ToxFree Solutions: Margin risk to the downside
ToxFree Solutions’ full-year result was slightly below our expectations with underlying net profit after tax flat at $23 million. The miss is due to the margin assumption rather than the amount of work completed.
The positives from the result were a higher than expected dividend at 8.5 cents per share and cash conversion of 102 per cent.
Tox has a strong business model, focused on obtaining key waste market positions with barriers to entry in resources-focused rural and regional areas. The easiest way to obtain a barrier to entry is from obtaining a hazardous waste license, given there is a regulatory limit to how many licenses are approved.
Although the high margins for hazardous waste can be defended, it is not as easy for some of the other waste treatment services. Earnings before interest, tax, depreciation and amortisation (EBITDA) were up 8 per cent to $71.9m, with the EBITDA margin at 17.6 per cent.
The Technical and Environmental Services (TES) division which comprises 20 per cent of EBIT saw revenues down approximately $10m (15 per cent) due to the slowdown in the offshore oil and gas development and lower waste volumes in Queensland.
Waste services is about 65 per cent of EBIT, and was the strongest division with 20 per cent growth on last year. Volumes in Queensland and the Pilbara remained strong but reduced volumes were achieved in the Browse basin and Launceston.
Industrial Services, which is 15 per cent of EBIT, saw revenue up 6 per cent but no margin growth. It is expected that this division will eventually benefit from increased infrastructure projects but with uncertainty around timing.
With the weakness in resources activity earnings margins have been declining for the past couple of years, and moving forward the cautious outlook statement is reason to downgrade our prior assumptions for the next two years. No quantitative guidance was given, but commentary suggested challenging conditions across most parts of the business.
Some stability is obtained from the production operations, and there is still a decent tender book. The new LNG facilities will provide opportunities, but offshore oil and gas is expected to be weak. A significant amount of revenue is contracted, which is why more of the uncertainty is around margins.
The balance sheet remains in good shape with gearing (net debt to equity) of 32 per cent at the lower end of the 30-40 per cent target range. This enables capability for relevant acquisitions, with a large part of the company’s prior growth been due to quality acquisition targets.
With TOX on a FY16 PE of 15, the earnings growth is not strong enough to justify a buy recommendation. But the downside is partly protected by the strong business model with a large percentage of forecast revenues already contracted.
We have downgraded forecasts by an average of 10 per cent across our forecast period. Our valuation has decreased to $2.80 and we maintain our hold recommendation.
PS&C Ltd (PSZ): Under-promise and over-deliver
After a couple of false starts since listing in late 2013, it appears that management has finally learnt to under-promise and over-deliver.
In late June, the company downgraded guidance to 20-25 per cent earnings before interest and tax (EBIT) growth or $8-$8.5m. But the company actually achieved normalised growth of 30 per cent to $8.72m. This partly reversed the share price carnage from the June downgrade.
Further helping the cause for a share price recovery was a 3 cent per share fully franked final dividend adding to the 3 cent interim dividend. The 6 cent full year dividend equates to a 7.5 per cent yield and 45 per cent payout ratio.
Revenue growth was strong with 33 per cent growth to $84.5m. Given the roll-up of five businesses initially at IPO and then Pure Hacking in August 2014, there is significant uncertainty with how these businesses all fit in together.
There are three divisions – people, security and communications, with security being the strongest performer. But there are question marks if it is in shareholder interests to continue running all the divisions. Allcom consulting, Securus Global and part of the people division have all struggled. The inconsistency of performance within the divisions as well as the significant deferred payments are part of the reason for the company trading on a PE multiple at a significant discount to the sector and market.
The Pure Hacking acquisition has been a major success, driving a large amount of the growth. Hacklabs has also performed well. Domestically there is more cyber security work than the company has capabilities to deliver. As such further acquisitions are likely to be considered.
Management commentary suggested a strong outlook, with the divisions that struggled in FY15 recovering in FY16. There are two potential acquisitions in due diligence, one being a security business and the other a people business.
It has been a very strong reporting season for IT services companies. Just about all have exceeded expectations, or had recent announcements about significant contract wins. After a few years of weakness with low capacity utilisation, the increase in spending from governments and large corporates is certainly positive news.
We maintain our buy recommendation with a $1.05 valuation.