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Temenos faces a difficult decision

For longer-term considerations, it would make sense for the Geneva-based manufacturer of banking software to convert its business model to a subscription system. In the short term, however, this would be associated with pain. Will a private equity buyer step in?

Temenos has a problem. The Geneva-based manufacturer of banking software holds a leading position in a long-term and structurally growing market. His products are excellent and he counts well-known banks among his customers around the world. In the past few years he has succeeded in steadily expanding his position in the important US market.

Temenos is also the only thoroughbred representative of the software sector on the Swiss stock exchange, which is generally popular and highly traded in the financial markets.

Even so, his share price does not move. The stocks are currently trading a good 30% below their all-time high reached in May 2019.

In October, the price got momentarily buoyant when rumors got around that private equity groups were considering a Temenos acquisition. But then it became quiet again.

What is holding Temenos back?

There are primarily two reasons for this: First, software sales are only recovering slowly after last year's pandemic-related slump. Although Temenos recorded double-digit growth rates in the past quarters compared to the previous year, the business momentum is still well below the pre-crisis level of 2019.

Second, Temenos management is reluctant to follow the successful example of other software providers and to switch the business model from a license to a subscription system. This would be associated with short-term pain, but would promise more success and a higher valuation of the shares in the longer term.

Highly profitable business

First of all, the positive attributes of Temenos: The Geneva-based software offerings are leaders in the industry. The company has succeeded in winning large banks such as HSBC, ING, Julius Baer or Santander as well as smaller banks in emerging countries and challenger institutions from the fintech sector as customers.

The strategy pursued in recent years to gain a better foothold in the US market is bearing fruit: In 2014 Temenos generated just 10% of its sales in North America, in 2020 it was already 28%.

The software business is highly profitable; At the operating profit level before depreciation and amortization (Ebitda), Temenos generates margins of over 35% and return on invested capital (ROIC) of 15%.

In addition, banks still have a lot of catching up to do to modernize their software infrastructure. For Temenos and other providers such as Infosys Finacle, Fiserv or Oracle, this promises a structurally growing market environment over the years.

One-time royalty payments vs. recurring income

Temenos typically sells its software packages as a license, which is usually associated with a maintenance contract. The license triggers a one-off payment from the customer, and the maintenance contract also secures annual recurring income. For smaller banks as well as for customers from the fintech sector, Temenos has also set up a subscription model in the form of Software as a Service (SaaS) in recent years, which also generates recurring sales and since then - albeit from a lower base - between 25 and 30% grows.

The license sales are very profitable and generate a high cash flow thanks to their prepaid nature, but they are also volatile and difficult for analysts to assess: Depending on when a larger license deal is signed, the quarterly sales reported by Temenos can fluctuate considerably and on the stock exchange lead to - positive or negative - surprises.

In the global software business, the trend has been moving away from license sales and towards subscription models for several years. Salesforce was one of the pioneers of the SaaS model in the USA, and providers such as Microsoft and Adobe later successfully introduced a subscription model.

From the perspective of the financial markets, this model offers the great advantage that the sales reported by the provider largely consist of recurring income and are therefore much less volatile - a fact that is rewarded with a higher valuation in the shares of software companies.

In the business mix of Temenos, however, recurring income from SaaS and maintenance contracts only represents a good 50% of sales. Around 35% is still attributable to license sales, which is increasingly being penalized by the financial market with a penalty.

The stocks currently have a price / earnings ratio of just over 30. That is still appealing, but over the past three years there has been a steady contraction in the value of Temenos shares:

There is also growing customer interest in subscription models for software: If a bank has to shell out a one-off payment of $ 10 million for a Temenos license, then that is a capital investment for them (“capex”). If, however, she pays $ 3 million per year for a software subscription, then these are annually recurring operating costs ("Opex"), which she can also better plan for.

To be more precise: On the part of larger banks, a SaaS model is not in the foreground, as they sometimes have good reasons to continue to run their software on their own computers and not in a SaaS cloud. But larger banks are also increasingly interested in changing the billing mode from a license to a subscription model with operating costs that can be planned annually.

