Sectra AB

STO:SECT B

Earnings Call Analysis

Sectra's Transition to Service Model Boosting Orders

Sectra reported a 33% jump in contracted order bookings, with a 21% increase in net sales and a 14% rise in profits. The transition to a service-based model, boding well for long-term success, led to a 28% boost in recurring revenue. Despite a temporary slowdown in revenue and profit growth, financial targets were hit, with an operating margin of 19% and a profit-per-share growth of 113% over five years. The push toward cloud services resulted in a 73% growth in cloud contracts but caused short-term cash flow setbacks. However, Sectra is betting big on the future, with innovative offerings in medical imaging and genomics for the treatment of elderly diseases and a solid foothold in the growing cybersecurity market.

Sectra's Shifting Landscape: From Traditional Sales to Cloud-Driven Growth

Sectra, under the leadership of CEO Torbjorn Kronander and CFO Jessica Holmquist, presented a strong quarter with all-time high contracted order booking up 33%. The company's pivot towards Imaging IT Solutions within healthcare, fulfilling needs for consolidated and efficient image handling, has propelled its growth, particularly in cloud services with large system orders spanning multiple years. This strategic transition has resulted in a 21% increase in net sales, and a notable 28% rise in recurring revenue, coupled with an impressively low churn rate of 0.9%.

Financial Fortitude and Market Expansion

Sectra has comfortably met its financial targets, with an equity ratio of 51%, and an operating margin exceeding the minimum threshold at 19%. Growth in profit per share over a five-year span has doubled the target, reaching 113%. Insecure Communications, demand has surged, partly due to heightened security concerns in Europe, although the future impact of Sweden potentially joining NATO remains unclear. Nonetheless, Sectra sells NATO-approved products through its Dutch operation, highlighting its robust presence in the security sphere.

Trends and Earnings: A Deep Dive into Sectra's Performance

Image IT Solutions has propelled Sectra's success, growing at 76%, despite a slight margin hit due to the shift from upfront payments to usage-based revenue streams in cloud contracts. This investment in service delivery is expected to yield long-term benefits, even as it dampens short-term revenue and profit. Sectra reported an 8% rise in operating profit to SEK 69 million, although the transition to service sales and heightened marketing expenditures have led to a marginally reduced operating profit margin.

Capital Allocations: Strategic Property Acquisitions

The company strategically acquired two properties, one being its headquarters in Linkoping, to potentially reduce operational costs. These investments are not expected to have a material impact on financial results, indicating Sectra's cautious approach to asset management.

Innovation and Customer Focus: Driving Future Success

Sectra's forward-looking strategy focuses on meeting burgeoning healthcare demands due to demographic changes and escalating cybersecurity threats. They have established a unique niche in medical industrialization and secure mobile communications for sensitive materials handling. Sectra measures success through high customer satisfaction, which they attribute to their corporate culture and employee contentment. Their innovation track includes pioneering work in digital pathology and genomics, with aims to consolidate cancer diagnostics into a single, integrated system, promising major advantages in patient treatment and medical cost efficiencies.

The Shift to Service and Enduring Customer Relationships

Transforming to a service-centric model, Sectra is focusing not only on software but also on hardware services. This shift has vast implications for growth and is gaining traction, especially in the U.S. market. Sectra's low churn rate is key to their strategy, reinforcing the sticky nature of its customer relationships and ensuring that growth in recurring revenue, which has risen to 59% of their total revenue, remains robust in the long run.

Earnings Call Transcript 2024-Q1

[Helena Pettersson, executive]

Welcome to Sectra's 3-month report presentation with CEO, Torbjorn Kronander; and CFO, Jessica Holmquist. My is Helena Pettersson, Investor Relations Officer, and I will be the moderator of the Q&A session later. The chat function is open from start, and you are most welcome to start writing questions during management presentation.

And with that, I hand over to you, Torbjorn.

[Torbjorn Kronander, executive]

All right. So welcome here to our 3 months report our first quarter for this fiscal year. We will start with interim highlights for the quarter by me, and then Jessica will come in and speak about financial development. I'll speak a little about our way forward, and then we'll end up with a Q&A session with both call in and we have the chat functions or you can write the e-mails too.

So our main business lines, sort of petition is Imaging IT Solutions, where we started up doing mainly radiology image handling of hospitals. Today, we increasingly do all image handling from hospitals as hospitals want to consolidate their IT system, they want to fewerize these systems. And we are a vendor who can do all their images in one single solution, which has resulted in some substantial orders over the last quarter.

