RS2 Software in transition phase

Financial Article 483 by Edward Rizzo - Apr 27, 2017

Last week, RS2 Software plc published its preliminary set of financial statements for 2016 and immediately convened a meeting for financial analysts. In a separate announcement two days later, the company also published its annual report incorporating the full set of financials including the CEO’s message to shareholders.

Many shareholders and analysts may have been taken by surprise at the headline figures. The Group’s earnings before interest, tax, depreciation and amortisation (EBITDA) amounted to only €2.13 million compared to €8.28 million in 2015 and pre-tax profits slumped to €0.88 million from €6.43 million in 2015.

The meeting with analysts was held at the RS2 office in Mosta and a video conference was held with the the company’s office in Germany where the CEO Mr Radi El Haj was present. He commenced the meeting by commenting that “2016 was a year of expansion and investment and the continuation of the implementation of our strategy”. The CEO also stated that the company registered a “strong business performance”. It is worth emphasising that Mr El Haj used the term ‘business’ and not ‘financial’ which would give it a rather different meaning. In fact, in the message to shareholders in the Annual Report, the CEO explained that the strong business performance is measured “in terms of revenue, current client portfolio and potential client pipeline”.

I will be delving into each of these matters separately in order to explain to investors how this positive performance is being interpreted in the eyes of the CEO.

Overall Group revenue during 2016 ‘only’ declined by 11.7% to €17.2 million with the main reason being a drop of €1.5 million in service fee income to €10.5 million and a decline of €500,000 in licence fees to €3.4 million. The CEO explained in the Annual Report that “the decrease in revenue is attributable to the implementation of our strategy of intensifying our focus on the managed services business”. During the video conference, the CEO explained the change in their business model in further detail. In the licensing business, which until recently was the core business area of RS2 as evidenced by the agreement with Barclays plc in 2013, the company is now adopting a very selective approach in order to avoid competition in certain markets. In the Annual Report, the CEO amplified upon this point further by stating that going forward, “licence sales will depend on the geographical markets RS2 considers to be strategic where licence clients do not compete with the Group’s managed services business”. Mr El Haj continued by explaining that the company is active in promoting the licensing business in the Asia Pacific and Latin American markets but the company is being very selective in the US and Europe since there is “considerable potential for our managed services business”. In fact, the CEO announced to financial analysts that during 2016 the company refused two significant licensing contracts with potential clients in Europe since they believed that this was not in the best interest of the company and its shareholders in the longer-term.

Shareholders are naturally more interested in the profitability of a company rather than the top-line revenue item. In fact, as noted above, EBITDA declined to €2.13 million and pre-tax profits amounted to only €0.88 million. Mr El Haj also warned that “due to the different inherent characteristics of revenue recognition between the licence and managed services, this may result in lower revenue and profitability in the interim period until stabilisation occurs”.

During 2016, RS2 incurred significantly higher costs in part due to the new offices in the Philippines and in Denver (US) as well as a higher staff complement and marketing efforts. This reflects the strategy of expansion and investment being undertaken by RS2 which is now gathering momentum. The other major factor behind the decline in the profitability was the negative impact from foreign exchange movements (mainly in Sterling). A sizeable part of the company’s income is generated in sterling and on conversion to euro for financial reporting purposes, a loss on exchange was recognised to the tune of €1.4 million.

Basically, these additional costs are being incurred as the company is gearing up for the very strong business pipeline ahead. In fact, in his message to shareholders, the CEO explained that the potential clients range from various new markets around the world including the US, Brazil, Argentina, Columbia, Mexico, Australia, Vietnam, India, Thailand and Indonesia. In view of the current business presence already in Europe, Middle East, the US and Asia Pacific as well as the potential clients in the various countries mentioned above, Mr El Haj stated that RS2 is “truly an international company with worldwide presence”.

During the meeting with financial analysts, the CEO also highlighted that the managed services business currently has 4 clients with a further 8 clients in the ‘implementation phase’ which are expected to go live by the end of 2017. More interesting was the announcement that there are several other potential clients who are in advanced contract negotiations. If these are concluded successfully, they will then pass onto the implementation phase for several months where the company receives hundreds of thousands in implementation fees per client before eventually moving onto the ‘live’ phase when RS2 starts receiving regular income based on the number of transactions processed as well as other ancillary services such as authorisations, statements, etc.

A few months ago, the CEO had re-iterated that the company aims to start providing guidance on financial projections to the market. Last week, Mr El Haj explained that financial guidance will be provided once a critical mass of clients in the managed services business is achieved. The CEO argued that the licensing business is very unpredictable with long lead times for contract negotiations. Furthermore, revenue recognition often takes place upon the signing of an agreement and this can lead to sharp fluctuations in revenue and profits from one reporting period to the next as was evident in the past few years. On the other hand, the managed services business is easily predictable once clients start processing a certain minimum amount of transactions. It is likely that once the current eight new client implementations within the managed services unit are concluded in the months ahead and a critical mass of such clients is achieved, regular financial guidance to the market would then follow.

At last year’s Annual General Meeting, the CEO and other members within the Board of Directors provided ample insight into the globalisation plans of the company. Shareholders would do well to be present at the upcoming AGM on 20 June 2017 and understand the progress on the updated strategy in further detail. At the AGM, RS2 may also be in a position to announce the identity of some of the new clients that have recently signed up as intimated by the company in previous announcements.

This would be very important news for all shareholders and would enable them to gauge the success or otherwise of the company’s expansion and globalisation strategy. At the AGM, shareholders should also direct some pertinent questions to the executive management on the company’s financial and operational objectives going forward.

Shareholders need to become more active during Annual General Meetings by seeking information that would be helpful when deliberating on investment considerations.

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