What happens when Australia’s leading financial software business achieves local market dominance but is priced for future growth? That was the situation for Iress in 2010 and explains why it has pursued overseas expansion with vigor since. Thus far the company has built operations in the UK, Canada, South Africa and Asia.
Australian dominance continues
Tough overseas but UK is improving
Iress isn’t cheap
But it hasn’t been easy, as Chart 1 shows. With each additional dollar of capital invested abroad, returns on capital have fallen. Is this a case of another high-quality Australian business being diminished by ego-driven thoughts of global domination? It doesn’t look that way. Despite numerous market corrections and industry headwinds, Iress has increased revenue every year since 1997. For the six months to June (it has a December year-end) the company increased revenue by 12% and net profit by 15%.
Quality Australian business
The result was testament to the quality of its Australian businesses. The company’s wealth management division is taking further market share from number two Rubik Financial and producing 47% operating margins, the highest of all the company’s businesses. Meanwhile, the ANZ financial markets division enjoyed a flat result and an operating margin of 43%.
Those numbers reflect the grip Iress has on Australian financial planners, institutions and brokers that rely on its business critical software (see Iress targets UK wealth from April 2015).
For a new financial planner, learning to use Xplan is as important as receiving an RG146 accreditation. And once they’ve got to grips with it there’s little inclination to switch to a competing system. The result is an immensely sticky customer base willing to absorb annual price increases. That has driven high-margin revenue growth for years. If there’s one company that can afford to invest in sensible overseas expansion, this is it.
Mixed performance overseas
The bigger question for investors is whether that expansion is paying off. Asia continues to lose money and Canada appears destined for a similar fate, with declining year-on-year returns since 2011. South Africa is stable, with growth expected following the recent $14m acquisition of INET BFA, a provider of market data, analytical tools and financial data feeds. But due to its small size, it is yet to move the revenue dial. There’s not much encouragement here.
But the UK operation is starting to hit its straps, as Chart 2 shows. Iress entered the UK in 2013 through the $360m purchase of Avelo and bolstered its position last year by acquiring Proquote and Pulse for £37.6m.
Part of Avelo’s attraction was the opportunity to migrate its existing Advisor Office customers to Xplan and sell more modules. Is it playing out like that? Well, the ex-Lending division (the new name of the combined UK financial markets and wealth management operations) certainly had a good first half with revenue rising 45% and earnings before interest, tax, depreciation and amortisation (EBITDA) rising an impressive 73%.
Xplan demand has indeed been strong, a trend which is expected to continue into the second half. But as Chart 3 shows, UK margins haven’t budged. The contribution from the lower margin Proquote and Pulse businesses is partly to blame, but whether Xplan growth can boost margins remains an open question. There is a case, though, that Iress’s UK ex-lending division is on the right trajectory. That bodes well for further growth and may arrest the decline in returns on capital.
Enterprise lending, the division responsible for originating one in every four UK mortgages, had a weak half-year with revenue down 5% and EBITDA down 43%. Expected losses in the second half mean the division will be barely profitable for the full year. Part of the problem is the shift to a recurring licence model, which is mostly a timing issue. But with management now referring to the division as a 'medium-term' growth opportunity, current challenges are unlikely to be quickly resolved.
IRESS doesn’t look cheap either, on a price-earnings ratio of around 25 based on the consensus forecast for full-year earnings per share of 46 cents. But this figure is misleading because the reported earnings dramatically understate the company’s true earnings power.
When Iress buys a business, it records a portion of the purchase price as software and customer accounts, both intangible assets amortised under accounting standards. For example, when Iress purchased Visiplan in 2007, 76% of the $49m purchase price was recorded under these balance sheet items. As a result, Iress was required to amortise 76% of its Visiplan investment over future years, under the (incorrect) assumption that customers would leave as the software drifted into obsolescence. This couldn’t be further from reality. The Visiplan acquisition solidified Iress’s leadership in Australian wealth management, delivering high customer retention and ever improving financial returns since.
As Chart 4 shows, the actual investment to maintain Iress’s software is far lower than indicated by the company’s amortisation charges, meaning free cash flow consistently exceeds reported earnings. Iress may trade on a PER of 25 times but the free cash flow multiple is in the high teens. That’s reasonable for a business of Iress’s quality and growth profile, and a more useful indicator of value.
We're raising our price guide to Buy below $10 (from $9) and Sell above $15 (from $13). HOLD.