased demand from emerging markets. At the same time high quality products are key for luxury brands. Fast retailers depend on extremely fast collection renewal times. In addition, an increasing number of companies are repatriating their apparel manufacturing due to increased labour costs in China, lengthy shipping times and exchange rate fluctuations. Lectra’s products can compensate for increased labour costs at home. Apart from that, with fabric representing approx. 60% of finished product costs, minimizing wastage has now become a priority for manufacturers.
Interestingly, cost of poor fit seems to be a substantial drag on profitability for fashion companies as management outlines in the annual report:
“Another major challenge faced by fashion companies today is managing fit across multiple populations, taking highly diverse morphologies into account. Indeed, the cost of poor fit is extremely high: experts estimate that one in five articles of clothing are returned due to fit issues, rising to one in three for online purchases. Fashion companies must therefore optimize their fit-related processes, including prototyping, and become experts at managing a wide range of body shapes and sizes.”
Based on the company’s information Lectra is the world leader in the fashion segment. In France and Italy they claim to hold a market share of more than 70%.
In the automotive sector (37% of revenue) leather is gaining market share resulting in increasing raw materials prices and demand for high precision cutting processes. Lectra offers high quality solutions by minimizing wastage at the same time to the automotive suppliers. Apart from that, the high variety of combinations for each car model combined with short production runs require the rationalization of design and production processes. The industry is currently moving from fixed cutting methods which are only worthwhile investments where very long series are involved, to automated cutters enabling considerable flexibility. Lectra is offering this equipment as well. In addition to that, Lectra is holding an 80% share in cutting machines for airbags, a market expected to grow by annually 6% until 2015.
From the table below you can see the company’s performance since 2007:
|in million euros||2007||2008||2009||2010||2011||2012|
|FCF excl WC||6.5||6.5||-0.5||20.8||24.0||16.4|
During the recession the business has been relatively resilient. Although in 2009 the company faced a 50% drop in new system sales, operating profit was only slightly negative resulting from the high proportion of recurring revenue. While new system sales are volatile, recurring revenues, after also having been impacted, now exceed their 2007 levels by 10%. Over the last couple of years the company reduced costs. In addition, they profited from pricing power due to its relatively high quality products and incoming orders which had been postponed due to the crisis.
In 2012, the company has started a cumulative investment programme of EUR 50 m which will last until 2015. The programme consists of a recruitment plan devoted to strengthening its sales and R&D department. This will weigh on operating profit in the next couple of years, as it did in 2012, but management is optimistic to keep profit margins at least constant at the 2012 level.
Cash Flow Generation
Looking at the table above what clearly stands out is Lectra’s sustainable cash generation. So let’s have a closer look at cash flows:
|in million euros except for per share data||2007||2008||2009||2010||2011||2012|
|Operating CF before WC||11.6||10.2||1.4||22.8||27.6||21.3|
|FCF excl WC||6.5||6.5||-0.5||20.8||24.0||16.4|
|FCF excl WC/share||0.21||0.23||-0.02||0.74||0.82||0.56|
Free cash flow generation was very strong over the last three years.
Changes in working capital are heavily influenced by receivables stemming from a research tax credit (Crédit d’Impôt Recherche) due to the companies high R&D spending. When the research tax credit recognized in the year cannot be charged against income tax, it is treated as a receivable on the French tax administration. If unused in the ensuing three years, it is repaid in the course of the fourth year.
At the end of 2012 total tax receivables summed up to €15.7 m corresponding to the research tax credit of 2010, 2011 and 2012, which have not been received and have not been offset against a tax charge. Management expects to receive reimbursement of the balance outstanding of research tax credits not deducted in 2014 (in respect of the 2010 tax credit), 2015 (in respect of the 2011 tax credit), and 2016 (in respect of the 2012 tax credit). This situation is expected to last for as long as the amount of the annual research tax credit exceeds the amount of income tax payable.
As a consequence, R&D spending which is fully expensed in the income statement, is partially subsidised by the French government. Before deducting the research tax credit applicable in France and certain R&D program grants, R&D costs amounted to EUR 17.4 m in 2012 and represented 8.7% of revenues (compared with EUR 18.2 m and 8.9% in 2011). Net R&D costs after deduction of the French research tax credit and grants amounted to EUR 11.5 m (EUR 11.5 m in 2011). The French government has pledged to maintain the research tax credit unchanged for the duration of the president’s current five year term. There is a risk that this law will be scrapped or changed after that period. However, government support for “innovative” businesses has been a part of French politics for decades and I do not believe that this will change in the near future.
