Rocket Software
Primary Analysis: Rocket Software $1B SSNs to Finance AMC Buyout Backed by Strong Margins, Cash Flow Despite High Leverage
Tue 04/16/2024 08:11 AM
Relevant Document:
Prelim. Offering Memorandum
Note: The Reorg Fundamentals team published an analysis on Rocket Software and its term loan on Monday, April 15. The forecasts provided by Reorg herein match those of the Reorg Fundamentals report and use a number of assumptions on the basis of the company's publicly disclosed commentary about go-forward strategy, peers’ commentary and macroeconomic assumptions. If you are a lender on this transaction and would like to see the full report, click HERE.
Rocket Software, an infrastructure software provider, is marketing $1 billion of senior secured notes due in 2028 to partially finance its acquisition of OpenText’s Application Modernization and Connectivity, or AMC, business for $2.275 billion. Price talk for the new B3/B- secured notes is in the 9% area and pricing is expected today, Tuesday, April 16.
The deal is being marketed off of pro forma adjusted net leverage of 5.9x on the basis of pro forma run-rate cash EBITDA of $773.6 million. This pro forma EBITDA figure includes AMC’s LTM pro forma adjusted EBITDA of $281.9 million, $24.8 million in stand-alone cost adjustments and $29.2 million in expected synergies from the acquisition.
The transaction will be financed by $200 million of contributed equity, $159 million of cash on hand, an extended and upsized $375 million revolver, a $1 billion sidecar term loan facility due in November 2028 and the $1 billion of senior secured notes.
The current sponsor, Bain Capital, has owned the company since 2018.
We believe that Rocket’s acquisition of AMC is complementary and adds market-leading products to Rocket’s portfolio, further enhancing its offering to existing enterprise customers while gaining it new customers. Specifically, AMC helps diversify Rocket’s modernization portfolio, aligning it with existing customer demands, whether on premises or through a hybrid cloud strategy, while supporting the entire mainframe life cycle for its customers.
In the modernization portfolio, Rocket and AMC have highly complementary product portfolios that can support the entire mainframe life cycle for enterprise customers, providing an opportunity to increase addressable spend within their overlapping blue-chip customer bases. At the same time, combined R&D engines will drive innovation and the modernization of solutions to further accelerate a shift to hybrid cloud technology from other legacy systems.
Our concerns largely stem from the group’s high pro forma leverage coupled with organic growth that is historically in the low single digits. Historical cash flow has been strong, with good cash conversion, however, and the company has successfully integrated several acquisitions over the last few years.
In our base case scenario, recurring revenue and customer retention continue, with a successful integration of AMC and deleveraging to 3.9x by 2027.
Selected pricing comparables are below:
Current price talk for the new notes is in the 9% area. On the basis of the trading levels of U.S. software issuers, many with relatively similar operating models, the yield is at the upper end of the range for single-B rated peers, reflecting the group’s high leverage at closing coupled with low single-B ratings.
Business comparables are shown below:
The selected publicly traded comparable companies operate within the software, analytics platforms, and cloud-based services industries.
Over the past five years, selected comparable companies have demonstrated continuous revenue growth, despite pandemic shock and economic downturn. Starting from 2020, Rocket Software has displayed consistent revenue growth. After strong growth in 2021 boosted by acquisitions, momentum weakened, however, with the company experiencing 1% year-over-year growth in 2022 and 4% in 2023, positioning it at the bottom of its peer group.
Rocket Software consistently boasts a top-of-the-bracket margin performance among peers of more than 40%, which could be attributed to its unique services. Likely because of the surge of labor cost inflation, however, EBITDA over the last two years has averaged 41%, down from a peak of 48% in 2021. Most peers maintained relatively stable EBITDA margins from 2019 to 2023, although Alteryx experienced a considerable drop in EBITDA margin starting in 2021, due to a significant surge in sales and marketing expenses related to the company’s marketing strategy and initiatives.
The software companies within the comparables group have experienced a significant trend of merger and acquisition activity over the past five years. In 2021, Rocket Software led the way with the largest business combination transaction, acquiring ASG Technologies to extend its technology and global reach. However, the company subsequently dialed back its M&A efforts in 2022 and 2023, focusing instead on integrating acquired businesses and cost savings. EverCommerce also curtailed its M&A activities during this period. In contrast, Progress Software, Informatica and Alteryx ramped up their M&A spending in 2022 and 2023.
