Kks

Accelya Kale Solutions

Buy above Rs.690/-

14th Mar, 2013

Find the right auxiliary business

If there is one industry that Warren Buffett has been most critical about it has to be
the aviation industry. The problem with the industry is that there are high fixed costs,
competition is intense and bargaining power with various stakeholders is low. This
results in a cost structure that is very vulnerable to macro headwinds. No wonder
then that historical y, investors have lost a lot of money in the airline industry across
the world.
While airlines may have been a bane for investors, it would be a big mistake to
overlook the fact that aviation has been one of the most important inventions of the
20th century. By providing fast and efficient connectivity across the globe, it has been
a vital aid to globe trade and commerce and has been a catalyst for social and
economic progress. Ever since airplanes came into existence, global passenger and
cargo volumes have grown at a phenomenal rate irrespective of the fortunes of
airline operators.
This is the reason the industry has not just survived but has continuously grown in
size over the last 100 years. What started with one passenger in 1914 has now grown
to over 3 billion annual passengers. In 2013 the total passenger volume stood at
about 3.1 billion. And this is set to grow to 3.3 billion in 2014. Thats a whopping 44%
of the worlds population! Each year, about 50 million tonnes of cargo is transported
by air. This comprises 35% of the value of goods traded internationally (Data source:
IATA).
So if your returns were linked to passenger and cargo growth and not to the
profitability of airline operators, you could have made handsome money.
This reminds of an interesting episode from the past. During the California Gold
Rush that started in 1848, about 300,000 people flocked to California to make
fortunes by mining gold. While few emerged very wealthy, many made little or no
gains out of this gold hunt. But irrespective of whether those miners found gold or
not, pick and shovel suppliers did make a lot of money.

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This brings us to an interesting point. Even within not-so-profitable main industries,
there can be auxiliary ways to build wealth if only you set your vision at the right
opportunity. So how must one go about investing in auxiliary businesses?
Here are some key attributes of fundamentally-strong auxiliary companies:
Products/services of the auxiliary industry must be critical to the main
industry and not discretionary.
Auxiliary industry must have favourable cost structure, strong balance sheet
and bargaining power.
Growth and profitability of the auxiliary industry must be linked to the output
of the main industry and not its profitability.
Auxiliary industry must have a fairly diversified client-base to avoid
concentration risk.
So the airline industry may continue with little or no profitability, but if you find an
auxiliary business with the right attributes, you could be in for some handsome
gains.

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About Accelya Kale Solutions Ltd.
I prefer to stay away from stocks and sectors which suffer from bad economics. Such
investments are unlikely to be long term wealth compounders. This is why I would
never touch aviation stocks even with a 10-feet pole. There is hardly any airline
operator in the industry that enjoys a strong moat and most do not generate
commensurate returns for shareholders.
Accelya Kale Solutions Ltd. (formerly known as Kale Consultants) is a small software
company based in Pune and Mumbai. Incorporated in 1989, the company has chosen
to be a niche IT service provider to the aviation industry. Accelyas competitive
advantage stems from its strong domain expertise and long term track record in the
airline industry. It has developed world class software products for airlines that are
critical for their business. These include products for revenue accounting, billing,
audit, business analytics, cargo handling and early warning systems, among others.
The company markets these products as an outsourced platform based service. This
means that airlines use Accelyas products on a pay-per-use model, while Accelya
handles the back-end services related to the product. This is beneficial for both
parties. Accelya benefits from a stable revenue stream that increases with the
number of passengers. At the same time, the airline is relieved of investing huge
amounts of money on capital expenditure relating to its in-house IT infrastructure.
Accelyas industry expertise and the quality of its products can be gauged by its longstanding relationships with marquee clients like US Air, Thai Airways, Gulf Air, Air
Canada, Etihad and Cathay Pacific, among others. This is where we believe Accelyas
economic moat lies. As the aviation industry as a whole becomes cost-conscious and
adapts to a low-cost business model, Accelya is very likely to be among the strongest
contenders for handling their software requirements.
In addition to this, the company has a strategic alliance with the International Air
Transport Association (IATA). It has developed products for the airline industry
under this partnership. Accelyas products are used by IATA to settle disputes
between airlines, record customer and flight data, monitor and measure performance
of travel agencies, handle settlements between airlines whenever passengers change
flights on long distance routes and many other applications. This means that Accelya
stands as a neutral third party in the airline industry. This has enabled the company
to develop deep domain expertise as well as to cater to the different needs of many
airlines around the world. The company has successfully used its knowledge to
develop products that have found wide acceptance by large global airlines. This is
amply demonstrated by the fact that the companys revenues are very well spread
out. No single geographical region contributes more than 30% of its revenues.