And then we have IT security, where we mainly do encryption systems and communication, secure communication solutions. Then we have growth opportunities outside the main business lines, which is our little greenhouse. These are small, but they are supposed to grow rapidly, medical education, IT, where students, medical students are nowadays trained in a very different way from historically. We have a special business unit for that, and that is more or less only doing recurring revenue today.

We have orthopedics IT, where we do some special image management for orthopedics. They use images very differently from radiologists and the diagnostic side of hospitals. They use it for therapeutic preparations. We have research division mainly doing research within AI and genomics now. And we have inside the main business lines, where critical infrastructure in secure communications and increasing digital pathology in imaging IT, which is then part of that overall image management of hospitals I spoke about. That area has grown rapidly right now.

And we added 2022 genomics IT, which is not images, but very much related to pathology images increasingly used in diagnosis of cancer and also treatment of cancer cell.

Highlights from the quarter. We had an all-time high contracted order booking up 33% from a very strong quarter last year as well. This result sort of for the order of the synergies. We have high demand within all business areas, signed the largest order to date for Sectra, U.S. Sectra One Cloud contract. That means we do not get paid upfront. We get paid after the customer uses it. It's one of the larger hospital chains all of the U.S. health care systems.

And we are -- initially, we got over for radiology, but there is also an umbrella contract that can be extended with other images and they had the vision of having only 1 vendor for all images in the entire system to save costs and increase efficiencies on their side, also increasing patient quality.

Our orders now are very large systems and over many years, which means the contracted order barge has become very large. And we have significant quarterly variations due to large individual laws. So of course, we get also this size and the order intake goes up and down between quarters.

We have a positive trend in all business areas. We have record progress in the transition to services and cloud deliveries. Also for hardware, not only software and medical, but also in hardware, we're moving into recurring revenue that is increasing faster than the revenue long term.

We have a currency tailwind, and that will not be forever. But right now, it has to cushion the effects of the change to a service providing business model. We have definitely seen a very strong turnaround from secure communications that I will come back to later.

We are transforming the entire company to Delivery as a Service, also our security business, where often we, instead of selling our high quality systems, we rent them to the customer. We let them use it for usage.

Our net sales for the quarter was up 21%. Profitable share was up 14%. Our recurring revenue, which is a very increasingly important measure now, was up 28%. And the churn, that is how large proportion of the recurring revenue we lose. Of course, if you get a lot and lose a lot, you don't gain nothing. But we have a very low churn at 0.9% of our recurring revenue, which means that the income becomes an integrator, which is good for long-term business.

The financial targets for the groups are all fulfilled. We have the equity ratio first, which is a measure of stability. That should be well above 30%. It's currently at 51%. The second one is profitability. Operating margin, we do not want that to be too high. We're too much to investing for future growth, but it should be at least healthy above 15%. It's currently at 19%.

And then the last and most important is growth per profit per share over a 5-year period. That is the target to be above 50%, we're capped at 113%. And that's our main target. The first 2 can be seen as hygiene factors, the third one is the main target of our financial targets.

In Sectra Secure Communications, we have considerably improved earnings, which is a very good thing. That depends on 2 things, I would say, both the world around us with the Callum 10 situation in European security right now with raised demand, but also a new management for this business area, which has proven very good.

Strong order intake as well. We don't know what the application to later from Sweden will mean we are not members on NATO yet. But so that is a little unsecured -- unknown right now. But we do sell into NATO because we have NATO approved products already now that we sell from our Dutch operation.

Image IT Solutions are the largest business area by far. We've got 3 significant Sectra One Cloud go-lives during the quarter. That means we are selling and getting paid per usage instead of upfront, which, of course, affects the growth rate. We, during this transition, have much lower growth than we would have had both in profit and growth than we would have had with the old business model. But long term, this is better. We have low churn on recurring revenue, as I said before, and we have a cloud recur revenue, which is a portion of the increase of the return revenue we sell for cloud applications. That is the main growth area that's up 76%. Then I will leave over to Jessica, who will tell you a little about the financial development.

[Jessica Holmquist, executive]

Thank you. Good morning, everyone on the call. And I will jump right into our Q1 financials, starting off with the order intake. Contracted order bookings was close to SEK 3 billion in the quarter, up 33% with high demand for our offerings, both in medical IT and Secure Communications. And the single largest contributor to the record high order intake is the already mentioned 10-year Sectra One Cloud contract in the U.S., which amounted to approximately SEK 2.4 billion.

And in this context, again, we point out that orders of this size do not come every quarter. We see stable top line development with growth in net sales of 21%. A reflection of our long-term commitment to customer satisfaction. And the SaaS transition is driving recurring revenue growth, up 28% in the quarter. And the recurring revenue from our cloud contracts was up 73% for the group to SEK 86 million, equaling or coming close to 15% of total sales, which is a sign of progress in this area.