Interestingly, the subscription model is also more attractive for software providers, as it generates higher returns over a longer period of time. On the last investor day in February, Temenos pointed out that the net present value (NPV) of a subscription contract over ten years is around 70% higher than that of a conventional license and maintenance contract:

The net present value (NPV) of a SaaS contract (red bar) is significantly higher than the NPV of a license and maintenance contract (blue bar) over a period of ten years.

The net present value (NPV) of a SaaS contract (red bar) is significantly higher than the NPV of a license and maintenance contract (blue bar) over a period of ten years.

Source: Temenos

So why doesn't Temenos management do everything in its power to switch software sales to a subscription model as quickly as possible?

Change requires a valley of tears

The reason is likely to be the short-term effects caused by this changeover. A license agreement brings in a high one-off payment at the beginning of the term, while a subscription agreement only pays off over several years. As a rule of thumb in the industry, a subscription contract only reaches the breakeven point after three years compared to a license contract and is then more profitable on the bottom line.

That means: If the Temenos management should make the decision to convert, sales, profit and cash flow would initially collapse. This effect was exemplified by Adobe when the US provider of design software announced the switch to a subscription model in 2012:

Autodesk, a provider of software for architectural applications, went through the same process after 2016:

In both cases, revenues plummeted significantly over two fiscal years - Autodesk even posted a loss - before embarking on a steady growth path and rising well above the level it had before the changeover. In retrospect, the radical switch to a subscription model has paid off for both companies.

In Europe in particular, however, investors are apparently having trouble supporting a software provider in the process of this changeover. When the German industry giant SAP forced the abandonment of the license model last year, the share price collapsed from 140 to 90 € and has only recovered to around 120 € since then.

Software AG, also from Germany, suffered on the stock exchange for more than two years after it announced the switch to a subscription model in 2018.

Short-term action at the expense of margins?

The Temenos management around CEO Max Chuard and the influential Chairman of the Board of Directors Andreas Andreades seem to shy away from this path in order not to provoke a collapse in earnings and the share price. It would rather continue to push the licensing model, while hoping for additional growth from smaller customers with the SaaS offer.

However, this approach means that Temenos has to shimmy from quarter to quarter on the stock exchange. From a short-term perspective, management may even have the incentive to lure new license customers with discounts, which in the longer term destroys margins.

This is the situation of Temenos today: The company has a good market position and the right product range, but it has the wrong sales model, which forces its own management and sales organization to act at short notice. The switch to the long-term correct sales model would cause sales, profit and cash flow - and thus certainly also the share price - to collapse for around two years.

So what's the way out?

An almost perfect case for private equity

The starting point is theoretically perfect for a private equity buyer who could force a quick switch to the subscription model without the short-term pressure that a public company is inevitably exposed to on the stock exchange.

From this point of view, Temenos would be attractive to a buyer. In this connection, a few weeks ago at the SuperReturn conference in Berlin, a statement by Orlando Bravo made prudish: The founder of the private equity company Thoma Bravo, which specializes in software companies, announced the establishment of another fund with a volume of 35, according to the "Financial Times" Billion dollars.

Once the business model has been completely changed, Temenos' sales profile would consist almost entirely of recurring income, which means that it could be brought back on the stock exchange at a higher valuation or sold to an industrial buyer. According to information from The Market, Microsoft, Oracle and Salesforce have repeatedly shown interest in Temenos. But they, too, should be aware that switching to the subscription model would temporarily entail a collapse in business figures.

The Market has no information to suggest that a private equity firm is about to acquire Temenos. However, for the reasons described, The Market considers such a transaction to be sensible; As a public company, Temenos has to contend with too much headwind in the event of a change in its business model.

At a price in the area between CHF 150 and CHF 170 per share, the board of directors should be prepared to accept a takeover offer, according to The Market. Major shareholder Martin Ebner, who holds a good 10% of the shares, would also be willing to sell at this price.

Based on these considerations, The Market recommends Temenos to buy at the current price of CHF 120. However, a clear warning is appropriate: If the Temenos management, contrary to expectations, decide to switch to the business model as a public company, the share price - similar to SAP a good year ago - would likely fall well below CHF 100.