OFX: running hard to stand still

There's been a complete overhaul in the corner offices of OFX Group since its profit warning and our downgrade to Sell just over a year ago, and the incoming management have impressive resumes.

New chief executive ‘Skander' Malcolm did great things at GE Capital; new chief financial officer Selena Verth has impressive credentials from BT Financial; Mike Kennedy, installed as President, North America, hails from McKinsey and Wells Fargo; while new chief technology officer Wendy Glasgow was previously responsible for managing and deploying Google's Ads Data Hub for Asia-Pacific clients. You can't say fairer than that.

The company's latest full-year result suggests they're already having an impact, with a second-half turnaround sending profit before tax up 26% over the first half to give a full-year increase of 4%.

Jawboning

Skander Malcolm had promised ‘positive jaws' (revenue increasing faster than costs) for 2018 and he pretty much delivered on that – at least if we exclude almost $5m of capitalised technology spend and a 62% increase in amortisation costs. Revenue increased 4.6% to $110m and cash expenses rose 3.5% to $80m – although taken after depreciation and amortisation, the cost increase was 4.8%.

The breakdown of costs tells a story. Staff costs rose 8% over the year, due to a 13% increase in staff numbers to around 340. IT spending also rose 8%, while amortisation increased 61% following a doubling of capitalised technology spend in 2017 and a 31% increase in 2018.

Other than that, in terms of controllable costs (ie excluding bad debts and irrecoverable GST), everything was lower – professional fees down 15%, communications down 5%, compliance down 8% and travel down 19%. Even promotional expenses fell 1%.

It gives the impression of a company that has pared everything to the bone – all so it can maximise its investment in technology. In the past year, this has led to a new portal for corporate customers to integrate OFX's payments systems with their own, a refreshed global website, a rebranded app, and a global currency account designed to give online sellers greater control of transfers.

And, while there are a lot of moving parts, all this work appears to be having a positive effect on the numbers. Active clients (those that have transacted within the previous 12 months) rose 3% over the year, and they conducted 9% more transactions on average, at 5.95 – although the average transaction size fell 4% to $22,000. New registrations also rose 6% over the year (although they slipped 4% in the second half).

Margin lower

The trouble is that cost-cutting alone can't be relied upon to drive ongoing growth in profits – at least not the kind of growth implied by OFX's price-earnings multiple of 23.

For one thing, you can only remove a particular cost once. Most of all, though, your peers will probably be doing the same thing and, in the absence of competitive advantages, the cost reductions are likely to end up in customers', rather than shareholders', pockets.

Sure enough, despite all the hard work and a 9% increase in total transaction value, the revenue margin was pegged back from 0.54% to 0.52%, so revenue only rose 5% to $110m.

The 5% cost increase meant a 4% rise in profit before tax, and there was more bad news at the bottom line, with a return of the tax rate to more normal levels at 25%. As a result, net profit fell 5% to $18.7m and earnings per share fell 4% to 7.7 cents. The tax adjustment won't be ongoing, but it means lower underlying profits and a lower starting point for the valuation.

The market appears happy to back management to make further improvements: after hitting an all-time low of $1.28 back in December, the stock has gained 37% (and it's up a similar amount since our earlier Sell recommendation). We're mindful, though, of Warren Buffett's warning that ‘when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact'.

There are worse businesses than OFX Group, but it's also showing little sign of the growth that attracted us in the first place, or the competitive strengths we imagined we saw. In their absence, and with a price-earnings ratio of 23, we're a long way from having another tilt and we're CEASING COVERAGE.