Although EverCommerce, Progress Software and Informatica maintained relatively stable or increasing cash conversions, the decline in capital expenditures, both for tangible and intangible assets, has improved Dye & Durham’s free cash flow, leading to an increase in its cash conversion to 97% in 2023 from 85.4% in 2020.
Out of recent transactions in the Reorg Fundamentals database, the AMC multiple is positioned at the bottom of the range.
Sources and Uses of Proceeds
Pro Forma Capital Structure
On a pro forma basis, as of and for the 12 months ended Dec. 31, 2023, the group’s nonguarantor subsidiaries represented 4% of its total assets, 16% of its total revenue and 11% of its pro forma run-rate cash EBITDA.
Rocket’s product portfolio provides solutions for customers’ modernization needs: Driven by rising competition and the increasing complexity and volume of legacy mainframe processes that need to be converted and updated, Rocket’s customers are focused on updating critical mainframe technology by improving processes and speed and migrating data, systems and applications to cloud computers or even a hybrid platform, and this focus is driving demand for Rocket’s services. Capitalizing on these market dynamics, Rocket offers a platform and focused R&D that provide a comprehensive solution for IT professionals, fully integrating into business processes as an operational tool.
Favorable secular tailwinds as long-term, blue-chip customers rely on Rocket to modernize mission-critical applications: Rocket’s focus on R&D helps customers build and deploy new services and applications to respond to marketplace changes and new technologies adeptly. These modernization services enable customers to improve proven applications on legacy environments without losing valuable business logic or decades of investment. Modernization is not a one-time event - it empowers customers to continually modernize and optimize applications and infrastructure, which creates recurring revenue and very sticky customer relationships.
Customer-centric R&D drives Rocket’s value proposition and customer stickiness: Employing 1,900 engineers across five continents, Rocket has a customer-first approach to business development, which has resulted in business units organizing their solutions and R&D efforts by underlying system type and technology themes to better align with customer needs and to increase accountability and the ownership of results. A granular view of investment strategy (high growth, end-of-life, etc.) coupled with planned, targeted R&D spending ends up better serving key customers and channel partners with unique solutions. These enhance customer stickiness and create recurring revenue.
Predictable, high-visibility revenue model: Rocket benefits from high top-line visibility, with most revenue consisting of subscriptions and fixed-duration maintenance contracts, which has arisen from its R&D focus. Rocket’s software solutions are mission critical and deeply embedded within IT infrastructure, resulting in high switching costs and sticky relationships. Also, the stable annual 70%-plus recurring revenue reflects the mission-critical nature of Rocket’s solutions, coupled with its significant domain expertise, which enables a high level of end-user customization, further entrenching Rocket’s solutions within its customers’ business processes.
Solid cash generation across historical periods and Reorg forecast cases: Rocket generated robust free cash flow after debt servicing in the past five years, driven by negative working capital and strong profitability. With low maintenance capex and the ability to scale back M&A spending as needed, the company maintains good financial flexibility and should generate strong cash flow going forward. Across our three forecast scenarios (base case, low case and high case), Rocket - combined with AMC - generates cash on the balance sheet, without M&A activities, and, given strong EBITDA margins, also has the flexibility of scaling back development spending if needed.
High exposure technology risk: Rocket and AMC will face numerous technological challenges, including the unknown frontier of how AI will affect client business practices and Rocket’s internal DevOps (COBOL) and ITOps functions, while maintaining its new combined R&D platform. The company must invest appropriately and aggressively in making sure each module of the modernization solution is “best-in-class” to withstand competitive challenges from existing and newly formed software development companies or competitors trying to create better, more cost-efficient solutions.
Large cloud service providers can be expected to provide an increasing number of tools that will make it simpler for enterprise clients to actually use and implement their own systems and reduce the amounts paid to third-party consultants and engineers like Rocket, posing a potential threat. Rocket and AMC have amassed numerous products through acquisitions, and the ability of these various software products to work seamlessly with each other and the integration of numerous sales force cultures, incentives and styles, will be rife with challenges.
