We See Value in SS&C's Offering

It's clear that the IPO market has put an added emphasis on companies with strong fundamentals and higher overall quality recently. We saw this sentiment in action with the Financial Engines IPO from last week, which priced above its range and has climbed roughly 45% above its offer price.

Here comes another quality offering--SS&C Technologies. We labeled this IPO high interest a few months back, and we see value in the shares. Morningstar analyst Brad Meeks thinks the firm is worth $18 per share, above the $13-$15 range. His expanded thesis on SS&C is below:

"SS&C Technologies Holdings is coming to market after being taken private in a leveraged private-equity deal by the Carlyle Group. We think the time is right to bring this high-quality IPO to market. Additionally, the firm's competitive advantages should allow it to increase its level of profitability over time.

"SS&C provides over 60 specialized software products and software-enabled services that allow financial firms to automate business processes in their front, middle, and back offices. The firm's value proposition is strong in our view, as it allows financial customers to efficiently analyze and manage information, increase productivity, and reduce costs. This is especially compelling as firms look to manage expenses, increase transparency, and update their risk management practices in the current market environment. Further, it becomes extremely costly to support custom in-house applications (or legacy systems). It makes more sense to use SS&C's software-as-a-service (SaaS) capabilities to reduce cost while updating technology.

"In addition to favorable industry dynamics, we think the firm exhibits several competitive advantages. The scalability of its operations provides a significant benefit, allowing the firm to add customers and assets under management with limited additional costs. Coupled with organic revenue growth at a historical mid-double digit clip, operating margins have averaged in the low 20% range with EBITDA margins in the low 40% range over the last four years.

"Additionally, switching costs tend to be high due to the ingrained nature of the firm's software, which is integrated into the day-to-day operations of its clients. This competitive advantage can best be seen through SS&C's client retention rates, which are close to 90%. Further, SS&C's business model provides recurring revenues (with contracts ranging from two to seven years in length). This model helps minimize fluctuations in revenues due to the upfront, software license and maintenance fees incurred by its customers. In fact, recurring revenues have increased as a percentage of consolidated revenues from 52% in 2000 to 85% of total revenue by 2009.

"An investment in SS&C is not without risk. The firm is going public after being taken private by the Carlyle Group in November of 2005. Because the firm was a leveraged buyout, it is heavily levered for a software business. The firm will use a portion of the proceeds from the offering to redeem some of its high-yield debt. Further, the firm is highly correlated with the financial services industry. Banking consolidation, bank failures, or general market weakness can curtail spending on technology or force banks to build in-house systems. Although SS&C is a relatively small competitor in a fragmented industry and is reliant on the capital spending patterns of its financial services clients, we believe the firm has room to grow over time."

With respect to SS&C's valuation, Brad assumes a five-year CAGR of 10% due to increased technology spend, as well as significant margin expansion, as he explains below:

"Our fair value estimate for SS&C Technologies is $18 per share. Our fair value estimate is based on the assumption that the firm sells over 8.225 million shares at the firm's IPO mid-point price of $14 per share (raising $115 million in capital). SS&C will use roughly $76 million of the proceeds to retire debt, with the remaining cash used to fund its operations. Over the past few years the firm has fueled its growth by acquisitions in an effort to gain a market presence in several industry verticals. Our assumptions do not include future acquisitions. We anticipate a five-year CAGR of 10% from 2009 to 2014 as the firm benefits from increased spending on technology. We also anticipate operating margin expansion of 700 basis points from 25% in 2009 to 32% by 2014, mainly due to declining amortization of intangibles. Due to the large amount of intangibles amortization stemming from acquisitions, we believe EBITA margins more accurately reflect the true profitability of the firm. Based on our assumptions, we anticipate EBITA margins could increase 200 basis points to 38% by 2014 from 2009's 36%, as the company benefits from leveraging its fixed costs."