PS&C: Take a second look

The PS&C (PSZ) share price has recently been sold off due to lower than expected profit guidance for FY15. Although the downgrade is disappointing, the IT services company is deeply discounted trading on a FY15 price-earnings (PE) multiple of 7.3 times, with a yield of 8.7 per cent.

Since listing at $1.00 in December 2013, the stock has ranged from $0.65 to $1.08. The current price of $0.69 equates to a market capitalisation of $38m. Given the company will continue to grow both revenue and profits, we are comfortable maintaining our “buy” recommendation.   

The business doesn't have exposure to fixed price contracts, and as such the largest risk is around utilisation of the cost base, rather than individual problem contracts.

The roll-up structure from the initial public offering (IPO) included significant earn-out payments for the initial five businesses, and also Pure Hacking that was acquired in August 2014.

The uncertainty around the earn-out payments is another reason for the discounted share price. But it needs to be remembered PSZ management has full discretion as to how they make the payments. We have assumed 50 per cent scrip and 50 per cent cash. Current estimates include $12.8m deferred consideration for the next 12 months, and $6.1m of longer term payments.

The company is in a net cash position with an unutilised debt facility.

Profit update details

The recently announced FY15 profit guidance was lower than market expectations. The company hadn't previously announced formal guidance, but analyst expectations had to be revised lower.

The 30 per cent increase in revenue was roughly inline with expectations. But the EBIT guidance was lower than expected with a 20-25 percent increase to $8-8.5m. This is roughly 15-20 per cent lower than our prior expectations for $10m.

The earnings before interest and tax (EBIT) result for Securus Global (security) and Communications consulting was below expectations. There was also higher than expected head office costs.

The company maintained an outlook for a 3 cent final dividend (October 2015) on top of the 3 cent interim dividend (paid in April 2015). Based on today's share price of $0.69 this 6 cent full year dividend equates to an 8.7 percent fully franked yield.

Management

Kevin McLaine is managing director and has over 20 years' experience in Australian public companies. He held senior roles at Shomega Ltd and CSG Ltd, as well as a number of years with GE Capital as managing director of its commercial lending business.

Julian Graham is chief financial officer and company secretary. Julian has over 25 years' experience in the manufacturing, distribution and software industries; he was most recently the chief financial officer of ASX-listed Wellcom Group.

The senior staff includes the founders and key management personnel from the six acquired businesses. As mentioned, a critical part of the strategy is to retain these staff, and especially during the initial integration.

As the company has only been listed since December 2013 the team are yet to prove themselves. But it does need to be remembered that the businesses that have been rolled up have an operating history of between 7-18 years.

Divisional Performance

People

Guidance was given that revenue has increased 25 per cent for FY15. This included a record number of billable days during the year. In the second half benefits of the increased costs base started to come through, with further gains expected for FY16.

The division comprises “systems and people” (SAP). Earnings are exposed to diverse segments of the economy led by telecommunications and IT, retail, mining and manufacturing sectors.

Key customers include Toyota, Schweppes, Amcor, and Fujitsu.

The focus is largely contract management, sourcing and recruitment for customers using SAP. The customer mix is mostly a long term non-discretionary IT spend.

The offset from the stable client base is that margins are low and growth opportunities are more limited in comparison to other parts of the business.

Security

Security is the fastest growing division, largely as a result of Pure Hacking. Full year revenue is expected to be 100 per cent higher than FY14.

Pure Hacking has performed above the guidance given at the time of acquisition.

Securus Global has had a weaker year due costs from capacity issues, but this has largely been resolved and the business should return to substantially increased profitability in 2016.

Hacklabs performed steadily but growth was also impacted by capacity issues.

The core of the work is around penetration testing of IT systems and providing preventative measures.

The “red teaming” depends on the customer, but generally can include testing for physical intrusion and network hacking. Basically, PSZ will get a contract to test if they can break into a physical site or IT network.

Some key customers include the major banks, Coles, Telcos, Tabcorp and Westfield.

The opportunity to grow and expand the security offering organically and via acquisition remains and is likely to present the company's most compelling growth opportunities.

Communications

This segment includes Allcom Networks and Allcom Consulting. Services include unified communications and IP telephony, network infrastructure, consulting and managed services.

Approximately 40 per cent of the division is with Telstra, with the next largest exposure being the NSW government and local governments.

The networks business has been an excellent performer and will have revenue 25-30 percent higher than 2014 (normalised) and EBIT approximately 20-25 percent higher. But some work expected in the last quarter was pushed into FY16.

The consulting business has disappointed with an EBIT to be well below 2014, dragging down the overall communications result.

Forecast changes

We have assumed higher head office costs and lower margins through the forecast period. Our EBITDA margin is forecast to be 10.4 per cent for FY15, 11 per cent for FY16 and 12 per cent for FY17. Our forecast revenue growth of 10 per cent for FY16 and 6 per cent for FY17 is a conservative base case.

The PEs of 7.3 times FY15, 6.4 times FY16 and 5.6 times FY17 will provide valuation support despite the potential further dilution from the earn-out payments.

We have forecast the FY16 dividend to drop to 5 cents which is still a very attractive 7.2 per cent fully franked yield.

The effect of all the changes on our DCF valuation is a reduction from $1.25 to $1.05.

We maintain our “buy” recommendation.

To see PS&C's forecasts and financial summary click here.