Synergy realizations and acquisition risk: Acquisitions in the software and tech industry are particularly risky, with numerous companies bought and sold that have volatile EBITDA with numerous add-backs and valuations often based on revenue (enterprise value/sales). Given the company’s long history of good cash flow, we note the numerous add-backs to AMC’s financials, although we are comfortable with the adjustments. Notwithstanding, forecasting and predicting credit improvement or deterioration is particularly difficult, as the industry is characterized by very talented and tough competition, new technologies, and the difficulties of implementing cost cuts expected with acquisitions and not risking a loss of customers.
Rocket has been built on a series of successful acquisitions thus far and has increased revenue over the last five years. Still, investors are expected to assume the add-backs of losses on the sale of recently purchased assets, one-time acquisition costs and expected synergies and add-backs totaling $200-plus million and representing 26% of “PF Adjusted EBITDA” of $774 million. Nonetheless, acquisitions come with significant uncertainties surrounding the performance of the personnel and products acquired, the demand for the target's products, and cybersecurity and accounting risks, among others. This results in a significant risk that the synergies and cost savings may not translate into future EBITDA or cash flow.
Moat/barriers to entry could erode: Rocket and AMC enjoy significant barriers to entry, with a strong market share and sticky customers, as their software products are embedded in a customer base of more than 12,500 clients and, in Rocket’s case, largely support mission-critical processes. However, as has been seen often in software technology, an improvement in the user experience of an application, due diligence or accounting could result in a shift in market share.
Users will go to the solutions provider that is the most efficient and easy to use. We think that the larger cloud-service providers - like Amazon AWS, Microsoft or Google Cloud - could develop Rocket’s/AMC’s expertise. Additionally, although less likely, new startups could also develop, with seasoned industry veterans teaming up with the latest generation of software engineers to produce better, more cost-efficient ways to convert legacy systems, and their services could possibly use new AI technologies to revolutionize how data is managed.
Operational, security and execution risks: Although this consideration is somewhat generic and inherent to the software industry, we think about breaches in security measures regarding Rocket’s/AMC’s customers or even third-party data centers hosting facilities used by the company. Rocket is intricately intertwined with cloud computing platform providers and third-party service partners; thus, a breach of security of the underlying internet infrastructure that allows unauthorized access to a customer’s data, the company’s data or IT systems, or the blockage or disablement of authorized access to the company’s services would add to costs of doing business and might inhibit the company’s ability to retain clients. We see the inability to realize the expected business and financial benefits of the AMC acquisition as part of this risk and its legacy COBOL focus as adding to this risk.
Lack of organic growth and reliance on M&A: Historically, Rocket’s growth has come from M&A, with organic growth appearing to be in the low single digits and below inflation. We think that this arises after initial customer penetration and legacy mainframe solutions are integrated or modernized; the company may have difficulty further penetrating that customer or raising prices.
We do not think there is any wage-inflation-pass-through-type mechanism in the contracts. This leads to low organic growth based more on new customer acquisition. Thus, M&A has been a big part of the group’s growth strategy. We think that AMC is very complementary and that cross-selling is possible, although we think that it is a complex acquisition. M&A will likely be on pause for the near term, as the two companies are integrated. Revenue growth may, therefore, continue to be in the low single digits, potentially slowing the deleveraging story.
Rocket is a leading global infrastructure software provider with a broad portfolio of mission-critical products servicing more than 12,500 large- and mid-size customers across a diverse set of verticals, including financial services, communications, manufacturing and healthcare. The group’s R&D philosophy has resulted in world-class revenue retention rates of 93% across a highly cost-efficient global platform. Rocket’s multifaceted go-to-market model is closely aligned with its relevant end markets. Its highly predictable and stable business model results in significant revenue visibility, with recurring revenue of 76%.
As Rocket has evolved, its more-than-25-year relationship with IBM has continued to grow and strengthen. Rocket’s R&D innovation extends the life cycle of IBM’s core platforms and enables IBM to invest its limited R&D budget in other growth areas. Rocket’s dedicated customer support, sales enablement and implementation teams enable IBM to exceed customer needs. Reflecting the success of Rocket’s products outside of the IBM ecosystem of customers, Rocket has reduced its partner concentration with IBM materially over the last several years, down to about 23% of its total revenue, from 56% at the time of the Bain leveraged buyout in 2018.
The company has three business units.
