IRESS: Does fear bring opportunity?

'Brokers: it's as bad as it's ever been'. While it might be the kind of headline to get a contrarian investor's juices flowing, that will be cold comfort for Andrew Walsh, managing director of IRESS, which makes its money oiling the wheels of the broking and financial services industries.

The Business Day article goes on to compound the pain, with Michael Manford, executive chairman of Patersons Securities, saying: 'This is a tough time for the markets, a tough time for investors and a tough time for those working in the industry, especially stockbrokers.' Ouch. Those wheels aren't so much in need of some oil as a root-and-branch rebuilding.

Concerns over the possible effects of such a rebuilding explain why investors have been fleeing IRESS, pushing its share price down 31% since reaching a post-global financial crisis high of $9.67 on 31 May 11 and 21% since we originally recommended the stock in The Iress money making machine on 20 Jul 10 (Long Term Buy – $8.40).

It's a massive share price fall for a business that by most financial measures has performed fabulously over the past decade. Indeed, total returns over the eight years prior to the recent peak were a Buffett-beating 25% a year. So should we panic?

In short: No. But before unpacking why, let's quickly review IRESS's business.

IRESS sells software systems to the finance industry via two businesses: 'financial markets' and 'wealth management'. The first designs software for stockbrokers to manage their trading systems and provides detailed financial information on listed companies. The wealth management division focuses on creating software for the financial planning industry, helping businesses manage compliance and customer accounts.

It's in the financial markets business that cost-cutting by brokers presents the biggest threat.

Short-term risks real

IRESS's financial markets business is exposed to activity in equity markets and the profitability of that activity. If equities are on the nose, there's a real risk of brokers cutting IRESS subscriptions and services.  Indeed, brokers such as Wilson HTM, Bell Potter and Euroz have already flagged their interest in cutting costs.

Chart 1 explains why: Equity trading volumes haven't returned to pre-GFC peaks.

Furthermore IRESS, like any software company, has high fixed costs, and this only exacerbates the threat. Losing just a few clients could devastate earnings.

For the far-sighted investor, however, this is nothing to fret about. Any drop in earnings from lower trading volumes should prove temporary. Even during the GFC, IRESS emerged relatively unscathed, barely losing a customer from its Australian financial markets business (see Chart 2).

The time to buy a cyclical business is now when conditions are deteriorating. The time to panic was when shares were trading at nearly $10, not now at around $7.

Success begets risk

But larger more permanent risks loom. Currently IRESS's Australian financial markets business generates 65% of the company's profits (see Chart 3) with IRESS controlling nearly the whole market data and broking market. But industry developments could undermine the profitability of this business.

If (when?) a recession bites there might be a consolidation of the broking industry, and with it might come a lean, more efficient broking model where demand for IRESS subscriptions diminishes markedly. Alternatively, brokers could develop in-house software and platforms. Even renewed competition from international data providers such as Bloomberg, Thomson Reuters, Fidessa or S&P Capital IQ is not out of the question.

These risks are real and, if they came to fruition, they would have a serious impact on earnings. However, they are also ever present in this sort of industry, so they need to be seen in context.

In fact, international competitors have already tried to breach IRESS's monopoly of the Australia market without success. Brokers have also shown limited interest in developing proprietary systems and the industry has been moving towards external solutions such as IRESS's. What's more, IRESS doesn't overtly exploit its market dominance, limiting excessive price rises and constantly developing products that exceed client expectations.

Management has a plan

Management, thankfully, is acutely aware of its overreliance on the Australian market and is rectifying this by diversifying IRESS's product offerings and geographic exposure.

Firstly, expansion into the wealth management software market looks very sensible. Demand for wealth management software isn't correlated to demand for equities. Indeed, even if 'equities are dead', money still needs to be managed.

Ever-increasing compliance burdens are also driving demand for sophisticated software systems.

Furthermore, once these systems are installed and integrated into clients' internal systems, they are very difficult to disentangle.

Combined, these factors mean wealth management is a growing, attractive business, one that IRESS has grown to 25% of revenue in just nine years.

Secondly, IRESS is expanding overseas. We're typically sceptical of overseas expansion plans but IRESS's military-like discipline has resulted in a slow, steady, low-cost approach that's yielding results.

For example, its Canadian operation was started in 2004 via a beachhead acquisition of KTG Technologies, and has since grown to 15% of revenue. This market still has further growth opportunities as IRESS currently only focuses on sell-side broking clients.

South Africa has also proved an area for growth. Starting with Spotlight in 2007 it has since purchased Peresys in 2011 for 375m rand (about $56m at the time). IRESS can still increase its presence in this market due to the rising demand for financial advice. But with an economy half the size of Australia or Canada, growth will have a natural limit.

IRESS is also building businesses in Singapore and the UK. Growth in these markets could be excellent, especially in the UK where there are an estimated 5,000 independent financial advisory firms.

All these markets are much more fragmented than Australia, meaning the benefit of controlling a monopoly is yet to be won, and explain why expansion abroad can yield results.

Growth needed, not cheap enough yet

IRESS is an excellent business with a clear understanding of the risks it faces and a plan to deal with them. But IRESS's future isn't going to mirror its past; while growth remains a necessity for a successful outcome, in future it is likely to come from overseas markets.

But with IRESS currently trading on an adjusted free cash flow yield between 6.0-7.1% and a dividend yield of 5.7%, we're getting adequate compensation while we wait for that growth.

For new investors, however, we're willing to wait for a wider margin of safety. Around $6.00 we'd upgrade to Long Term Buy, until then HOLD.