And as Torbjorn also mentioned, our recurring revenue churn is limited and the recurring revenue development is supported by that, and it remains just below 1% on a 12-month rolling basis. And also looking at the non-recurring revenues, growth in those in Q1 came mainly from secured communications. All business segments increased sales in Q1.

Imaging IT was up 19%. And as customers expand the use of our solution and also due to a growing customer base. And we also note that the currency tailwind contributed to growth in this segment. Secure Communications increased top line by 35% and the positive trend that we've seen over the past quarters remained in Q1 and also the demand was also confirmed by additional order intake secured during the quarter. We also have growth in business innovation, although this segment still represents a smaller share of our total revenues.

All geographic markets increased sales, except in the U.S. where we now see an impact of the change in business models. In the comparable quarter, we had more upfront or more deployment revenue from licenses, whereas this quarter's deployments were SaaS contracts to a larger extent. And the highest growth in absolute terms we had in the U.K., largely driven by recurring revenue growth.

Our operating profit rose by 8% to SEK 69 million in the quarter, whereas the operating profit margin was slightly reduced. The operating profit is affected by the shift to service sales and cloud deliveries. This, in combination with our continued investments in the organization, preparing for large deliveries caused lower margin in the quarter. We also had increased costs for marketing activities in Q1 versus last year.

The weak Swedish crown give a favorable currency effect that is partly offsetting the transition to service sales. And on a rolling 12-month basis, the margin was at 19% at the end of Q1. Imaging IT delivered less operating profit than in Q1 last year.

During the quarter, 1 customer in the U.K., 2 customers in the U.S. went live in Sectra One Cloud. And as these cloud installations ramp up in production volume, they will contribute nicely to revenues and profit over time. But short term, it means less revenue than traditional license sale. And Secure Communications delivered a strong performance in Q1 versus last year. Demand for encryption products and cybersecurity is high. And we have seen that the market situation has normalized. We still note that quarterly variations are expected in this segment due to the nature of the business.

Cash flow from operations was negative at SEK 98 million in Q1 due to negative changes in working capital. Q1 is normally weak, and timing effects in customer projects caused tied up capital in projects and accounts receivable to increase. The overall cash position is strong with SEK 808 million, including the SEK 120 million that we have in a short-term bank deposit.

During Q1, we signed an agreement to acquire 2 properties, the headquarters in Linkoping, plus an additional property nearby. We paid a deposit during the quarter, and the rest was transferred on closing -- on the closing date, September 1. We do not expect these acquisitions to have a material impact on our financial results.

With that, I hand it to Torbjorn for the presentation.

[Torbjorn Kronander, executive]

Thank you, Jessica. I can comment on the acquisition properties that it is not our intention to be a real estate company, but this was an opportunity to reduce operational costs a little bit. And we signed up instead of renting the entire boat.

So our way forward where others see a problem. We have a demographic challenge all over the place -- over the world. And with cybersecurity threats all over the world, we see opportunity. With our special niches in when health care must scale up and become industrial production and industrial in a positive sense. Some say that health care shouldn't be an industry because we're treating humans but industrialization means repeatable quality at the lowest possible price. That is exactly what health care is all about now in order to survive the demographic explosion.

And you can do that in a very humane way if you're careful about it. And then when mobility -- when top level secured needs go mobile, we see that very much at the COVID. People dealing with very sensitive materials. They also need for online when they are traveling or working from home, and that's a very special niche for Sectra.

Focus forward is high customer satisfaction as before. The only way to have long-term success in the company, and we are long term, is to have high customer satisfaction, which we have proven over and over. We measure this by net promoter scores, and we measure -- we are externally measured, especially in Medical by the KLAS institute in Utah homes customer satisfaction in the U.S. and other countries, and we have had the highest customer satisfaction for many years in a row now.

But you cannot have higher customer satisfaction if you have unhappy employees in the full culture. We're working a lot with recruiting the right people and having the right culture because then customers will be happy. It won't work otherwise. And then, of course, profitable growth and this is what this is all about. And also seeing, we've been good at seeing where things is going to end u and skate where the puck is going to be.

And we started in digital pathology 8 years ago. And now other companies are saying this was a correct move. But we are now very well positioned in that. Now sometimes, we have to take a few bets and we have to shut it down, but we are willing to take risks for these opportunities that might become very big for the future. And we say the main culture thing we use in our discussions internally, externally, is the oldest rule of humanity. People forget it. It's the one thing you've seen in old religions we found overall, and that is the go-to rule. And it might be strengthen and IT CEO preaches the oldest rule of religion in the world, but it's a good rule. Behave on to others as you want them to behave to you, and we'll be fine. And that is what we try to teach and infuse in our employees.