For modeling purposes, we assume that AMC has a similar cost structure to Rocket, with slightly higher margins. In our forecast, we prioritize integrating the acquisitions and realizing synergies, setting aside potential M&A opportunities in the industry. We note that M&A has been responsible for a large portion of Rocket’s historic growth, while organic growth is in the low single digits.
In our base case, combined company revenue is forecast to grow at 4%, slightly higher than historic Rocket organic growth but in line with AMC’s revenue growth. We forecast two years to realize the $29.2 million of cost synergies, which we believe is prudent, and do not see a lot of cross-selling in the first instance, as the two companies focus on integration. EBITDA margins are expected to be around 60%, as AMC’s modernization solutions centered around COBOL-related noncritical mainframe processes are slightly more profitable, producing an overall deleveraging of the balance sheet to 3.9x in 2027, down from 6x at closing. Cash grows on the balance sheet and is not used to reduce debt beyond amortization payments.
In our low case, we stress the company with low growth of 1.5% in 2024 and a mere 1% top-line growth during the remainder of the forecast years. The synergies again take two years to realize, and the stickiness of the group’s customer relationships and recurring revenue provide for good free cash flow and deleveraging down to 4.7x by the end of the forecast period.
In the high case, we assume 6% revenue growth throughout the forecast years, as the company can cross-sell the modernization solutions offered by AMC and vice versa. Note that the revenue growth here does not include any M&A, and the growth rate is somewhat higher than the historic low single-digit organic growth rate at Rocket. We like the complementary nature of the businesses, as mentioned, and we have given credit for cross-selling in our high case.
Our model accrues cash on the balance sheet. If this cash were deployed toward reducing debt, interest costs would be lower, translating to a steeper deleveraging trajectory.
Fundamentals by Reorg has financial models of and transcripts on more than 2,500 public and private companies across leveraged loans and high yield. The full universe of companies for Fundamentals by Reorg subscribers is HERE. To request a trial of Fundamentals by Reorg, please email sales@reorg.com.
Prelim. Offering Memorandum
Note: The Reorg Fundamentals team published an analysis on Rocket Software and its term loan on Monday, April 15. The forecasts provided by Reorg herein match those of the Reorg Fundamentals report and use a number of assumptions on the basis of the company's publicly disclosed commentary about go-forward strategy, peers’ commentary and macroeconomic assumptions. If you are a lender on this transaction and would like to see the full report, click HERE.
Transaction Overview
Rocket Software, an infrastructure software provider, is marketing $1 billion of senior secured notes due in 2028 to partially finance its acquisition of OpenText’s Application Modernization and Connectivity, or AMC, business for $2.275 billion. Price talk for the new B3/B- secured notes is in the 9% area and pricing is expected today, Tuesday, April 16.
The deal is being marketed off of pro forma adjusted net leverage of 5.9x on the basis of pro forma run-rate cash EBITDA of $773.6 million. This pro forma EBITDA figure includes AMC’s LTM pro forma adjusted EBITDA of $281.9 million, $24.8 million in stand-alone cost adjustments and $29.2 million in expected synergies from the acquisition.
The transaction will be financed by $200 million of contributed equity, $159 million of cash on hand, an extended and upsized $375 million revolver, a $1 billion sidecar term loan facility due in November 2028 and the $1 billion of senior secured notes.
The current sponsor, Bain Capital, has owned the company since 2018.
We believe that Rocket’s acquisition of AMC is complementary and adds market-leading products to Rocket’s portfolio, further enhancing its offering to existing enterprise customers while gaining it new customers. Specifically, AMC helps diversify Rocket’s modernization portfolio, aligning it with existing customer demands, whether on premises or through a hybrid cloud strategy, while supporting the entire mainframe life cycle for its customers.
In the modernization portfolio, Rocket and AMC have highly complementary product portfolios that can support the entire mainframe life cycle for enterprise customers, providing an opportunity to increase addressable spend within their overlapping blue-chip customer bases. At the same time, combined R&D engines will drive innovation and the modernization of solutions to further accelerate a shift to hybrid cloud technology from other legacy systems.
Our concerns largely stem from the group’s high pro forma leverage coupled with organic growth that is historically in the low single digits. Historical cash flow has been strong, with good cash conversion, however, and the company has successfully integrated several acquisitions over the last few years.
In our base case scenario, recurring revenue and customer retention continue, with a successful integration of AMC and deleveraging to 3.9x by 2027.
