Recently in December we introduced traffic enforcement technologies developer Redflex Holdings (ASX:RDF) as a company we see as improving during 2018, and one we hold within the Clime Smaller Companies Fund (CSCF). Our thesis is unchanged after the company reported its 1H18 in February, although we believe some context to the result is necessary.
Of the companies we follow, RDF’s 1H was one of the less inspiring, with revenue and earnings before interest, tax, depreciation and amortisation (EBITDA) down 16% and 21% respectively. However, the cosmetics belie significant operational improvements made during 2017, several of which took place later in the year.
Drilling down into the result components we can see the weakness was driven by the Australia/International segment, while earnings from the Americas segment were flat.
Figure 1: RDF half-on-half EBITDA by segment
Source: Company reports, Clime
Although both segments market RDF’s proprietary traffic infringement detection (cameras) and back-office (citation management) systems, each have distinct business models and opportunity sets.
The Americas mainly comprises the mature US business with growth coming from Canada and Mexico. RDF operates in these markets primarily via multi-year Build, Own, Operate, Maintain (BOOM) contracts from which it derives highly recurring revenues. Retention (contract renewals) in the Americas is typically 90%. One of the drivers of non-renewal recently has been changes in legislature in some States banning traffic enforcement programs (at present only 22 States utilise traffic enforcement systems), however this trend has slowed markedly. Currently RDF manages approximately 1,000 of the ~4,000 installed base in the US, and assuming it can maintain share we expect the Americas to continue generating around $10m of EBITDA per annum.
The Australia/International segment is where RDF will focus much of its newly acquired financial and human capital resources to drive growth, particularly in the UK and Europe. Sales in this division are more project-based and therefore financial performance is lumpy, however RDF intends to drive increased recurring revenues via sales of new back-office software product (Alcyon). The important point to in relation to the 1H figures is that they aren’t an appropriate barometer of what’s potentially to come.
Based on the following timeline of improvements to RDF’s balance sheet, leadership team, product set, and opportunity pipeline, we believe the company’s capacity to grow has markedly improved:
- Between 2013 and 2017 the company was capital constrained due to a legal dispute involving previous US divisional head for which RDF faced potential fines of up to US$300m. The case was resolved for US$20m, effectively allowing recapitalisation over the course of 2017.
- In early 2017 RDF finalised a multi-year technology refresh of its camera system (HALO) and citation management software (Alcyon), resulting in a much more competitive offer.
- In August industry veteran Mark Talbot moved across from competitor Conduent to take up RDF’s CEO position, citing RDF’s IP as a key factor in his decision.
- In November the company raised $16.4m and later acquired a US$10m working capital facility, the majority of which will be used to support growth in the UK and Europe.
- In February this year management estimated an opportunity pipeline at $350m (up from $300m previously) over the next four quarters, which is well above annual revenue of ~$120m.
RDF’s enterprise value of approximately $80m (net of $12.8m cash and remaining US$10m legal settlement liability) is about 8 times US segment EBITDA. In our view this implies the market is ascribing little value to the international opportunity.
With a refreshed management team, strengthened net cash balance sheet and a highly prospective sales pipeline, we are of the view that better times lie in wait for the business. Of course, time will be the ultimate judge on whether our reasons for optimism are well-founded.
Clime Group owns shares in RDF for and on behalf of various mandates for which it acts as investment manager.