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To find out more, we met the companys management. The company is owned by
Accelya Holding World SL, a leading airline software solutions provider in Spain,
Europe. The parent company is owned by a private equity firm, Chequers Capital
which specializes in acquiring companies in partnership with its management. The
financial performance of the company has improved significantly since the new
promoters have taken over. The parent company has most of the large airlines as its
clients and this has benefited Accelya Kale. Due to the promoters focus on keeping a
tight lid on costs, the operating margin has improved from 20% in FY11 to 43% in
FY13. The company has paid out more than 100% of its net profits as dividends in the
last two years. The business model of the company is very asset-light, i.e. Accelya
does not need to spend too much on capex or continuous product development. This
will help the company maintain its strong financial health.
Accelyas revenues and net profits have grown at a compounded annual growth rate
(CAGR) of around 23% and 45% respectively over the last six years. The gross
margin has improved from 41% to 61% during this time while the Return on
Invested Capital (RoIC) has grown from 10% in FY07 to 148% in FY13. The
companys balance sheet is very strong. It is debt-free and has a cash balance of Rs
345 m as of FY13. The dividend yield also stands at an excellent 10% on a trailing 12
months basis.

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How Accelya Kale Solutions will improve its fortunes
A well-established presence in a niche market
Accelya Kale Solutions is a company focused on only one industry- Aviation.
It has exited from all other verticals like hospitality and logistics. This has
enabled the company to focus al its resources to develop high quality software
products for its customers. This approach has held the company in good stead.
Its products cater to the entire span of an airlines operations. Accelyas
products have achieved industry leadership positions global y, in the areas of
revenue accounting, streamlining of receivables and payables, audit
operations, card bil ing and cargo handling.
Accelyas clients use these products on pay-per-use or lease basis. This means
that every time a passenger books a ticket, or every time a cargo shipment is
successfully delivered, Accelya receives a small fee. This steady revenue
stream lends stability to the topline. About two-thirds of the companys
revenues come from such annuity-based revenue. This model helps airlines to
significantly cut down on their capex. As airlines around the world operate on
thin margins, Accelyas products play an important role in maintaining their
profitability and competitiveness. Accelya has pioneered this business model.
Around 60 airlines from around the world use Accelyas products.
Strategic partnership with IATA
Accelya has partnered with the International Air Transport Association
(IATA). As per this partnership, the company provides IATA with software
that is used on an industry-wide scale. IATA uses a software platform
developed by Accelya for the settlement of revenues between two or more
airlines on account of changes in the flight plans of customers. Along with
IATA, the company has developed a product for dispute resolution between
airlines. This enables the company to stand as a neutral third party in the
event of a dispute and solve the issue promptly. This is highly beneficial for
the airline industry, as it allows airlines to outsource their entire billing and
settlement process and focus on their core operations.
The partnership has helped Accelya develop an intimate understanding of the
airline industry that other IT companies cannot match. Accelya does business
with most airlines around the world (more than 200) through IATA. Accelya
has successfully made use of its domain expertise to deliver customized

