The market has put Computershare through the wringer lately but, in presenting its full-year results, management was keen to point out that the company is still plugging away, delivering value.
The very first slide of the results presentation, in fact, showed how underlying operating profit before depreciation and amortization (EBITDA) – ignoring currency movements and the interest the company earns (or doesn’t earn more like) on client cash balances (aka ‘margin income’) – had risen 4% in 2016 and 14% a year over the past three years.
Underlying EPS down 8% in line with guidance
Negative currency impact and lower margin income
Shares cheap on 8% free cash flow yield
That performance has been helped by a number of acquisitions, the amortisation for which isn't captured in the EBITDA figure. However, on an absolute basis the underlying EBITDA has risen by US$120m on a US$56m increase in capital employed. These figures provide some context to concerns that the company is diluting the quality of its business with a lower returning mortgage servicing business. Lower returning it might be – but it’s clearly no slouch.
|Year to June ($m)||2016||2015|| /(–)
|U'lying net profit||304||333||(9)|
|U'lying EPS (c)||55||60||(8)|
|DPS (c) ($A)||33||31||6|
|Final dividend||17c (up 6%) ($A), 20% franked,
ex date 16 Aug
The company also announced a new cost-cutting initiative, although few details were given and we tend to feel that cost cutting should be a normal part of business rather than an 'initiative'. Guidance for the costs involved in centralising the company’s US facilities in Louisville was also cut by US$5m to US$80–85m. The expected annual cost savings are still expected to be US$25–30m, with about half of that to be achieved by 2018 and the rest by 2020.
Blockchain and Brexit
Management even had some good things to say about blockchain and Brexit, although their comments were understandably vague. ‘Arguably they impact a smaller proportion of our business than some investors think,’ suggested chief executive Stuart Irving in the conference call.
On blockchain, the presentation notes suggested that ‘our global presence makes us an attractive partner to blockchain solutions providers and gives us access to a wide range of potential commercial blockchain opportunities’. On Brexit, Irving pointed out that all there’s been so far is a vote and that ‘much has to be negotiated and resolved by the UK before a final position is clear’.
The show of confidence was backed up by a 6% increase in the final dividend to A$0.17, 20% franked, giving an annual payout of A$0.33 cents, also up 6%. That represents just 45% of underlying EPS, so the dividend is in little danger despite the weak earnings growth – something that sets Computershare apart from many other large Australian companies.
Over the past year the company has also bought back shares worth about A$101m at an average price of A$10.73. That amounts to about A$0.18 per share and takes the cash returned to shareholders up to A$0.51, or around 71% of underlying earnings.
Despite all the optimism, though, underlying EPS still fell 7.9% in 2016, compared to guidance for a fall of about 7.5%. This was mostly due to the strength of the US dollar (the company reports in US dollars, so a rise in that currency reduces the value of non-US revenues) and lower margin income.
The currency effect will come and go and is largely immaterial to Australian investors in any case, since the US dollar value of Computershare’s earnings needs to be converted back into Australian dollars. Indeed, if Computershare reported in Australian dollars, its underlying EPS would actually have risen 6%.
Margin income lower – again
Margin income, though, has been stubbornly low for many years and is one of the main factors that has undermined the investment case we laid out in our original upgrade in Computershare takes the lion’s share on 22 Jun 11 (Long Term Buy – $9.19) – the other being the disappointing performance of the US registry business (see below).
The 2016 financial year was the worst year for margin income since 2010, in fact, when client balances were roughly half current levels. At some point interest rates have to go up – and Computershare had a chart in its presentation showing that futures prices were anticipating exactly that (see Chart 1) – but we’ve given up trying to guess when. The good news is that margin income now only accounts for 8% of revenue, so there’s a limit to how much worse it can get.
It’s worth noting that Computershare achieved a return of almost 1% on its client balances in 2016, even though the prevailing market cash rate was below 0.5%. In fact its returns have beaten the cash rate by 0.5–1% consistently over the past five years (See Chart 1) – which is what you’d expect, since deposits still offer positive yields even if many government bonds don’t. On that basis, we’re not too worried about the possibility of Computershare actually losing money on its client balances.
All but two of the company’s divisions increased revenue, in constant currency terms, including even the downtrodden Corporate Actions division, which made 2% more than in 2015. Business Services – the second-largest division with 30% of total revenue – enjoyed a 21% constant currency revenue increase, boosted by acquisitions in mortgage and bankruptcy services.
The largest (Register Maintenance – 37% of revenue) and third-largest (Employee Share Plans – 11%) divisions, though, saw revenues fall.
Register Maintenance revenues dropped 4% in constant currency terms due to the disposal of a registry business in Russia as well as weak merger and acquisition activity in the US. Irving explained that the company's strategy for the US registry business is to offset client losses from mergers and acquisitions with new client wins and efficiency gains (eg from the Louisville relocation project), so as to maintain profitability and free cash flow.
That's a far cry from the hopes we had for this business when upgrading the stock in 2011, but with this being the third year running that Register Maintenance revenues have fallen, the company is clearly struggling to meet even this lower objective. Even so, Irving was on the front foot, explaining that Computershare had added a new client every two business days in the year, which was twice the rate of client losses.
Employee Share Plans saw a 5% fall in constant currency revenues largely because weak share prices (particularly in some large resource clients) meant fewer employees took advantage of plans. Irving noted that the company was trying to diversify this business away from resources and that recent client wins had helped with that.
During the half, the company was able to sell a large portion of the advances made in the first half by its SLS mortgage servicing business in the US (which we noted in our review of the interim result). As a result the net investment in SLS during the year was $89m, only slightly higher than the $87m investment made in the first half. Underlying free cash flow excluding these advances came to US$347m – down 11% but representing a very healthy 110% of underlying net profit.
Management would clearly like us to believe that Computershare is powering along just fine on an underlying basis. Given the weakness in Registry revenues we'd say that's a bit of a stretch, but the company does at least appear to be plugging away satisfactorily in difficult conditions.
We gain more comfort from the valuation. Even if we assume the current low levels of margin income continue for eternity, little growth is needed from the rest of the business to justify a price-earnings ratio of 14 and underlying free cash flow yield of 7–8%. The stock is up 6% since we reviewed the interim result and we continue to recommend that you BUY.