Return on Invested Capital
Looking at the balance sheet, another positive issue with this company is the very low requirement for working capital. Working capital in 2012 amounted to only EUR 2.3 m. Excluding the receivable of EUR 15.7 m on the French tax administration working capital was actually negative at EUR 13.4 m. This is due to a high amount of deferred revenues as Lectra is able to demand substantial down payments from customers to fund work in progress. Obviously, this has a very positive effect on ROIC. Including goodwill, I am conservatively estimating invested capital to be approx. EUR 60 m. This also includes an upward adjustment for their commercial site in Bordeaux-Cestas, which is only represented with a net value of EUR 3.9 m in the balance sheet. However, management is of the opinion that the value of the site currently exceeds its historical cost of EUR 10.7 m.
Based on a net profit of EUR 12.3 m and an invested capital of roughly EUR 60 m, I am estimating a strong ROIC of 20.5% for 2012.
The company has substantial stock options outstanding with the potential to be dilutive for existing shareholders. If all of the options were exercised, regardless of whether these are fully vested or have not yet vested, and regardless of their exercise price relative to the market price of Lectra shares at December 31, 2012, the number of shares could increase by 10.2% to approx. 32.3 m. However, it seems not likely that all options will be exercised. Nevertheless, given a current share price of EUR 6.5 and exercise prices in a range from EUR 2.5 to EUR 6.3 an exercise of at least a large number of stock options seems to be possible in the future.
Over the last three years the company was able to generate on average EUR 20 m of free cash flow per annum. This time period reflects substantial cost decreases in fixed overhead costs of approx. 20%. With EUR 6.3 m of free cash flow (FCFF) ignoring the negative effect on working capital from the activated tax refund receivable and a positive non-recurring cash flow of EUR 11.1 m, H1 2013 numbers indicate a lower free cash flow for full 2013. This is mainly the result of the investments made to further strengthen sales&marketing and R&D. So to be conservative I am estimating that Lectra will be able to generate EUR 15 m of FCFF going forward.
Based on this assumption, with a current market cap of EUR 190 m, EUR 7.8 m of debt/pension liabilities and a cash balance of EUR 23.3 m, the company is offering a free cash flow yield of 8.6%.
In 2011, Lectra’s major competitor Gerber was acquired by Vector Capital for USD 11 per share “plus a non-transferable contractual right to receive additional contingent cash consideration payments if net recoveries are obtained in connection with certain claims for infringement of a Gerber Scientific patent covering print to cut technology”. Based on the information of this website Gerber’s market cap at a share price of USD 11 was USD 276.1 m. Adding net debt of USD 10.2 m the acquisition value (enterprise value) sums up to USD 286.3 m ignoring the value of the contractual right. The average EBITDA from 2007 to 2011 Gerber was USD 23.9 m translating into an EV/EBITDA of 12.0x. During that time period Gerber suffered from low profitability and they are also offering other products than CAD/CAM equipment. Nevertheless, Lectra is currently trading substantially below that level at an enterprise value to 5yr average EBITDA of only 8.3x.
Based on my information Lectra has a technological edge compared to its competitors due to high R&D spending in the past and a strong distribution network. This leads to a high market share and a certain level of pricing power. Apart from that, secular changes in the fashion and automotive industry support demand for Lectra’s products. The quality of its business model enables Lectra to generate a high ROIC and to cover a large portion of its cost base with recurring revenue. In addition, an alignment of interests is given between management and shareholders, as management is holding 38% of the company.
There is a small risk that the current research tax credit will be scrapped. Moreover, one has to keep an eye on the company’s stock option programme as it has the potential to become relatively dilutive for existing shareholders. Nevertheless, at least the second aspect plays only a minor role in evaluating the company. More important is the question, whether Lectra will be able to capitalize on the challenges its customers are facing at the moment and whether potential growth should be included in the valuation of the company. However, at the current share price the company offers an attractive 8.6% free cash flow yield ignoring any growth prospects. So from my perspective any growth the company might be able to achieve in the future comes on top, but is not necessary to justify an investment in this company.
I will start with a 2% position for the portfolio with a share price limit of EUR 7.0. Liquidity is relatively low and it might take approx. 5 trading days to set up the position assuming Wertart Capital trades one third of daily volume. Please click here for more information on WertArt Capital and the virtual portfolio.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always do your own research!