IT Services under a cloud - Part 2

The legendary Australian investor Don Brinkworth once said that ‘profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed’. And so it has proved, unfortunately, in our search into the nether regions of the IT Services sector.

Following our upgrades to SMS Management & Technology and DWS, in IT Services under a cloud on 16 May 14, we’d hoped to find one or two more opportunities to make more of a portfolio.

But following a diversion to look at Technology One earlier in the week (see Technology One battles the giants on 03 Jun 14 (Hold – $2.62)), we’ve only come up with one stock nearing our Buy price and a highly acquisitive tiddler for your watch list.

Oakton

We’ll start at the top of the list with Oakton, a fairly traditional IT consultant. Its revenue is broadly spread, with a notable absence from telecoms. In the first half of the current year, about 25% of revenue came from federal and state governments, 21% from financial services, 17% from wholesale and retail and 16% from construction and property. The company has a strong bias to south-eastern states, with Victoria contributing 42%, NSW 32% and ACT 17%.

After listing in 2000, Oakton grew quickly, both organically and by acquisition. Revenues rose from $12m to $201m in 2008 – an annual rate of 42%. However, the company's earnings before interest and tax margin gradually slipped, from 52% to 20%, and the doubling of shares on issue to pay for the acquisitions meant that earnings per share ‘only’ rose by an average of 26% a year, to 31 cents.

Since then, however, it’s all been downhill. While margins have continued their decline, to 7% in 2013, revenues have also gone into reverse, dropping to $160m in 2013. One positive is that the share count has also fallen slightly in the past couple of years, as the company has bought back stock. Overall, earnings per share fell to 10 cents in 2013 – a level they last saw back in 2005.

As with SMS Management & Technology and DWS, the slide reflects weak business confidence and, particularly in the past couple of years, reduced government spending. A few years ago, quality IT services were in short supply, but now there’s a glut, and the consultants have had to cut their prices to get some of the dwindling pool of work.

Oakton has had to cut its prices more than the others to get an acceptable level of work – as reflected in its 7% margin for 2013 compared to 10% for SMS and 22% for DWS, as well as its lower revenue per employee, of about $150,000 compared to $187,000 for SMS and $189,000 for DWS.

The situation has been exacerbated by changes in the way IT services are delivered, with the cloud taking control away from the traditional consultants and making their services more transparent. Oakton passes interesting comment on this in its 2013 annual report:

Increasingly [our] solutions are being delivered to our customers as a combination of our intellectual property and partnerships with cloud based infrastructure and software providers. In many situations this allows the reuse of knowledge and assets that reduce the risk, time-frame and investment required to deliver a successful outcome for our customers.

Translating, this means that its business is becoming increasingly commoditised. That adds to the pressure on margins and, with revenues also falling, profits have been crunched. Oakton is trying to embrace this trend by moving towards packaged solutions and using other people’s software and hardware that it can repeat for different customers.

These solutions are increasingly being produced in Hyderabad, which will soon be the company’s largest single office, employing 283 total staff at December 2013, out of a total of 1,106, and contributing 25% of total billable hours in the first half of 2014.

The resulting reduction in costs has enabled Oakton to price its services lower and win market share, but it’s been at the expense of margins. Management hopes that economies of scale will eventually enable margins to recover, but we suspect it’ll just lead to a permanent reduction in business quality, less product differentiation, more competition and more pressure on margins.

Companies like SMS Management & Technology and DWS appear to be resisting this trend more than Oakton at the moment, but they start from a stronger position, with higher margins in the first place. Of course they might pay for their resistance, but it does allow for some potentially much better outcomes if demand recovers, and that supports their valuation.

Oakton is fighting to safeguard its future, but it might be giving up much of the potential cream to do so. As a result, the stock’s multiple of 13 times the 10 cents in earnings per share expected for 2014 is a little too high to tempt us, although we’d be interested at closer to 10 times. We’re officially bringing the stock onto our radar and recommend you HOLD.

ASG Group

As we move down the value chain, the response to changes in the industry appears increasingly frantic. Perth-based ASG Group, for example, has reinvented itself a couple of times over the past few years, to provide what it describes as ‘New World’ services. At first these were to be served up as an adjunct to the company’s traditional managed services, but more recently they have taken centre stage.

When we last passed over the stock, in Pressing the button on IT stocks – Pt 2 on 17 May 12, we wrote that ‘ASG isn’t without risk. The company is trying for larger contracts than ever before – between $100m and $500m – which may lead to it butting heads with large multinationals like IBM and Accenture’.

