Nemetschek: Observe How The Transition Period Unfolds

Thesis

Since I first wrote about Nemetschek (OTC:NEMTF) stock in March, it has risen dramatically in price (29.25%). To review the situation once more: NEMTF provides software to constructing firms, architectural firms, and engineering firms. Customers of NEMTF are able to do better forward planning, information sharing, and teamwork thanks to digitalization. The latest earnings report from NEMTF was positive, thanks in large part to the acceleration of demand from 2Q23 in design due to price increases planned. The notice and timing of pricing here is important as it meant that it could see near-term upside in the financials due to price increases (high margins) in both Design and Build, where there will be cohorts of customers that are up for renewal this year. The success of the subscription transition in terms of time and velocity is currently a matter of debate. The faster, the better, as the uncertainties that often obfuscate the P&L will be shorter. Investors would also have a quicker understanding of how the normalized post-transition unit economics are. Finally, while the company has seen a stabilization in the macro environment, I am still cautious on certain risks in Europe (Germany in particular) where NEMTF saw slight changes in 1Q where there is still some form of hesitation on the demand side (the positive note here is that things seem to be stabilizing). As such, I still think it’s best to wait and see how well the transition period goes before investing, so I’m sticking with my hold recommendation for the time being. In particular, I think the valuation at 41x forward earnings represents a lot of room to fall if things go south.

Pricing and Macro

Total revenues grew 5.5% constant currency, ahead of consensus estimates, leading to a beat of ~11% on the EBITDA level as well. As discussed, the increase in prices have led to a pull forward in demand from 2Q, which caused the beat. Specifically, the pull forward was in the Design segment, which also means that 2Q growth in design is likely going to be lower. Management expects it to be more around low to mid-single digits. The price increases are expected to be in the high single digit percentage range; however, they will be implemented more gradually, which should aid in boosting Design’s growth after 2Q23. The good thing about raising prices, I think, is that it contributes directly to the profit line, and it is something within management’s control. This should help smoothen out any volatility due to the uncertain macro environment – which management noted that it is stabilizing since 4Q22. However, management did note a few problems with smaller projects, while larger projects, such as those in non-residential construction and public infrastructure, held up well. All in all, I see the increase in prices as a positive thing, and the stabilizing/recovery of the macro environment as a boost to NEMTF’s ability to meet/beat FY23 guidance.

Bluebeam

In my previous post, I wrote about Bluebeam gaining momentum, and I am positive about its success in the long run. As expected, growth was sustained in Q1 of 23. The subscription transition is on schedule, with over 20% of users already on subscription. The goal of having 90% of the user base subscribe by the end of 2024 is expected to be met if the current quarterly run rate of 10% of users switching over holds. This ended any doubts I had that the transition period would be longer than expected. Also, the timing of the first batch of subscribers is going to reach its renewal date, which would be renewed at the increased pricing, giving NEMTF a further boost in growth.

Skeptical view on 1Q

Given the high valuation, I thought it would give a balanced view if assess 1Q results more skeptically. The headline news was clearly positive for NEMTF as they beat consensus. However, the truth is the beat was due to timing – 2Q demand pulled forward to 1Q. Which means, it is not hard to imagine 2Q23 being weaker than expected, and importantly, the reason for pull forward was pricing. We could see a short-dip in demand as new customers take more time to digest whether they want to purchase/subscribe post the price increase. If we tie this “positive” headline news to the 10% jump in stock price, it would also mean that the premium awarded to it due to the earnings is not well-supported as the beat was not structural, but a matter of timing. If 2Q23 performance is a lot weaker than expected, this valuation premium can easily be lost in my view.

Valuation

I think the transition to a subscription-based model will be the dominant theme in NEMTF’s equity story, despite the company’s seemingly strong position in an industry that is benefiting from the ongoing digitalization trend. This change may have long-term benefits like increased recurring revenue and reduced revenue cyclicality, but it also presents implementation challenges that may have an adverse effect on near-term estimates. Furthermore, there is no margin of safety in the current stock valuation of 47x price to earnings. As a result of these considerations, I continue to recommend a hold rating.

Conclusion

While NEMTF has experienced significant price growth since my previous assessment, there are several factors that warrant caution. The transition to a subscription-based model is crucial, offering long-term advantages but posing implementation challenges and potential downside risks to near-term estimates. Additionally, any deterioration in the macro environment could lead to extended sales cycles and impact purchasing decisions. Also, the current valuation of 47x earnings provides no margin of safety, further emphasizing the need for careful consideration. Therefore, I maintain my hold recommendation, and that investors should wait and observe how the transition period unfolds before making any investment decisions.

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