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solutions for global airlines. An example is a product developed by Accelya for
airline managements which enables them to analyse their passenger data in
real time and make critical business decisions. In this manner Accelya adds
significant value to its clients business.
Strong support from parent (EBIT Margin %)
Accelya Kale is owned (74.66%) by Accelya Holding World S.L. which is
headquartered in Barcelona, Spain. The parent company is a leading software
and Business Process Outsourcing (BPO) service provider to the airline
industry in Europe. The original promoters of Kale Consultants sold their
entire stake in the company to Accelya between September 2011 and July
2012. The new management is shareholder-friendly and extremely costconscious. They have increased their stake in the company to the current level
via an open offer and a buyback.
The companys revenues have increased by 37% in the last two years. At the
same time, the employee costs have remained stable resulting in the
improvement in gross margin to 61% in FY13 from 41% in FY11. On
operating cost front, the company has cut back significantly on non-productive
expenses and is focusing on increasing its spending in areas that really matter.
The spending on sales and marketing as well as software development and
research has more than doubled in the last two years. The operating margin
has expanded from 20% in FY11 to 43% in FY13. During the same period, the
net profit has risen over four times. However the biggest improvement is seen
in the productive al occasion of capital by the management. This is reflected in
the steady improvement of the return on Invested Capital (ROIC) which now
stands at a staggering 148%.

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More about Accelya Kale Solutions
Accelya Kale is an integrated software solutions provider to the global airline
industry. It develops software products which cater to the entire lifecycle of processes
involved in the operation of an airline. The company has pioneered the software
product-based outsourcing model in the airline industry. It is also the primary
strategic software partner to the International Air Transport Association (IATA). The
company has well-established products, an extensive track record, a competent
management and a geographically well spread out revenue profile. The company is a
recognized leader in the space that it operates.

Key Management Personnel

Mr. Philippe Lesueur, Chairman, is also the Chairman of all Accelya Group
companies worldwide. He has over 30 years of experience in the airline industry. He
is a well-known and respected authority in the airline industry and has worked in
various capacities in leadership roles in the Accelya group.
Mr. Vipul Jain, CEO and MD, holds a B.Tech degree from IIT, Kanpur and a Post
Graduate in Management from IIM Ahmedabad. He had promoted the company
along with Mr. Narendra Kale. He has held several positions in the company and has
handled the critical responsibility of marketing the companys products.

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Key challenges for Accelya Kale Solutions
Loss of large clients to competition
Accelya Kale derives about two-thirds of its revenues from the lease of its
products. This revenue increases in line with the increase in the number of
airline passengers. This part of the revenue is stable and linear. However, it
will grow at a slow rate which necessarily means that the company has to keep
on adding new airline customers every year to maintain its growth. In FY13,
the company was successful in adding 13 new clients which led to a big jump
in revenues of nearly 40% YoY. Unfortunately, this works both ways.
The competition that Accelya faces from global and Indian IT firms is intense.
If a large client were to leave, then the revenues for that year would not grow,
despite the addition of new smaller clients. This is exactly what happened in
FY12. In fact in FY14 also, the sales growth is likely to be impacted for the
same reason. The possibility that a few large clients may end their relationship
with the company has already been factored in our estimates. However, this
risk cannot be wished away.
Aviation sector risk
It goes without saying that out of the 230 airlines around the world (as per
IATA) most are not in a good shape financially. Their need to cut costs and
improve efficiency will certainly lead to more outsourcing. At the same time,
their ability to spend large amounts of money on IT infrastructure will be
impacted, when they are under financial stress.
When I met the management of Accelya Kale, they were of the opinion that
the best way for the company to handle this situation was to focus on its own
strategy rather than worry about the fate of the aviation sector. While this is
fine, the investment risk does remain. Any recession in the developed world
would severely impact the airline industry and possibly Accelya Kale as well.

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Risk Analysis
Regulatory Risk
Some businesses are subject to regulations by external government agencies.
These companies are subject to regulatory risk since they do not have the
liberty to operate in a free environment. Excessive regulations can create
bureaucratic hassles and impede growth. Thus, higher the regulation, higher
is the risk for any business. Though the regulatory framework in India is
conducive for IT companies, however the companies are subject to the
regulations in their client countries. As seen in recent times, most of the
changes in regulations in the client countries have had an impact on the
Indian IT companies.
Cyclicality Risk
A business cycle is characterized by alternating periods of expansion and
contraction. Businesses whose fortunes typically swing with industry cycles are
known as cyclical businesses. Cyclical businesses do well during an industry
upturn and vice versa. On the other hand, there are some businesses that are
not very cyclical. These businesses are more immune to changes in industry
cycles in the sector and have less risk. In short, if the business is cyclical, the
risk is higher. Given that the IT sector is not a cyclical business, we assign a
low risk score of 8 to the company on this parameter.
Competition Risk
Every industry is characterized by competition. However, some industries
where entry and exit barriers are typical y low have higher competition risk.
Low barriers means more players can enter into the industry thereby
intensifying competition. The competition in the IT services sector is intense
and global in nature.
Sales Growth
Over the eleven year period (actual history of past 5 years and explicit
forecast for the next 6 years) we expect sales CAGR of around 16.4%.