Comparables
Selected pricing comparables are below:
Current price talk for the new notes is in the 9% area. On the basis of the trading levels of U.S. software issuers, many with relatively similar operating models, the yield is at the upper end of the range for single-B rated peers, reflecting the group’s high leverage at closing coupled with low single-B ratings.
Business comparables are shown below:
The selected publicly traded comparable companies operate within the software, analytics platforms, and cloud-based services industries.
Over the past five years, selected comparable companies have demonstrated continuous revenue growth, despite pandemic shock and economic downturn. Starting from 2020, Rocket Software has displayed consistent revenue growth. After strong growth in 2021 boosted by acquisitions, momentum weakened, however, with the company experiencing 1% year-over-year growth in 2022 and 4% in 2023, positioning it at the bottom of its peer group.
Rocket Software consistently boasts a top-of-the-bracket margin performance among peers of more than 40%, which could be attributed to its unique services. Likely because of the surge of labor cost inflation, however, EBITDA over the last two years has averaged 41%, down from a peak of 48% in 2021. Most peers maintained relatively stable EBITDA margins from 2019 to 2023, although Alteryx experienced a considerable drop in EBITDA margin starting in 2021, due to a significant surge in sales and marketing expenses related to the company’s marketing strategy and initiatives.
The software companies within the comparables group have experienced a significant trend of merger and acquisition activity over the past five years. In 2021, Rocket Software led the way with the largest business combination transaction, acquiring ASG Technologies to extend its technology and global reach. However, the company subsequently dialed back its M&A efforts in 2022 and 2023, focusing instead on integrating acquired businesses and cost savings. EverCommerce also curtailed its M&A activities during this period. In contrast, Progress Software, Informatica and Alteryx ramped up their M&A spending in 2022 and 2023.
Although EverCommerce, Progress Software and Informatica maintained relatively stable or increasing cash conversions, the decline in capital expenditures, both for tangible and intangible assets, has improved Dye & Durham’s free cash flow, leading to an increase in its cash conversion to 97% in 2023 from 85.4% in 2020.
Out of recent transactions in the Reorg Fundamentals database, the AMC multiple is positioned at the bottom of the range.
Capital Structure & Uses of Proceeds
Sources and Uses of Proceeds
Pro Forma Capital Structure
Corporate Structure
Source: Page 23 of the OM PDF
On a pro forma basis, as of and for the 12 months ended Dec. 31, 2023, the group’s nonguarantor subsidiaries represented 4% of its total assets, 16% of its total revenue and 11% of its pro forma run-rate cash EBITDA.
Key Credit Considerations
Rocket’s product portfolio provides solutions for customers’ modernization needs: Driven by rising competition and the increasing complexity and volume of legacy mainframe processes that need to be converted and updated, Rocket’s customers are focused on updating critical mainframe technology by improving processes and speed and migrating data, systems and applications to cloud computers or even a hybrid platform, and this focus is driving demand for Rocket’s services. Capitalizing on these market dynamics, Rocket offers a platform and focused R&D that provide a comprehensive solution for IT professionals, fully integrating into business processes as an operational tool.
Favorable secular tailwinds as long-term, blue-chip customers rely on Rocket to modernize mission-critical applications: Rocket’s focus on R&D helps customers build and deploy new services and applications to respond to marketplace changes and new technologies adeptly. These modernization services enable customers to improve proven applications on legacy environments without losing valuable business logic or decades of investment. Modernization is not a one-time event - it empowers customers to continually modernize and optimize applications and infrastructure, which creates recurring revenue and very sticky customer relationships.
Customer-centric R&D drives Rocket’s value proposition and customer stickiness: Employing 1,900 engineers across five continents, Rocket has a customer-first approach to business development, which has resulted in business units organizing their solutions and R&D efforts by underlying system type and technology themes to better align with customer needs and to increase accountability and the ownership of results. A granular view of investment strategy (high growth, end-of-life, etc.) coupled with planned, targeted R&D spending ends up better serving key customers and channel partners with unique solutions. These enhance customer stickiness and create recurring revenue.
