Tech consultancy syncs into growth

UXC Limited (UXC) has been a stand-out performer in the listed information, communications and technology (ICT) services sector.

The company has successfully increased revenues and earnings over the past couple of years, despite the decline in IT industry spending amongst its medium to large corporate customers.

The outperformance has been driven by a successful restructure that started in 2010 with the divestment of its Field Solutions division for $61 million – a unit that outsourced infrastructure and environmental solutions to utilities companies and governments. There were also 14 separate subsidiaries with independent branding, strategies and systems.

Now there are three divisions under the one UXC brand, all based in one location, and with logical cross-selling opportunities. This is providing ongoing earnings margin growth, and a more customer-focused business model.

As well as creating a consolidated business structure, the cash injection enabled UXC to complete a buyback and increase its dividend payout ratio to 74% in FY13. The company’s strong balance sheet also has enabled a number of important acquisitions over recent years.

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Board and management

One of the key outcomes from the strategic review in 2010 was to align the board and management with the company’s more focused ICT services growth path.

Managing director, Cris Nicolli, was appointed in November 2010, and has a 25-year successful track record of leadership and management in the IT industry.

Deputy chairman Geoff Lord is the founder and was chairman until October 2012.  He remains the largest shareholder, with 5.2%. Lord’s continued involvement as deputy chairman has enabled a smooth transition for the newly appointed chairman, Geoffrey Cosgriff.  Cosgriff has been on the UXC board since 2002, is also on the board of Transurban Group (TCL), and was former managing director of MITS.

Mark Hubbard is finance director and company secretary and has been a member of the management team since 2002.

The refreshed board also has had three new non-executive directors appointed since November 2011 – all with extensive IT experience including directorships of other listed and non-listed companies.

Other than Lord, the other board/management ownership in UXC ranges from 0.5-1.5%.

Stand-out ASX listed ICT services stock

UXC is now the largest Australian-owned ICT consultancy company, with more than 2,500 staff across its three key divisions – consulting, applications and infrastructure.  The company’s ongoing vision is to be recognised as the leading Australasian IT service provider and the number one alternative to the big multinationals.

Its increased scale and strategic positioning has resulted in UXC being the only domestic-listed ITC services company with the capabilities to compete with multinationals on the longer-term larger  contracts ($100 million-plus). Approximately 80% of the value of the total Australian IT spend is from contracts that are greater than $100 million, and hence it is a meaningful advantage UXC has over its listed peers. With UXC’s FY13 revenues of $594 million and net profit after tax of $20 million, any large-scale project wins would have a material impact on future earnings.

UXC’s differentiator is the applications implementation division, where management has developed very strong relationships with the key global Enterprise Resource Planning (ERP) vendors – SAP, Oracle, Microsoft, and recently cloud-based ServiceNow. There is a need for implementation partners such as UXC because the global applications vendors generally prefer to focus on the higher-margin development of their software. Furthermore, the software and infrastructure packages are usually very complex and require unique solutions to fit individual company needs.

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UXC’s dominant market position in the applications services space enables cross-selling opportunities into its consulting and infrastructure divisions. In regards to ICT requirements, across the three divisions the service offering for customers includes planning and design (consulting), implement and enhance (applications) and operate and manage (infrastructure).

The customer base comprises both private and public sectors in Australia and New Zealand, from a broad range of industries – health, consumer goods and state governments are currently the largest exposures, representing approximately 15% of earnings for each.

Cyclical vs structural drivers

In regards to the industry outlook, there is consistent commentary from listed IT service companies that there are early signs of improved activity. We are likely to see the beginning of a cyclical upswing, either in the second-half of FY14 or into FY15. The first-half of FY14 was weak, with UXC and other competitors revising guidance lower due to continued weak business confidence, project delays, margin pressure and the business interruption from the federal election. There is a level of pent-up demand that could flow through in 2014, with risks to the timing and magnitude of this cyclical demand from some key structural issues. (See Brendon Lau’s article, IT sector needs reboot).

However, due to the need for a local presence for many of UXC’s services it is less exposed than many of its listed peers to the offshore labor shift that has been occurring across the industry.

The change in IT spending from up-front capital expenditure to an annuity based operating expense is also a major industry change. This trend has been occurring due to the increased amount of cloud services, managed services and asset outsourcing.

Other pressures include latent capacity, increased competition and cost pressure. It is difficult to determine if these will be ongoing structural industry problems or if they are largely related to the cyclical industry downturn.

Further company specific risks include keeping up with changing technology, staff turnover, acquisition risk and cost over-runs on fixed-price contracts.

Strategic acquisitions

Acquisitions have been a key focus for management in recent years, with a target of increased exposure to new regions with high growth, as well as expanding its capabilities. Many of the recent acquisitions have been particularly focused on the applications division to align itself with the key growth opportunities for its major vendors.

UXC has positioned itself for the shift to cloud-based services, viewing this as an opportunity rather than a threat. It has a newly established Cloud Solutions division within its applications division, which focuses on the two main cloud-based vendors in ServiceNow and Netsuite. Industry surveys suggest more than 40% of organisations will be shifting at least part of their managed services spending to cloud services over the next two years.

The acquisition of Keystone Management in November 2013 was motivated by the opportunity to increase the cloud-based service as Keystone introduced ServiceNow into the Australasian marketplace. Revenues from this cloud business are currently 10% of group earnings.

The other major strategic growth opportunity is through Microsoft AX in North America. UXC acquired Cole systems in December 2012, and also Tectura Corporation in December 2013, to enable the opportunity to implement and support the Microsoft Dynamics application. The growth opportunity is 50-60% per annum in North America, exceeding domestic growth opportunities.

Investment opportunity

Our earnings forecasts and valuation are under review prior to the half-year results to be released on February 27. Management recently provided guidance for first-half profit before tax to be in the range of $7-8.5 million.

UXC should be valued on a price-earnings premium to its listed peers, due to its strong partner relationships with the major applications vendors, its niche positioning in key growth regions, and continued margin improvement from the ongoing restructure.

The company is also highly leveraged to an eventual cyclical upturn through multiple recent acquisitions.

While there is timing risk with this cyclical upturn, it is likely to be a three to four-year growth story. Once an IT spending rebound is confirmed, UXC consensus earnings forecasts will be increased for FY15/FY16 and beyond.

Thus it is worth looking through the high one-year forward P/E of approximately 16, and focusing on the value from the medium-term earnings growth.