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Net Profit Growth
Over the eleven year period (actual history of past 5 years and explicit forecast
for the next 6 years) we expect a net profit CAGR of around 22%.
Operating Margin
The operating margin is a measurement of what proportion of a company's
revenue is left over after paying for variable costs of production such as raw
materials, wages, and sales and marketing costs. A healthy operating margin is
required for a company to be able to pay for its fixed costs, such as interest on
debt. The higher the margin, the better it is for the company as it indicates its
operating efficiency. Accelyas average operating margin over the eleven year
period (actual history of past 5 years and forecast for the next 6 years) stands
at 34.2%, which is very good.
Net Margin
The net margin is a measurement of what proportion of a company's revenue
is left over after paying for all the variable and fixed costs inclusive of interest
and depreciation charges. Net margin is the final measure of profitability. It
reflects the total profits the company takes home. Higher the margin, better it
is for the company as it indicates better pricing power and effective cost
management. For Accelya Kale, the average net margin over the eleven year
period (actual history of past 5 years and explicit forecast for the next 6 years)
stands at 21% which is good.
Return on invested capital (RoIC)
RoIC is an important tool to assess a company's potential to be a quality
investment by determining how well the management is able to al ocate
capital into its operations for future growth. A RoIC of above 15% is
considered decent for companies that are in an expansionary phase. The
average RoIC over the eleven year period (actual history of past 5 years and
explicit forecast for the next 6 years) for Accelya stands at a very impressive
104.1%.
Earnings quality

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This measure helps us assess the quality of earnings reported by the company.
For instance, some companies may follow aggressive accounting practices and
recognize revenues earlier than warranted. Earlier recognition of revenues
boosts profits. However, at the same time they do not generate sufficient
operating cash flow (OCF). This signifies debtors are not liquidated on time as
sales were booked in advance. Such companies face working capital issues and
their quality of earnings is poor.
I assess earnings quality by dividing operating cash flow to net profits. Higher
the ratio better is the quality of earnings. For Accelya the average OCF/net
profit ratio over the eleven year period (actual history of past 5 years and
explicit forecast for the next 6 years) stands at 1.27 which is healthy.
Transparency
Transparency is the key to any business. Transparency can be gauged by
assessing the past dealings of the company with various stakeholders, the way
it displays its financial information and the frequency of management's desire
to communicate with external shareholders whenever some unfortunate
incident happens. The easiest way to gauge the same is checking the level of
disclosures in the company's quarterly financial updates and annual reports.
Transparent managements would get a higher rating. In my view, the
companys level of disclosures is not up to the mark, as per industry standards.
Capital allocation
Apart from transparency, capital allocation skills are equal y important in
assessing management quality. By capital allocation I mean how the
management chooses to deploy capital in the business. There are many
instances where growth is given priority over returns on the investment. This
results in a company with larger size but with poor returns. Managements are
enticed to increase the size since their compensation is tied to the size of
organization they manage.
Also, they sometimes destroy shareholder wealth by making expensive
acquisitions or by diversifying into unrelated areas. Hence, capital al occasion
skill s assumes great importance in gauging management quality. Capital
allocation skills are good when return ratios depict resilience. In short, more
stable/higher the return ratios better the capital al occasion skills. Accelyas

