The trouble with Iress

In late May I sold Iress Limited (ASX:IRE) out of my growth portfolio.

At that time the share price was about $8.30 and the outlook was for lacklustre growth as IRE was battling weak local market conditions and struggling to build an offshore footprint across Asia, Canada and the United Kingdom. Simply stated, the market price exceeded the StocksInValue valuation in both the current year and in 2014.

IRE was originally in the portfolio because of its impressive track record of profitability. The return on equity (ROE) generated by IRE was consistently good and well above broader market averages.

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Source: StocksInValue.com.au

In early August, IRE announced the acquisition of Avelo FS Holdings (Avelo) in the UK for a price of £210 million ($A370 million). After synergies, the acquisition is predicted to be earnings per share (EPS) positive. The acquisition is to be funded by an equity issue ($206 million), internal cash resources and the assumption of debt. The shareholder entitlement is on the basis of a two-for-nine share issue at $7.15. The retail offer closes in the next few weeks.

The significance of the acquisition cannot be understated and its announcement overshadowed a rather poor interim result, which saw June-half earnings decline by about 6%. The profit result justified my decision to exit the stock – but does the acquisition justify the rally in the share price?

What caught my eye in the IRE presentation documents?

As a so-called “veteran” fund manager I tend to draw upon my experiences to identify statements and propositions that I believe require more analysis or investor scrutiny.

So let’s review some key statements in the IRE presentation before I look at the StocksInValue valuation to determine whether I should re-enter the stock in my portfolio. These include:

1. “The acquisition will be 10% earnings per share accretive in 2014” and there will be $3 to $4 million of cost synergies to be realised in 2015;
2. There will be one-off implementation costs of $5 million and one-off transaction fees of $9 million to be expensed in 2013;
3. The largest IRE shareholder is the listed ASX Limited (ASX:ASX) and it committed to take up its entitlement for a “commitment fee” of 1.5% (i.e. about 11 cents per share);
4. IRE has 712 staff generating $209 million of revenue and Avelo has 546 staff generating $95 million of revenue;
5. Avelo revenue is split 68.5% from Wealth Management services (similar to IRESS product) and 31.5% from Enterprise Solutions (a mortgage sourcing and origination  product with no clear overlay with IRE);
6. Avelo declared EBIT in 2013 of $25 million, which was lower than that achieved in 2012; and
7. Following the acquisition, IRE will have $395 million of intangible assets and this exceeds the $312 million of shareholders’ equity.

Let’s consider the seven points above

Personally, I do not like the forecasting of profits in terms of EPS. Indeed for that to be an appropriate forecast for 2014, shouldn’t there be an EPS forecast for 2013?  Without 2013 numbers the forecast has no context and a valuation is difficult to derive.  In my view, IRE should have forecast net profit and EPS for the current and next financial year. Furthermore, the guidance should have included sensitivities to changes in currency and delays in synergies, etc. It also should have been clear on provisioning, as the bringing forward of provisions in 2013 would allow 2014 to look better.

With IRE, we are effectively considering the forward estimates of merged entities and so the question becomes, in this instance, whether IRE is forecasting EPS pre “one-off” expenses or are they included? There would appear to be a fair amount of “fudge ability” in these forecasts and investors need to understand this.

Why does ASX get a commitment fee to take up its entitlement and yet smaller shareholders do not? Was the discounted price of the rights issue not an attractive entry price in itself? I can guess the explanation from IRE advisors, who will claim that the deal needed the ASX (as the largest shareholder) to agree quickly to take up its rights so there would be no apparent shortfall.

Frankly, the capital raising timetable is unnecessarily short and there is no rights trading for shareholders. The expedited rights issue format was developed through the GFC because of volatile markets. Is that really the situation today? In any case, it is fascinating to see the ASX use its equity position as a means to achieve a better deal than other shareholders. I doubt that would have happened when it was both a mutual and it was regulating the market!

The comparison of staff numbers throws up additional questions. Presumably it means that Avelo is terribly overstaffed and so employee cost synergies will flow as expected. However, that assumes that Avelo management was not particularly good in managing their business.

The two businesses appear to be direct competitors in wealth management, and Avelo’s $70 million of revenue from this source should slot nicely into IRE. However, growth in revenue may be more problematic as Avelo is a major player in the UK market and market share gains may be difficult to achieve. Given that Avelo has struggled to grow profit in recent years, it may be more important that profit is grown by driving cost savings and lifting product prices.

Finally, there will be questions concerning the competing IT systems and platforms. Which one is better or can they run together? A lot of goodwill ($350 million) has been paid for Avelo and this will need to generate a substantially better return than it did in 2013. The opening return on employed equity (including debt) is less than 8%, and so IRE has introduced debt to charge up returns on capital.

Conclusion and valuation

The above may sound like an overly aggressive review of IRE but I believe it is essential for investors to look at fundamentals and scrutinise the facts rather than market price before they invest.

IRE itself gave an indication of risk by discounting the issue price. The ASX has given an indication of risk by requesting a fee to take up its discounted entitlement. There is much risk in this transaction that appears to have been dismissed by the market.

In my view, the market price reflects a herd mentality that permeates through capital markets at present. With low bond yields, many large investors are prepared to pay excessive prices for the promise of growth in the future.

The acquisition is likely to substantially reduce IRE’s future return on equity (Figure 1). It has also introduced debt to a pristine balance sheet. To my eye, the acquisition was essential for IRE to achieve growth into the future but I question the cost.

I wish IRE well and will follow its progress over the next few years with interest. However at today’s high market price above $8.75 I can see no justification to bring it back into the portfolio.

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Source: StocksInValue.com.au

John Abernethy is the Chief investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Growth Portfolio Statistics

Return since June 30, 2013: 9.05%

Returns since Inception (April 19, 2012): 28.25%

Average Yield: 6.29%

Start Value: $141,128.64

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Dividends accrued since June 30, 2013: $596.47

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