The gear shift hasn’t gone well, although that has had less to do with large multinationals and more to do with projects being pulled at the last minute after huge investment had been made in trying to win them – and capitalised on the balance sheet.

The result was some large writedowns, new accounting policies, a commitment to take a ‘more disciplined and economical approach in relation to bidding for new contracts’, annual cost savings of $8m and an increased focus on ‘New World’ services (by which management means cloud-based technology and ‘software-as-a-service’ (SaaS)).

Perhaps the most curious thing is that it may be working. In the first half of 2014, the company signed $101m of contracts, and at the half-year result it boasted of a further $200m plus of ‘select opportunities at proposal or qualification stage’, including $90m of contacts being negotiated or short-listed. Earlier this month, the company revealed that it had signed $21m of the pipeline and that $80m was ‘in final stages of approval’.

EBIT margins recovered in the first half to 9.2%, to give EBIT of $7.3m – the best half-yearly result for a couple of years. Earnings per share were 1.85 cents and, with around 3.5 cents hesitantly forecast for the full year, the stock is priced on a price-earnings ratio of a little over 10. That could end up looking conservative if the turnaround continues, but it’s too early to be confident about that at this stage.

Net debt of $38m is also a concern. The company points out that it’s only twice its ‘annualised operating EBITDA’. But we’d point out that it represents almost half its market capitalisation of $80m, that the interest bill was covered less than five times by EBIT in the first half and that in 2013 the company made a loss. ASG is only a step away from that debt becoming a problem.

If the company gets more runs on the board at its full-year result, it may become interesting. For now, though, there have been too many false dawns already to jump to too many conclusions about the current glimmers of sunlight, and we're sticking with NO VIEW.

Data#3

A clue to Data#3’s business is contained in its name, which is apparently a hat tip to the excitement caused by IBM placing the # and the 3 on the same key of its 1984 PC keyboard (although earlier versions appear to have done the same).

While the company talks of supplying the ‘Hybrid IT environment from on-premises to outsourced to cloud, through its software, infrastructure and managed solutions’, the truth is that 83% of revenue in 2013 came from reselling other people’s software and hardware. No doubt the company offered some advice along the way, but it can’t have been much judging by the overall group EBIT margin of 2%.

This is just the sort of business that’s most at risk from the cloud and it would need to be priced very cheaply to get us interested. The stock jumped 20% at the beginning of May after the company effectively provided a range for full-year earnings of 3.5 cents to 7 cents per share. Even towards the top of that range the stock would be priced on a PER of close to 10, which isn’t cheap enough when higher quality IT Services stocks are available on similar multiples.

If the stock did get cheap enough then, given its current market capitalisation of about $100m, that would probably also make it too small for us to cover. We're sticking with NO VIEW.

RXP Services

The final stock on our list has been bucking the trend, by actually increasing revenues. In two years since the company floated in 2011 revenues have doubled, to $30m. EBIT margins have also improved, to 16% in 2013, and net profit has more than tripled. The bad news is that the company has achieved all this with a string of acquisitions and its share count had consequently more than trebled, keeping earnings per share pegged at about five cents in 2013.

In an update in April, management said it was happy with full-year forecasts for EBITDA of about $9m. Adding about $1m of interest on the company’s $25m net cash balance (as at December) and taking off tax would give net profit of about $7m. Based on our estimate of the weighted average number of shares on issue through the year, of 116m, that would imply earnings per share of about 6 cents and a prospective PER of about 10.

Aside from the undemanding valuation, the company’s appeal lies in the potential for chief executive Ross Fielding – previously Executive Director at Telstra for Product and Services and who owns 8% of the shares – to build a modern IT consultancy from the bottom up, without some of the baggage carried by its larger competitors.

Some of these larger players have been saying that you can’t buy the right technology to suit the changing environment, but their own track records show that it has worked in this sector in the past. Although, Lloyd Roberts – the founder of SMS Management & Technology and formerly its chief executive – retired as chairman last October, the association is interesting and it’s comforting to know that he oversaw the company’s formative acquisitions. It’s also interesting to see Perpetual on the register with a 10% stake.

The company is still pretty small, with a market capitalistion of only $81m, and the situation is a little too fluid for us – despite the positives, we’re still put off by a string of acquisitions that amount to 87% of the company's market capitalisation. But those with specialist knowledge or the willingness to do a lot more research might find it worth a look. We'll keep an eye on the stock but our official recommendation is NO VIEW.