Predictable, high-visibility revenue model: Rocket benefits from high top-line visibility, with most revenue consisting of subscriptions and fixed-duration maintenance contracts, which has arisen from its R&D focus. Rocket’s software solutions are mission critical and deeply embedded within IT infrastructure, resulting in high switching costs and sticky relationships. Also, the stable annual 70%-plus recurring revenue reflects the mission-critical nature of Rocket’s solutions, coupled with its significant domain expertise, which enables a high level of end-user customization, further entrenching Rocket’s solutions within its customers’ business processes.
Solid cash generation across historical periods and Reorg forecast cases: Rocket generated robust free cash flow after debt servicing in the past five years, driven by negative working capital and strong profitability. With low maintenance capex and the ability to scale back M&A spending as needed, the company maintains good financial flexibility and should generate strong cash flow going forward. Across our three forecast scenarios (base case, low case and high case), Rocket - combined with AMC - generates cash on the balance sheet, without M&A activities, and, given strong EBITDA margins, also has the flexibility of scaling back development spending if needed.
Key Credit Risks
High exposure technology risk: Rocket and AMC will face numerous technological challenges, including the unknown frontier of how AI will affect client business practices and Rocket’s internal DevOps (COBOL) and ITOps functions, while maintaining its new combined R&D platform. The company must invest appropriately and aggressively in making sure each module of the modernization solution is “best-in-class” to withstand competitive challenges from existing and newly formed software development companies or competitors trying to create better, more cost-efficient solutions.
Large cloud service providers can be expected to provide an increasing number of tools that will make it simpler for enterprise clients to actually use and implement their own systems and reduce the amounts paid to third-party consultants and engineers like Rocket, posing a potential threat. Rocket and AMC have amassed numerous products through acquisitions, and the ability of these various software products to work seamlessly with each other and the integration of numerous sales force cultures, incentives and styles, will be rife with challenges.
Synergy realizations and acquisition risk: Acquisitions in the software and tech industry are particularly risky, with numerous companies bought and sold that have volatile EBITDA with numerous add-backs and valuations often based on revenue (enterprise value/sales). Given the company’s long history of good cash flow, we note the numerous add-backs to AMC’s financials, although we are comfortable with the adjustments. Notwithstanding, forecasting and predicting credit improvement or deterioration is particularly difficult, as the industry is characterized by very talented and tough competition, new technologies, and the difficulties of implementing cost cuts expected with acquisitions and not risking a loss of customers.
Rocket has been built on a series of successful acquisitions thus far and has increased revenue over the last five years. Still, investors are expected to assume the add-backs of losses on the sale of recently purchased assets, one-time acquisition costs and expected synergies and add-backs totaling $200-plus million and representing 26% of “PF Adjusted EBITDA” of $774 million. Nonetheless, acquisitions come with significant uncertainties surrounding the performance of the personnel and products acquired, the demand for the target's products, and cybersecurity and accounting risks, among others. This results in a significant risk that the synergies and cost savings may not translate into future EBITDA or cash flow.
Moat/barriers to entry could erode: Rocket and AMC enjoy significant barriers to entry, with a strong market share and sticky customers, as their software products are embedded in a customer base of more than 12,500 clients and, in Rocket’s case, largely support mission-critical processes. However, as has been seen often in software technology, an improvement in the user experience of an application, due diligence or accounting could result in a shift in market share.
Users will go to the solutions provider that is the most efficient and easy to use. We think that the larger cloud-service providers - like Amazon AWS, Microsoft or Google Cloud - could develop Rocket’s/AMC’s expertise. Additionally, although less likely, new startups could also develop, with seasoned industry veterans teaming up with the latest generation of software engineers to produce better, more cost-efficient ways to convert legacy systems, and their services could possibly use new AI technologies to revolutionize how data is managed.
Operational, security and execution risks: Although this consideration is somewhat generic and inherent to the software industry, we think about breaches in security measures regarding Rocket’s/AMC’s customers or even third-party data centers hosting facilities used by the company. Rocket is intricately intertwined with cloud computing platform providers and third-party service partners; thus, a breach of security of the underlying internet infrastructure that allows unauthorized access to a customer’s data, the company’s data or IT systems, or the blockage or disablement of authorized access to the company’s services would add to costs of doing business and might inhibit the company’s ability to retain clients. We see the inability to realize the expected business and financial benefits of the AMC acquisition as part of this risk and its legacy COBOL focus as adding to this risk.
