Upgrading UXC

In recent months, new contract wins have resulted in significant share price growth for many companies in the IT services sector. After a number of years of under-spending it appears the cyclical component of IT is finally picking up. There is also a structural shift in IT towards more cloud-based applications and new IT technology, replacing the former labour for hire consulting model. Since the GFC a number of Australia's largest corporations and state/federal governments have cut their IT budgets, but there comes a time when old systems need to be replaced.

Confirmed earnings guidance and new contract wins have seen the UXC share price grow from $0.735 to $1.03 since the start of July. Although we have had a Buy recommendation with a $1.10 valuation, we didn't include the stock in the model portfolio.

We didn't include UXC because the company has spent the last three reporting periods talking about how it would transform the company through acquisitions to significantly enhance group margins. Although we could see the acquisitions were adding value, we were concerned about the level of organic growth within the existing business.

But in recent months, the company has confirmed FY15 earnings guidance, and then announced a further $100 million of contracts to benefit future years' earnings. We still don't have clarity around what margin impact this will have for FY16/FY17 but the company is clearly moving in the right direction.

The wins are also confirmation for UXC management, that their mix of solutions can add value for new and existing customers. The strategy has revolved around leveraging its capabilities to provide customers with integrated and complete solutions including cloud-based platforms.

Our past UXC Buy recommendations in September last year (UXC prepped for IT restart, September 8, 2014) and after the half-year result earlier this year (Stock updates: NTC, UXC and EPD, March 2, 2015), saw our estimates and valuation at the top end of analyst expectations. We also discussed the past issues of project budget blow-outs and the opportunity from integrating five key acquisitions.

The company has three divisions in consulting, infrastructure and applications. Applications and infrastructure are the key divisions with the company having excellent relationships with its four main vendors – Oracle, SAP, Microsoft Dynamics and ServiceNow.

The applications division is also where the high margins can be achieved – medium term target of 11-12 per cent (profit before tax).

As discussed in our UXC recommendation from September if the margins in the table below are achieved by the end of FY16 then this is likely to lead to a valuation/share price of $1.30-$1.50. This is currently not assumed by the market with consensus analyst estimates and our prior forecasts assuming approximately 8 per cent for consulting, 4 per cent for infrastructure and 9.5 per cent for applications.

The impact of the new contracts and improved outlook for the IT services industry on margins will be the key driver of the stock moving forward.

FY15 profit guidance

On June 29, management announced confirmation that they were on track to meet FY15 earnings guidance with net profit after tax (NPAT) expected to be $20-22m or earnings per share of 6-6.7 cents. After the recent share price re-rating the mid-point of guidance places the company on a FY15 PE of 16, which is still reasonable given the strong growth outlook, balance sheet and healthy dividend yield of 5 per cent.

Microsoft Dynamics in North America is growing very strongly, and UXC has got more work than it can deliver on. Given the balance sheet is very strong with debt reduced to below $8m, an acquisition to increase capabilities of servicing this region would make sense.

In the second half of FY15, the company's contract win rate has increased and there has been a reduced number of contract deferrals.

New contract wins

On July 28 UXC announced $100m of new contracts for FY16 and beyond, and in recent weeks the company has announced more detail on some of these contracts.

The most positive detail about the wins is that 60 per cent are new customers. UXC is likely to create further opportunities by cross-selling other services to these new customers.

A number of these contracts are annuity based managed services contracts that provide revenue security moving forward. The contracts range from 3-7 years in duration.

Transpower New Zealand: UXC will support the organisation's Oracle and Microsoft SQL databases, Oracle application middleware and mid-range services with a three year contract.

Global listed beverage company: Will build and support their Oracle based manufacturing platform on an “as a service” basis.

Australian construction company: Will implement Oracle based ERP systems with a five-year annuity contract to manage service desk, applications and infrastructure.

Ixom: Assist in transforming and migrating Ixom from its current Orica-hosted IT environment to its own environment. UXC to provide application managed services and an Infrastructure-as-a-Service platform. Ixom is a water treatment and chemical distribution company. The three year contract is expected to be worth at least $12m.

Ausgrid (NSW Government agency):  UXC was awarded a three-year contract plus the option of two two-year extensions to provide service desk and end user computing support services. The estimated total value of this contract is in excess of $25m.

IT services comparison

Risks

The contracting nature of the business means there is risk of cost and duration over-runs that can have a significant effect on group margins.

In past years there has been significant un-utilised capacity in the IT services industry which has resulted in contract price deflation. With conditions now improving there may be scope for margin improvements.

But improved conditions can also cause the issue of greater staff attrition rates which can be a costly exercise for the company.

Offshoring and structural changes from new technology have been occurring over recent years, but UXC has done a reasonable job at managing these risks and moving with the market.

Valuation/Summary

As discussed our prior forecasts were already at the top of market estimates, but we have made slight increases to our FY16 and FY17 forecasts, with an increase from our prior $1.10 valuation to $1.20. The company should be able to grow revenues by at least 7 per cent for the next three years. Prior to recent announcements the market had been assuming revenue would only grow by about 4 per cent per year.

We maintain our Buy recommendation with the company set to benefit from its Microsoft AX application opportunity in North America, and growth in cloud-based applications through the alignment with ServiceNow. Further with recent acquisitions integrated into the business there are continued cross-selling opportunities.

To see UXC's forecasts and financial summary, click here.