In Medical, we have the growth areas that are a consequence of the demographic situation all over the world, and that is the old people diseases. We have more or higher and higher shares of old people or people all over the world, a little different time scale in different countries, but this is coming in the entire developed world.

And we have no way of doing this. I have a friend who said that if we are going to keep the relationship between staff in health care in hospitals and patients in 20 years or 15 years from now, we need to use every single student who are examined or graduated high school and put them in health care. That won't happen.

So we need -- that's why industrialization is so crucial. And the things that are most important are the diseases of the elderly, and that's neurodegenerative disease, cardiovascular disease, cancer disease, musculoskeletal disease and vision. If you cannot see, you become very expensive and dependent.

And all over this is medical imaging. But we try to be very good in these 5 areas because that is where the money is going to be and the needs and thus, the money, which we can get a share of our customers' profits.

And we added genomics, which fits perfectly into cancer. We don't do everything in genetics and genomics. We do solid tumor diagnosis, which is very closely related to pathology even called molecular pathology, and it's a very high-growth area of medicine that has not been industrialized yet, but needs to become so.

Our vision for the medical imaging area is for like all emission-related diagnostics must have data in 1 system to support better care for patients and lower cost and reduce complexity. And the large order we got from the U.S. was exactly about this. This customer wants 1 single system for all image-related data they have in the entire operation. That saves cost for them. They don't have so much staff claimed in different systems. And they can also do what we call integrated diagnostics, where they can use multiple inputs for the same diagnosis, which is very important for the correct diagnosis and follow-up during cancer treatment.

And we are currently the only company who have radiology and pathology in one single system because we started so early. Now we're adding genomics IT. That means complete cancer diagnostics in 1 single system. And it's build for production. This is not research equipment. It can be used for research as well. We are good at that. But it mainly build production -- so doctors actually can come home at reasonable times instead of burning out, which is a big risk today. Medical doctors all over the world are working so hard, that the risk of burnout is increasing in unacceptable way. And our job is to help them out so they do not burn out.

Going from research IT to the production in genomics. And just genomics alone, we see estimated market growth in 90% per year for the over-seeable future. Now this is very small. We have no revenue there yet. We have a collaboration product with University of Pennsylvania in the U.S., who wants to take this into production during 2024.

And we are developing together with them right now to build this. But it is a large interest all over the world for this integrate with pathology and radiology. This is, as we see, spot on for skating to where the puck is going to be. Data needs for integrated, decisions for diagnosis must based on all available data in one single system, and we have a huge growth in genomics asset, the number of DNA sequencing for cancer is going up all the time.

In cybersecurity, we have a new digital reality. Cybersecurity market will grow. It has to grow because cyber threats, cyber fraud and cyber espionage are growing. We see it every day in the papers, not the least in health care, but also in other areas. We are very, very well positioned. We have a super strong brand known as the only vendor with top or secret approved mobile phone in Europe, for instance, which we can use to sell all the other equipment.

And the current crisis in Europe will boost demand even further as we'll see. Hackers are expanding. Attackers are getting smarter. They utilize advanced technology and be able science to find vulnerability. I think you all have been exposed to phishing attempts. A few of you might have even bit that hook, a bottle impact a larger and larger, and that means that cybersecurity will continue to grow. Demand more and more countermeasures and thus invests in society in capital like us.

We are transforming as a service company, not only software. We also do the Hardware as a Service to some extent in communications, and that has quite large implications for growth we would have grown much faster than we do right now if we had everything upfront. But long term, this would be good when this integrating system against the work.

We have increased our recurring revenue to 59% now, and we have 58% for the full year last year. We have a large interest in this, and we see more or less all deals we're discussing, especially in the U.S. right now is this model. But in order to be successful, you require low churn. As we said before, we have a very low churn. We are below 1%, which means we add on -- everything we add on will be long-term.

During that transition, revenue and profit growth will temporarily be smaller. This we have spoken about for several years. We also had our Capital Market Day in this year said that we'd be stronger this fiscal year that we're now '23, '24, and we see the effect that we predicted happening.

Long term, the financial effects would be strongly positive. However, this will be better than they would model, but it will take a few years to get there.

Why should you invest in Sectra? We are positioned in markets that are by external factors for us to grow. No one can do anything about the demographic situation. We want to keep petcare, and we are very well positioned in that area. And cybersecurity likewise, it has to -- the market has to grow, we will position there. We have a very high customer satisfaction.

