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Morningstar | Computershare Increasingly Undervalued Despite U.K. Mortgage Servicing Issues. See Updated Analyst Note from 23 May 2019

The market appears to have over-reacted to narrow-moat-rated Computershare’s news of problems within its U.K. mortgage servicing business. Management used its annual investor day to announce a one-off USD 35 million EBITDA impact in fiscal 2020, relating to information technology issues, in addition to slower than expected lending growth by its "challenger bank" clients in the U.K. However, the EBITDA impact equates to only around 5% of fiscal 2020 group EBITDA whereas the 9% share price fall implies AUD 800 million in lost market capitalisation.

We have updated our financial model following the investor day announcements, but the relatively small negative fair value impacts have been offset by the positive time value of money impact and so we maintain our fair value estimate at AUD 19.40 per share. Management maintained fiscal 2019 earnings guidance of 12.5% growth in "management" EPS on a constant currency basis, which is in line with our forecasts. At the current market price of AUD 16.65, we believe Computershare is undervalued.

Our fair value implies a fiscal 2020 P/E ratio of 18 and a dividend yield of 2.9% or 3.5% including franking credits. In contrast, the market price implies a P/E of 15 and a dividend yield of 3.3% or 4.0% with franking. Our forecasts imply a 6% EPS CAGR over the next decade, boosted by an expectation of rising interest rates, versus a 3% CAGR over the past five years. There’s no avoiding that Computershare remains highly dependent upon interest rates, and increasingly so as the U.S. business grows. Our forecasts assume interest rates will rise in the long term as detailed in our December 2018 special report "Computershare’s Margin Outlook is Better Than We Thought." Although Australian interest rate weakness appears to undermine this view in the short term at least, the weaker Australian dollar has an offsetting effect to some degree.

Computershare’s U.K. mortgage servicing business remains dominated by the U.K Asset resolution, or UKAR, contract which administers the closed mortgage books of failed lenders, Bradford & Bingley and Northern Rock Asset Management, on behalf of the U.K. government. Management expected to transfer these mortgages from the legacy UKAR information technology platform to Computershare’s new IT platform this fiscal year. However, for reasons beyond Computershare’s control, the transfer has been deferred by around one year, meaning Computershare must incur the USD 35 million cost of the UKAR platform for one year longer than expected.

Aside from the short-term UKAR transfer issue, management’s comments about soft U.K. loan growth, which it attributed to Brexit-related uncertainty, also appears to have concerned the market. In the long term, Computershare will need to replace around GBP 40 billion worth of amortising UKAR-related mortgages, meaning it needs to grow its new mortgage lending business. However, management remains confident about the long-term prospects of the U.K. mortgage business and provided more detailed growth forecasts which are in line with our forecasts outlined in our December 2018 special report "Computershare is Well Placed to Manage Mortgage Servicing Risks." At this stage, we do not believe the long-term investment thesis has significantly changed and management’s cost reduction programme could reduce divisional costs by around USD 50 million per year within four years.

In contrast to challenges in the U.K., the U.S. mortgage servicing business appears to be performing well. Computershare still has a market share of less than 1% in the U.S. mortgage market meaning the company has significant growth potential, in contrast to its more mature share registry business where it is already the leading global provider. Management announced that the value of mortgages being serviced, known as the unpaid principal balance, or UPB, has exceeded its long-term target of USD 100 billion and a new target of USD 150 billion has been made which is likely to be reached in around three years. However, both progress to date and the new target are in line with our forecasts.

Management also announced a reorganisation of the company with the creation of a new issuer services division from fiscal 2020 which will combine the register maintenance, corporate actions, and governance services businesses. In addition, the mortgage servicing business will be split out from the business services division. Restructures such as this are usually a red flag because they can sometimes be used to disguise poor performance. This is particularly concerning with Computershare which already has complicated accounts and consistently incurs nonrecurring costs. However, on balance, we agree with the logic behind this restructure and expect more details to be announced at the full-year result in August 2019.

Computershare’s issuer services businesses appear to be making steady progress, but the restructure is partly intended to help drive growth. Management have identified large adjacent markets into which they hope to expand and improve long-term divisional growth. However, it’s still early days and improvement is expected to be a multiyear project. The employee share plan business also continues to perform well, with the Equatex acquisition helping make Computershare the largest employee share plan provider in the world. Aside from positive long-term industry growth trends, we continue to expect the division to achieve margin expansion as a result of its cost reduction programme.