Management at IT services group UXC (UXC)has come out fighting with reassuring outlook commentary in last week’s results saying the company has never been better placed for growth. But rhetoric aside, we believe earlier issues in executing large contracts have been addressed and the ground prepared for continued earnings and margin growth. Also in the outperform category are Tox Free Solutions (TOX) and Pental (PTL).
The second half is setting up to be a defining period for UXC Ltd (UXC), with management effectively placing its credibility on the line. Cris Nicolla (MD) has gone to great lengths in explaining why the first-half weakness was due to one off factors, and has confidently talked up a much stronger second-half.
The half-year result was in line with guidance from late December - however operational performance was lacking. The result was the first six-month period since the company restructured in 2010 that the new management team failed to achieve earnings growth.
Under the guidance of Nicolla, the company has restructured from 14 unrelated businesses with minimal uniform branding or cross-selling opportunities. Today there are three aligned divisions, all in core areas of competency with significant growth opportunities. This transition has been the source of significant efficiency gains - which we expect will continue as the company improves its project execution and integrates its new technology service offerings.
Nicolla stated that “UXC has never been as well placed strategically to continue our growth in the market as we are now” and further explained: “Our core strength in the Application space, enhanced by our acquisitions and our customer centricity have won us a valuable reputation that allows us to bid, win and deliver larger projects and provide more services to our customers”.
|UXC - $0.93||FY13||FY14||FY15||FY16|
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There were three key strategic acquisitions in late-2013 that will assist the growth in the second half. All of the acquisitions – Keystone, White Labelled and Tectura - attempt to target new and emerging technologies: cloud computing, digital e-commerce and regional growth into Nth America. Under founder and former Chairman Geoff Lord (currently vice-Chairman) there was a history of non-core unrelated acquisitions, but, significantly, this culture appears to have changed since 2010 with the new management team.
Combined cost over-runs of $4.4 million from four major contracts contributed to first-half weakness. Management has stated that the projects are now finished, with no damage to its reputation with customers. The execution of larger projects will remain a key company risk, and management has put their credibility on the line stating that they are confident lessons have been learnt and there will not be any ongoing issues.
The company has a history of above market growth reflecting its status as the number one domestic alternative to multinational IT competitors. In the first half, 6% revenue growth was achieved with a normalised 17% decline in earnings before interest, tax, depreciation and appreciation (EBITDA). If acceptable delivery of the major projects was achieved then there would have been underlying EBITDA growth.
The first two months of 2014 have been very strong, with January achieving the company’s record operating cash flow month with $10.5m. This was partly due to the seasonal affect where the first half cash-flow conversion is weak due to the timing of receipts. With cashflow back on track for the full-year result there is also expected to be a reduction in net debt from $52m to $35-40m.
Part of management’s confidence can be seen from the strength of the back-log of work to be delivered (up 6.5%), and the pipeline of opportunities (front-log) up over 11%. The unknown is whether the strong start to the second half is the beginning of a cyclical up-turn in IT spend - from a very low base. With the market effectively looking through the poor first-half result, it is unlikely to be as forgiving if there is any further weakness at the full year.
We have an outperform recommendation with $1.20 valuation and price target. The company is well placed through its strong relationship with the key application vendors (Oracle, SAP, Microsoft Dynamics and ServiceNow). Management has positioned the business to gain maximum leverage from these relationships through cross-selling and servicing new technology opportunities.
Tox Free Solutions (TOX)
Waste management company Tox Free Solutions reported an excellent half-year result, presenting further confirmation of managing director Stephen Gostlow’s vision of creating a network of regional hubs. The company’s strategy of building hazardous waste facilities in regional areas has created barriers to entry for potential competitors ensuring high growth with a defensive component through long-term annuity style contracts. The crucial component has been targeting growth both organically and by acquisition in the most attractive sub-sectors of waste management.
The domestic waste management industry includes sub-sectors of contrasting quality. Metro municipal work has low barriers to entry, and hence is very competitive with low margins. TOX avoids this work and lets large competitors Transpacific (TPI) and Veolia fight this out with a number of smaller players.
Hazardous waste on the other hand is extremely attractive. With high barriers to entry created from its treatment sites requiring an EPA licence and planning approval. What this means is once a treatment site is established in a key location, it is very hard for competitors to move in and win work.
