IT sector: Time to reboot

Slowly, but surely, there have been signs of life for the long-suffering domestic IT services sector.

The sector is dependent on corporate business confidence and state and federal government spending. There also is a need to replace old systems, providing the underlying support because IT spending can only be delayed for so long. Hardware typically has a useful life of three to six years, and we are at least five years into an under-investment cycle.

Although it would be a bold call to suggest the sector has definitely turned the corner, commentary from listed companies in the sector was generally more positive for the fourth quarter of FY14. However, there have also been continued reports of some volatile conditions and a general reluctance to confidently guide towards strong growth in FY15. This aside, I see the potential for a cyclical bounce in the sector as a case of “when” and not “if”.

Across the board, there is a lot of bad news priced in, with most companies trading at large discounts to valuation, and at the low end of their historical range of earnings multiples. At Eureka Report our coverage list includes Buy recommendations for two IT services companies in Empired Ltd (EPD) and UXC Ltd (UXC).

Due to low utilisation levels there is high operating leverage when the sector does turn the corner. By way of example, Oakton (OKN) traded above $6 in 2007, and is now priced at $1.40. The share price has followed earnings down, with earnings before interest, tax depreciation and amortization (EBITDA) at least three times higher at the peak. 

Often at the end of extended cyclical downturns the market gives up trying to pick the bottom, and concrete evidence of a recovery is required to increase discounted share prices. For IT services an increase in large contract awards, from corporates and/or governments, would provide the required spark. Another possibility that could provide a catalyst for the sector would be an opportunistic takeover bid for a deeply discounted company such as UXC, Oakton or SMS Management (SMX).

Both SMS Management (SMX) and DWS Ltd (DWS) have decided that the best way to utilize their excess cash is to buy back shares in the company. Buy-backs are generally good lead indicators – assuming the particular company’s management knows how to pick the cycle and the outlook.

The structural changes of the new IT world, including the introduction of multinational cloud providers, are an opportunity for those companies that are moving with the times. Through acquisitions and enhanced technical capabilities, both UXC and Empired have positioned themselves to benefit from these structural changes.

Another challenge in recent years has been cheaper offshore labour. However, this has only affected pockets of the sector. Offshoring is not an option for many domestic corporate companies due to data security, skills availability, service levels and brand image aspects.

Preferred IT Services Picks

Out of the sector my preferred picks are UXC (UXC), with a market cap of $250 million, and the smaller higher-risk Empired (EPD) with a market cap of $60 million.

UXC Limited (UXC) – Maintain BUY

UXC provided guidance towards the end of June, which projected earnings in the second half to be approximately double that of the first half. Management then came back to the market at the end of July with further news that debt had reduced to $4.4 million against the previous guidance of $34 million. The debt reduction was due to strong cash collection and the delivery of milestones on key projects. The final result is due to be announced on August 28.

The first half was impacted by disappointing project execution in the infrastructure division, with project overruns costing at least $4 million. Management claimed to have learned critical lessons and have concluded that extra care will be taken to ensure more accurate tender pricing and the breaking up of large projects into smaller deliverables. The strong second half provides evidence that the situation is under control.

After slightly downgrading my prior forecasts, the valuation and price target is reduced from $1.20 to $1.10. Both my forecasts and consensus earnings forecasts don’t assume the company achieves its medium-term earnings margin targets.  For the consulting division the earnings before interest, tax, depreciation and amortisation (EBITDA) target is 9-10%, for applications it’s 11-12%, and for infrastructure it’s 4.5-5.5%.

UXC has the opportunity to benefit from an eventual sector uptick and to leverage its strong relationship with each of the four key application vendors – Oracle, SAP, Microsoft Dynamics and ServiceNow. Management has done an excellent job integrating acquisitions, and is well placed to benefit from an increase in cloud-based applications.

I maintain my Buy recommendation, noting the discounted FY15 PE of 10, and I see upside risk to my earnings forecasts and $1.10 valuation when the sector eventually picks up.

To see UXC's Forecasts and Financial Summary, click here.

Empired (EPD) – Maintain Buy

Empired recently announced a record earnings performance for its fourth quarter and its unaudited full-year result was roughly in line with my forecast. The final audited result is due to be announced on August 27. 

The company has grown earnings through the sector weakness, benefiting from acquisitions and a recent capability to deliver larger contracts. The company has not looked back since its key boost to the management team in 2011 and 2012 to assist Managing Director Russell Baskerville. Chief Operating officer Rob McCready has three very capable executives under him who have excellent industry contacts and experience with the business challenge of transitioning towards larger contracts. The team has long-term ambitions of achieving the scale of some of the larger domestic IT services providers.

While the company is based in Western Australia, recent acquisitions display an intention to increase interstate exposure.

In May it announced the acquisition of eSavvy, a provider of customer relationship management (CRM) consulting and integration services to large corporate clients. It is claimed to be Australia’s leading Microsoft Dynamics CRM partner and will enhance EPD’s already strong relationship with Microsoft. It will sit in the Applications Services division and further enhance the company’s East Coast offering. On an acquisition multiple of 3x EBIT, it is accretive for our FY15 forecasts.

The full-year result was highlighted by a 44% increase in revenue to $67 million and a 58% increase in underlying EBITDA to $5.7 million.

The acquisition of OBS was completed in October 2013, adding $32 million of annualised revenue in high-growth services across the East Coast. We are forecasting strong earnings growth in FY15, due to a full year from acquisitions and recent tender wins that see 45% of targeted revenue contracted.

Management is positioning to be a differentiated IT services company, by providing complete business solutions to clients rather than the traditional consultants and technical labour. They are particularly focused on enhancing capabilities in the higher growth cloud, big data/business analytics, mobile, social and security components of IT.

We maintain a Buy, with EPD trading on a FY15 PE of 8, and the current share price remains at a large discount to my $0.90 valuation and target price (previously $0.85).

To see Empired's Forecasts and Financial Summary, click here.