This financial year offers managing director Cris Nicolli and his team at UXC the opportunity to regain credibility with the market. The full year 2013-14 results displayed evidence that the project overrun issues of the first half are in the past. It also appears that the five acquisitions completed during the year have been successfully integrated, and the full-year impact in 2014-15 will give a large boost to earnings.
Much of the result had been pre-announced in June, with confirmation and further guidance of stronger-than-expected cash collection in July. The delivery of milestones on key projects meant that the net debt position had declined to $4.1 million against guidance of $34 million.
Total revenue lifted by 8% to $643 million for 2013-14, with annuity revenue now representing an increased 27%. Underlying earnings before interest, tax, depreciation and amortisation (EBITDA) was, however, down 2% for the year due to the first-half issues with the large infrastructure contracts. Normalised net profit was down for the year, despite the fact that market share gains have been achieved.
The weakness in organic growth was due to the contract issues in the first half, as well as the continued weakness in the IT services market. Low utilisation rates have been placing pressure on contract margins for UXC and its competitors.
The five acquisitions during the year had integration costs, and there was also significant investment in new technology capabilities which should be monetised during 2014-15.
The strategy behind the acquisitions is to move into new areas of technology and solutions, as well as increase vendor application alliances. On top of the focus on functional capabilities, there is also an element of geographic expansion.
With the three divisions – consulting, infrastructure and applications – there are unique drivers at play. Management has consciously decided to reduce its focus on consulting due to the more commoditised nature of that work. Applications is the key company differentiator due to the excellent relationships with key vendors. Infrastructure was the troubled division during the year, due to project execution issues.
The new capabilities enhance the model that is underpinned by strong relationships with the four application vendors – Oracle, SAP, Microsoft Dynamics and ServiceNow. There will also be an increasing opportunity to cross-sell from the divisions as the customer base expands.
An encouraging outlook
Moving forward, there are two key uncertainties that I think the market will focus on. Firstly, whether the project execution issues with the infrastructure projects are ongoing or they were a one-off impact that the company has learned valuable lessons from and, secondly, if the improved industry conditions in the fourth quarter and UXC’s encouraging commentary about their performance in July and August represent a cyclical turnaround.
From an investor’s perspective, project execution remains a risk until management can provide stronger evidence that they have it under control. The commentary suggests lessons have been learnt and it won’t happen again … but time will tell.
The uncertainty surrounding the industry outlook contributes to the discounted price-earnings (P/E) multiple that UXC is trading on, as well as its discount to valuation. While commentary from chief executives among the sector has been broadly more positive, not one of them has confidently suggested that the volatile industry conditions have definitely passed (see IT sector: Time to reboot).
I think the cyclical nature of the industry is priced into the stock and the risk is to the upside. To put this into context, management is guiding for profit before tax (PBT) margins of 9-10% for consulting, 11-12% for applications and 4.5-5.5% for infrastructure in 2015-16 (during 2013-14 PBT margins were 7.6% for consulting, 9.4% for applications and 1.8% for infrastructure). However, at an investor presentation Nicolli suggested that if trading conditions for July and August were maintained then these margin targets could be achieved by the end of 2014-15 – a year ahead of schedule.
Consequently it is clear that the cyclical turnaround – and specifically the timing of it – presents material upside to current market earnings expectations.
Indeed, consensus earnings forecasts for broking analysts assume that the margin targets are not achieved by 2015-16, suggesting that analysts and the market remain sceptical on management’s ability to execute on its strategy.
In regards to industry conditions, we are at least five years through a cyclical IT downturn. The nature of IT hardware is that this spending can only be delayed for so long. While some businesses will shift to the new IT world, UXC is positioning itself to benefit from them. But there are also many businesses that will upgrade old traditional IT systems.
Even if conditions do remain weak, you can do worse than holding onto a stock at the bottom of the cycle with a PE of 12 and dividend yield of 6% before franking credits. Indeed, the stock is one of the best yielding small caps in the Australian market (see Our top yield stock stars).
Netting all this out, my view is that if industry conditions remain challenging the 12-month valuation and price target for UXC is $1.1-$1.20. But if conditions continue to improve there will be consensus earnings upgrades with UXC valuations increased to $1.30-$1.50.
I maintain my BUY recommendation with a conservative $1.10 valuation and price target.
To see UXC's forecasts and financial summary, click here.