And in order to have that, we have high -- we need to have high employee satisfaction with strong corporate culture. I think we are ranked very high in glass door, for instance, in the U.S., which is a site where in prospects and employees can evaluate the employers. The strong brand in markets for trust is critical. If our systems fails, people will die in the hospitals, and that's when brand is very important.

Likewise, in cybersecurity, if we fail, their secrets that should not be public will become public or known to the enemy. And that's a brand -- both our brand markets, and we have strong brands in both markets where trust is critical. We have rapid growth in the largest medical market in the world, which is the United States.

We have profitable very strong cash flow, not this quarter, but over the years we have that. We have a solid balance sheet, which is trust for our customers. We have rapidly increasing revenue, return revenue, especially the cloud-based revenues, which is important. We have a good collaboration with public cloud vendors, especially Microsoft and we have very low churn.

Sustainable investments in R&D with exciting future opportunities. One with small greenhouse products we're doing. If they grow, we will have very strong business in that. We do not invest in these unless they have good potential for the future. Now some of them will not succeed and might be have to be closed down. but that is okay. They are all profitable, which is the important thing, except for genomics yet.

And our management on shares, which we think is important, not only options and stuff, but they actually own the shares. The upcoming financial events after this is September 7, which is now, 3 days from now, 2 days from now. our Annual General Assembly here in Linkoping in Sweden and then December 14 with our Q2 report.

And please remember, your feedback is important. We try to modify these meetings and presentation based on what you think. So if you have any suggestions to improve, please send an e-mail to [e-mail], and we will review it and modify the presentations so they become effective for you. And then we open up for the question section.

[Helena Pettersson, executive]

Thank you, Torbjorn and Jessica. I will start the questions from Kristofer Liljeberg at Carnegie, who has sent a mail. And the first one is could you please explain when you expect revenue to start for the recent large U.S. order? According to the press release, the deal was supposed to generate about SEK 2.5 billion over 10 years. Is it back-end loaded?

[Torbjorn Kronander, executive]

It's back-end loaded that we do not get paid. It's a lot of hospitals. Some of them will go live quite soon, they will begin to get. But taking so many hospital life will take time. So it's definitely gradually build up over 1 to 2 years for.

[Helena Pettersson, executive]

And the next question from Kristofer is historically, external costs tend to be lower in Q1 than in Q4, but not this time. What is the reason for that?

[Torbjorn Kronander, executive]

It has been some hard work that we shifted and some peculiarities about that. Jessica, do you have any more?

[Jessica Holmquist, executive]

And then also the ramp-up of the organization that we are hiring, like I mentioned before, preparing for the large deliveries ahead of us.

[Helena Pettersson, executive]

And the third question is looking at order to be delivered in the next 12 months, it was at half the level seen in the past 4 quarters. Does this reflect natural variations? Or should we expect that to be lower in the past because of the change in revenue model to more subscription?

[Torbjorn Kronander, executive]

We ask more and more customers, they want -- they cannot sign up a contract with us. It's -- some cases, it's a framework contract. Sometimes it's a definite single provider contract as we have with a big deal right now, but they will promise what they are going to buy for every quarter, which means we cannot report it in that way. It will be money anyways, but we cannot guarantee it because they only pay when they use the system. But they also commit that they will not use any other system.

So unless they stop doing medicine, they will pay.

[Helena Pettersson, executive]

And then we have a question from David Vignon at Stifel. You shared in the report that you were hiring in North America to be able to deliver on major contracts. Can you share your plans in terms of hiring for the coming quarters? How many hires should we expect? And should we expect personnel expenses to grow faster than sales in the short term?

[Torbjorn Kronander, executive]

In the short term, personnel expenses will grow faster than sales because we have to deliver these large products before we get income. We do not reveal how many people we are employing.

[Helena Pettersson, executive]

And then we have an additional question from Kristofer Liljeberg, Carnegie. What is the total investment for the properties? How large will the positive impact be on EBIT from owning instead of renting?

[Jessica Holmquist, executive]

Yes, SEK 150 million is the preliminary purchase price for the properties. We count on a smaller EBIT impact that we did not quantify, but it's immaterial.

[Torbjorn Kronander, executive]

But it's positive.

[Jessica Holmquist, executive]

It's positive, yes. For sure, it's positive, but it doesn't have a material impact on our P&L.

[Helena Pettersson, executive]

And what I can see, we have no further questions on the chat function. I will check the e-mail again. And we have no further questions on e-mail. So we end.

[Torbjorn Kronander, executive]

And we thank you for your attention. We look forward to see some of you on Thursday, if you come down to the General Assembly and the rest of you in December for our Q2 report. Thank you for listening, and goodbye.