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Morningstar | Computershare Remains Fairly Valued as Margin Income Growth Drives 1H Result

Narrow-moat-rated Computershare’s first-half result was strong but only slightly ahead of our expectations. Although statutory NPAT rose by 52%, Computershare frequently reports a range of nonrecurring items, meaning that the 15% increase in underlying NPAT is a more accurate reflection of the underlying performance of the company. Although we expected strong margin income growth, we were surprised by the 21% jump in client-owned cash balances and the USD 10 million in EBITDA from the corporate and technology division. However, we have maintained our long-term low-single-digit annual growth forecast for client-owned cash balances as management expects the jump to reverse in the second half.

We previously assumed the corporate and technology division would become a cost centre following the divisional loss in fiscal 2018. However, management claims the fiscal 2018 loss was an aberration and the first-half result is more indicative of long-term divisional earnings. We have increased our divisional earnings forecasts accordingly, which constitute around 3% of group EBITDA, in addition to lowering our Australian dollar/U.S. dollar exchange rate to 0.71 from 0.73. Combined, these changes cause a 2% increase in our fair value estimate to AUD 19.40 per share.

We think the 5% share price rise following the result was caused by the increase in management’s fiscal 2019 EPS growth expectations, to 12.5% from 10.0%, and better-than-expected cost synergy guidance. However, these factors alone haven’t caused a material change to our forecasts, and guidance remains well below our 16% underlying EPS growth forecast.

At the current market price of AUD 18.77, Computershare is slightly undervalued, in our view. The market price implies a fiscal 2019 price/earnings ratio of 18 versus 19 at our fair value estimate. The market price-based dividend yield is 2.8%, or 3.4% including franking credits, versus 2.7%, or 3.3% including franking, at our fair value estimate.

The first-half result was driven by a 58% increase in margin income, which offset earnings weakness elsewhere in the company. The USD 38 million, or 13%, increase in group EBITDA comprised a USD 46 million increase in margin and a USD 8 million fall in other earnings. Although revenue growth was flat, the higher proportion of higher-margin revenue from margin income caused the group EBITDA margin to increase to 29% from 26%, which is broadly in line with our investment thesis outlined in our Dec. 4, 2018, report, "Computershare’s Margin Outlook Is Better Than We Thought."

The register maintenance division, which makes up about 44% of group EBITDA, delivered a mixed result with margin income-related revenue increasing 59% but other revenue flat on the prior comparable period. This is largely in line with our investment thesis that the registry business is reasonably mature and likely to generate low-single-digit revenue growth, excluding margin income, in the long term.

The U.S. mortgage servicing business, which constitutes around one fourth of group EBITDA, continues to grow in line with our expectations. The value of mortgages serviced, also known as unpaid principal balance, or UPB, increased 30% to USD 93 billion and is rapidly approaching management’s long-held target of USD 100 billion. However, management confirmed that UPB would continue to grow beyond the target, which is in line with our expectations detailed in our Dec. 18, 2018, report, "Computershare Is Well Placed to Manage Mortgage Servicing Risks."

We aren’t concerned that the U.S. mortgage servicing business’ revenue growth rate of 11% was below the UPB growth rate. This was caused by several factors such as the timing of the UPB growth and a reduction in high-margin servicing fees, which are likely to normalise over the long-term. Importantly, the business continues to be highly rated by agencies, win competitive subservicing contracts, and expand profit margins as we expected.

The U.K. mortgage servicing business, which we estimate constitutes 5%-10% of group EBITDA, also performed in line with our expectations. The 13% fall in UPB reflects the amortisation of the closed UKAR mortgage book, which is in line with our forecasts. Management continues to expect mortgage originations by "challenger" bank clients to offset this amortisation within the next 12 months. Although management claims revenue growth was aided by new originations and project fees, details of the non-UKAR UPB growth were not disclosed, which increases the risk to our forecasts somewhat.

The performance of the employee share plan division, which makes up around 10% of group EBITDA, was a little weaker than we expected but not sufficiently so to change our forecasts at this stage. Although headline EBITDA growth was flat, EBITDA fell 1% excluding margin income growth and about 10% excluding the Equatex acquisition, which closed in November 2018. However, divisional earnings are slightly muddied by the Equatex acquisition, which will provide a much higher second-half contribution, and management maintained its USD 30 million cost synergy expectation from the transaction.

Computershare reported very weak free cash flow (operating less investing), with an outflow of USD 386 million for the first half, but largely due to the USD 438 million cost of the Equatex acquisition. Operating cash flow of USD 69 million was also weak and implied a conversion of statutory NPAT of just 26%. However, aside from noncash items, the main cause was the timing of collecting receivables, which we expect to normalise in the second half. Generally speaking, Computershare is capital-light and generates strong cash flows, although short-term fluctuations in cash conversion are not unusual. Importantly, the balance sheet remains strong despite the 56% increase in net debt to USD 1.5 billion during the half. The duration of debt has been increased to 4.4 years from 2.8 and credit metrics remain comfortable. For example, the net debt/management EBITDA ratio is just 2.2, or 1.9 excluding nonrecourse SLS-related debt, and is within management’s target range of 1.75-2.25. Similarly, the EBITDA/interest coverage ratio of 10 is very comfortable, and we expect all metrics to gradually improve.