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return ratios have not only been good but have also improved significantly
over the years.
Promoter pledging
Promoters typical y pledge their shares to take a loan which is generally
infused in the company. This exercise is generally resorted to when al other
sources of external liquidity dry out. The risk with this strategy arises when
share price falls. This triggers margin calls. If management is unable to
provide some sort of a collateral to the lending party from whom the money is
borrowed that party may sell the shares to recover its money. This accentuates
the share price fall. Hence, higher the promoter pledging higher is the risk
Debt to equity ratio
A highly leveraged business is the first to get hit during times of economic
downturn, as companies have to consistently pay interest costs, despite lower
profitability. We believe that a debt to equity ratio of greater than 1 is a highrisk proposition. The D/E ratio for Accelya over the last five years has stayed
low. The average D/E ratio over the eleven year period (actual history of past 5
years and explicit forecast for the next 6 years) stands at 0.1.
Interest coverage ratio
The interest coverage ratio is used to determine how comfortably a company
is placed in terms of payment of interest on outstanding debt. It is calculated
by dividing a company's earnings before interest and taxes (EBIT) by its
interest expense for a given period. The lower the ratio, the greater are the
risks. Given the low debt levels and strong cash flows of Accelya Kale.

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Financial at a glance
Consolidated (Rs. In m)
Sales
Sales Growth (%)
Operating Profit
Operating Profit margin (%)
Net Profit
Net Profit margin (%)
Balance Sheet
Current assets
Fixed assets
Others
Total Assets
Current Liabilities
Net worth
Loan funds
Others
Total Liabilities

Valuation (in Rs. m)

Net Sales
PAT
No. of shares
EPS (Rs.)
Price to Earning (x)
Price to Sales (x)
Price to book value (x)

13

FY13
3038
39.80%
1304
42.90%
844
27.80%

FY14E
3190
5.00%
1271
39.80%
787
24.70%

FY15E
3669
15.00%
1467
40.00%
908
24.70%

FY16E
4219
15.00%
1693
40.10%
1057
25.10%

FY17E
4852
15.00%
1953
40.30%
1229
25.30%

FY18E
5580
15.00%
2252
40.40%
1427
25.60%

FY19E
6417
15.00%
2596
40.50%
1655
25.80%

FY13
1348
346
607
2302
1144
1020
0.04
138
2302

FY14E
1118
373
607
2098
1201
759
0
138
2098

FY15E
1487
402
607
2496
1381
976
0
138
2496

FY16E
1922
434
607
2963
1588
1237
0
138
2963

FY17E
2425
471
607
3503
1827
1538
0
138
3503

FY18E
3007
512
607
4126
2101
1887
0
138
4126

FY19E
3678
558
607
4843
2416
2289
0
138
4843

FY13
3038
844
14.9
56.5
12.2
3.4
10.1

FY14E
3190
787
14.9
52.7
13.1
3.2
13.6

FY15E
3669
908
14.9
60.8
11.4
2.8
10.6

FY16E
4219
1057
14.9
70.8
9.8
2.4
8.3

FY17E
4852
1229
14.9
82.4
8.4
2.1
6.7

FY18E
5580
1427
14.9
95.6
7.2
1.8
5.5

FY19E
6417
1655
14.9
110.9
6.2
1.6
4.5

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Conclusion
The software sector is very dynamic in nature. The valuation of companies in this
sector depends on macro as well as company specific factors. The macro factors
include economic growth in the clients countries, the latest trends in software
technologies and the performance of the respective sectors that the IT firms cater to,
among others. The company specific factors also play an important role in
determining the valuations of an IT company. The managements integrity, foresight
and competence rank right at the top. Others are domain expertise, employee
productivity, return ratios, the scale and type of the services offered and the
competition.
Most IT firms operate with little debt and have a low capex requirement. Therefore
the Enterprise Value (EV) method is not useful in valuation. Also, due to intense
competition, uncertainty surrounding the economic conditions in the western world
as well as the dynamic nature of the sector, there is a high probability of volatility in
the earnings of IT firms. Thus using the Price to Earnings
Growth (PEG) ratio is also not very useful. We therefore value IT firms based on the
price/earnings (P/E) ratio. Over the years, Accelya Kale Solutions has traded at a P/E
of 3 to 8 times trailing twelve months (TTM) earnings. The companys fundamentals
are strong and it is a niche player in its industry. We believe that the lower end of the
valuation band should be higher than what has been observed in the past. However, it
faces stiff competition from Indian and global IT firms. Also the airline industry
itself faces severe headwinds. This is why we believe that the upper end of the band
should not be much higher than the past. Therefore, after considering all the above, I
assign a P/E band of 6-9 times to the stock.

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