TOX has specifically focused on key regional hubs, where it will first acquire the treatment site and then work on winning and providing complete waste management services in the area. TOX has achieved its long standing ambition of becoming the leading hazardous waste management company in the country partly assisted by the acquisition of Dolomatrix in 2012.
Under the leadership of Gostlow, TOX has made 17 acquisitions since 2005 increasing revenue from approximately $5m to above $350m with a roughly even spread between organic growth and acquisitions.
Whilst the acquisition strategy is likely to continue, cash flow conversion should improve in coming years. This is because the company’s capital expenditure should reduce from the recent high levels - management have been heavily investing in the national network of regional hubs. TOX reported a maiden interim dividend of 3 cent per share, providing further evidence that it expects improved free cash flow.
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Contracted waste services to the mining sector are expected to comprise approximately 8-10% of FY14 revenue. Exposure to the mining sector is mainly through the operational phase and so should be less effected by a slowdown in capital expenditure over the next few years. It is estimated that 85% of revenue is from producing assets, with over 60% contracted.
This high level of contracted revenue has been a key part of the strategy providing exceptional earnings security and an attractive defensive compliment to the growth strategy.
Importantly the result confirmed that the April 2013 acquisition of Wanless has been successfully integrated with key financial targets met. Tender activity also remains at record levels. New contracts with Chevron, Titan Energy, Cement Australia, Rio Tinto and Rio Tinto also position for further growth.
We have an outperform recommendation and $3.80 valuation and price target. We believe there is further shareholder value to be created from the strategy which has seen the transition from a small waste services business to an integrated service provider operating in niche markets with a national footprint.
Our outperform recommendation for household cleaning products manufacturer Pental goes against one of our key criteria – that is the existence of niche opportunities in an attractive industry structure. Supplying the major supermarkets is likely to remain a difficult job, but Pental is an overlooked turnaround story and is recovering from a very low base.
The company also owns many leading “Australian-made” brands, including laundry staples such as White King and Jiffy. With Charlie McLeish recently becoming CEO it appears that the supermarkets are supportive of the company getting back on its feet. This is evident from its improved product offering and branding gaining support and further private label tenders won.
We see a 2-3 year growth opportunity where the company will benefit from investing in its business and achieving efficiency gains as well as revenue growth from improved branding, product range and tender wins. The manufacturing capacity at its Shepparton site has also increased enabling volume growth.
|PTL - $0.033||FY13||FY14||FY15||FY16|
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PTL is also currently trading at a large discount to listed FMCG supplier peers. However, once this discount is removed after the relatively easy efficiency gains are achieved, it will likely be the time to exit. On a cautionary note though, the risk remains that - for whatever reason - the major supermarkets might decide to change their current supportive relationship.
The Australian owned and made factor, is a key positive for PTL. For one, the lower Australian dollar helps, with many of its competitors importing products from overseas. Also the major supermarkets are currently concerned by the ACCC and government attention on the power they hold over suppliers.
In November 2013, Woolworths and Coles signed a voluntary “code of conduct” with the Food and Grocery Council. The council, which represents manufacturers, is attempting to protect its members by prohibiting some of its questionable behaviour towards suppliers. This behaviour includes using supplier’s intellectual property to create its own products and changing contracts retrospectively.
Most industry participants remain sceptical that the code will actually change supermarket behaviour, and hence any FMCG supplier is operating in a high-risk environment. Nevertheless, the strong half-year result provides us with confidence that the company is in the early stages of a turnaround that will create shareholder value.
A highlight of the result included the large EBITDA margin gains, following PTL’s recent investment in its facilities at Shepparton, which boosted efficiencies at the plant. EBITDA increased 37% to $4.9m, despite revenue only increasing 3.2% to $53.8m.
The other highlight of the result was the large increase in net profit after tax (NPAT) from $0.247m to $2.147m. This was driven by the $2.4m reduction in finance costs.
The company’s balance sheet is now secure with net debt down to $4.7m and gearing (net debt to equity) down to 6.7%. Further evidence that the company is back on track is the new banking facility that removes current restrictions on dividends and capital investment. Management stated that they will consider reinstating the dividend at the full year.
We have an outperform recommendation and $0.046 valuation and price target. Whilst recognising the poor industry structure, the turnaround has further to go and new MD Charlie McLeish has got some early runs on the board with an improved product offering that has been well received by the major supermarket retailers.