Lack of organic growth and reliance on M&A: Historically, Rocket’s growth has come from M&A, with organic growth appearing to be in the low single digits and below inflation. We think that this arises after initial customer penetration and legacy mainframe solutions are integrated or modernized; the company may have difficulty further penetrating that customer or raising prices.
We do not think there is any wage-inflation-pass-through-type mechanism in the contracts. This leads to low organic growth based more on new customer acquisition. Thus, M&A has been a big part of the group’s growth strategy. We think that AMC is very complementary and that cross-selling is possible, although we think that it is a complex acquisition. M&A will likely be on pause for the near term, as the two companies are integrated. Revenue growth may, therefore, continue to be in the low single digits, potentially slowing the deleveraging story.
Business Overview
Rocket is a leading global infrastructure software provider with a broad portfolio of mission-critical products servicing more than 12,500 large- and mid-size customers across a diverse set of verticals, including financial services, communications, manufacturing and healthcare. The group’s R&D philosophy has resulted in world-class revenue retention rates of 93% across a highly cost-efficient global platform. Rocket’s multifaceted go-to-market model is closely aligned with its relevant end markets. Its highly predictable and stable business model results in significant revenue visibility, with recurring revenue of 76%.
As Rocket has evolved, its more-than-25-year relationship with IBM has continued to grow and strengthen. Rocket’s R&D innovation extends the life cycle of IBM’s core platforms and enables IBM to invest its limited R&D budget in other growth areas. Rocket’s dedicated customer support, sales enablement and implementation teams enable IBM to exceed customer needs. Reflecting the success of Rocket’s products outside of the IBM ecosystem of customers, Rocket has reduced its partner concentration with IBM materially over the last several years, down to about 23% of its total revenue, from 56% at the time of the Bain leveraged buyout in 2018.
The company has three business units.
- Infrastructure modernization: optimization of legacy mainframe operating systems.
- Data modernization: optimization of legacy mainframe data sets, enabling faster access and preparing for eventual access in the “cloud” or other digital platforms.
- Application modernization: helping enterprise customers migrate entirely to the cloud or digital platforms, where the company solves unique problems where a mainframe application cannot be upgraded to manage the data or processes in the cloud. The company becomes embedded into the actual processes and the R&D effort focuses explicitly on solving problems that may arise.
Financial Overview
For modeling purposes, we assume that AMC has a similar cost structure to Rocket, with slightly higher margins. In our forecast, we prioritize integrating the acquisitions and realizing synergies, setting aside potential M&A opportunities in the industry. We note that M&A has been responsible for a large portion of Rocket’s historic growth, while organic growth is in the low single digits.
In our base case, combined company revenue is forecast to grow at 4%, slightly higher than historic Rocket organic growth but in line with AMC’s revenue growth. We forecast two years to realize the $29.2 million of cost synergies, which we believe is prudent, and do not see a lot of cross-selling in the first instance, as the two companies focus on integration. EBITDA margins are expected to be around 60%, as AMC’s modernization solutions centered around COBOL-related noncritical mainframe processes are slightly more profitable, producing an overall deleveraging of the balance sheet to 3.9x in 2027, down from 6x at closing. Cash grows on the balance sheet and is not used to reduce debt beyond amortization payments.
In our low case, we stress the company with low growth of 1.5% in 2024 and a mere 1% top-line growth during the remainder of the forecast years. The synergies again take two years to realize, and the stickiness of the group’s customer relationships and recurring revenue provide for good free cash flow and deleveraging down to 4.7x by the end of the forecast period.
In the high case, we assume 6% revenue growth throughout the forecast years, as the company can cross-sell the modernization solutions offered by AMC and vice versa. Note that the revenue growth here does not include any M&A, and the growth rate is somewhat higher than the historic low single-digit organic growth rate at Rocket. We like the complementary nature of the businesses, as mentioned, and we have given credit for cross-selling in our high case.
Our model accrues cash on the balance sheet. If this cash were deployed toward reducing debt, interest costs would be lower, translating to a steeper deleveraging trajectory.
Fundamentals by Reorg has financial models of and transcripts on more than 2,500 public and private companies across leveraged loans and high yield. The full universe of companies for Fundamentals by Reorg subscribers is HERE. To request a trial of Fundamentals by Reorg, please email sales@reorg.com.
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