Hexagon’s Q1: PPM revenue down 11% — are we poised for an uptick?

Hexagon today reported Q1 results that showed that strength in other markets couldn’t offset continued sluggishness in oil and gas. The details:

• Total revenue of €778 million was up 7% as reported and up 3% in constant currencies and a comparable organizational structure – so, organic and constant currencies (cc, organic)
• The Geospatial Enterprise Solutions businesses reported total revenue of €403 million, up 9% as reported and up 4% cc, organic. Growth was driven by strong demand from civil construction in EMEA and North America, offset by a weak mining sector in North America. Safety & Infrastructure continued to experience weak demand from the US defense sector but saw demand for its Smart City and public safety offerings
• The Industrial Enterprise Solutions, which include PPM, reported revenue of  €375 million, up 6% as reported and up 2% cc, organic. Demand from the electronics and aerospace sectors continued to grow but could not offset weakness in oil and gas. PPM revenue declined -11% year/year due to the continued weak demand from the oil and gas market. This, from the Q1 report, is ominous: “Actions have been taken to ensure future growth and increased profitability.”  More on what that means, below.
• In Western Europe, the largest contributors were Germany, France, the Nordic countries and UK, on strong growth across the manufacturing sectors.
• The Middle East returned to growth, after oil-related downturns across the Hexagon businesses.
• In Asia, China reported 6% organic growth with solid demand across industries; and Australia bounced back with sales to infrastructure and construction. Strong growth was also reported in Japan but South Korea, beset by strong competition in the electronics sector from China, declined by double digits.
• In the Americas, North America reported slightly negative organic growth primarily due to weak demand from the mining industry as well as the oil and gas market in the US. However, South America continued to improve and returned to growth, driven by strong demand from the mining industry.
• In other bits of news in the earnings materials, Hexagon in February announced a group-wide cost savings program, including “reducing administrative costs”, that affects approximately 500 employees. All restructuring costs were expensed as non-recurring items in the first quarter 2017. CEO Ola Rollén told investors that the two divisions were equally affected but that, within the Industrial segment, “PP&M was cut a bit harder than MI”. (I included this tidbit because of a discussion of GAAP versus non-GAAP accounting that happened over on LinkedIn. These restructuring charges are a one-time item that has to be shown on the income statement –after all, the severances were really paid out– but shouldn’t be included when modeling expenses for future quarters.)
• Then, MSC Software. That acquisition closed late in April, so no revenue or operating expense is included in the Q1 financials. However, “non-cash PPA adjustments of €10.4 million related to impairment of overlapping technologies and cash transaction costs of €2.1 million have been expensed as nonrecurring items in the first quarter 2017.” PPA stands for Purchase Price Allocation, and is a way of allocating the purchase price into assets and liabilities on the balance sheet. More on MSC, below.

Hexagon is a complicated company, with many parts operated independently so it’s interesting when we can see the overlaps. On the earnings call, Mr. Rollén told investors that Audi is the first commercial manufacturer to use Hexagon’s Command and Control solutions, usually applied for public safety, to manage its Ingolstadt production facility, He said that this implementation “will support the complete range of control centre tasks at the Ingolstadt plant, bringing together all physical security systems, building technology systems, cameras, communication systems and notification systems into one unified platform. This could be an expansion area for us; if we combine this with robotics, for example, we have a clear vision for the future.” That sounds like IoT to me, and not security; I’ve asked for more information.

PPM came up a lot during the call. This was Hexagon’s largest acquisition and was supposed to transform Hexagon to a mostly-software company. It largely did that, but the troubles in oil and gas have put a damper on growth expectations. Mr. Rollén reminded investors that PPM sees 50% of its revenue from oil and gas, with the “lion’s share from onshore. Our cost structure is going down in the quarters to come, so we can say that we see profitability going up. We restructured the sales force, are focusing on regional implementations, and have a good pipeline for Ecosys. We believe we’re at the bottom and see recovery in the sector. [For example,] offshore oil rig counts growing again for the first time in 3 years, as mothballed oil rigs are taken into operation again — we see that as a first sign of recovery. Hope for organic growth improvement for 2017.”

One observant investor asked about recurring versus non-recurring revenue; 70% is recurring, while 30% of revenue is perpetual plus services. That 30% has been hurt more than the recurring by the downturn, but each client’s recurring contract is renegotiated every 3 years and some customers have renewed for smaller deal sizes. So while the 70% is more secure, even in tough economic times, it’s not a “lock” once the contracts come up for renegotiation.

About MSC: This is Hexagon’s third largest acquisition, and investors want to understand how to model its contributions to Hexagon. Mr. Rollén declined to discuss it specifically but said that CAE is expected to grow at least 5% per year, with EBIT margins of 25% to 35%. As far as the R&D roadmap for integration, Mr. Rollén said that it would be connected to the metrology business, PCDMIS, as well as with the other CAE tools (as in Vero) and the Q-DAS Statistical Process Control solutions. Mr. Rollén summarized it this way: “At the end of the day we want to use all of the data captured by metrology in a production line and getting that data into CAE so that design engineers can make cleverer, smarter decisions for the future.”

Mr. Rollén’s legal concerns, which are unrelated to Hexagon, only came up once. I think he was only half-joking when he told an investor that there had been a board meeting earlier in the day and “he wasn’t fired then.”

Hexagon doesn’t offer specific guidance per quarter, but the Financial Times has the average of the 11 analysts who follow the company suggesting Q2 revenue of €877 million, and fiscal 2017 revenue of €3.46 billion.