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Morningstar | Computershare's Fiscal 2018 Result Benefits From Cyclical Trends, but Shares Remain Overvalued

Narrow-moat-rated Computershare’s fiscal 2018 financial result was in line with our forecasts. However, we’ve made a number of minor adjustments to our financial model, which has increased our fair value estimate 3% to AUD 13.70 per share. Specifically, we’ve slightly lowered our forecast revenue, increased margins, and lowered capital expenditure. At their current market price of AUD 18.82, we continue to believe that the shares are overvalued and that the market is overestimating the potential benefits from further interest rate rises and growth from the mortgage servicing and employee share plan businesses. Based on our underlying earnings per share forecast and the current market price, the fiscal 2019 price/earnings ratio is 21 versus 15 at our fair value estimate. The market price also implies a fiscal 2019 dividend yield of 2.4%, or 2.9% including franking credits. Management provided fiscal 2019 underlying constant currency EPS growth of "around 10%" for fiscal 2018, a little stronger than our 8.5% forecast.

Although Computershare increased underlying EPS by 16% in fiscal 2018, and the 14% increase in constant currency EPS exceeded management’s guidance of "12.5% growth with a positive bias," we believe these growth rates are stronger than the company can sustain and we maintain our mid-single-digit underlying EPS compound annual growth rate over the next decade. Of the 15% increase in group EBITDA in fiscal 2018, foreign exchange movements drove a 2-percentage-point increase, higher margin income contributed a 7-percentage-point increase, and underlying business performance drove a 6-percentage-point increase. That’s not to say the increase in margin income isn’t sustainable, just that it doesn’t necessarily reflect a strong operational performance and that it’s largely outside management’s control.

Margin income continues to be an important component of Computershare’s earnings; it grew to 29% of group EBITDA in fiscal 2018 from 25% in the prior year. Interestingly, the 32% increase in margin income came with only a 1.8% increase in client-owned cash balances, although the proportion of cash balances exposed to interest movements increased to 42% of total balances from 23% in the prior year. This likely reflects a strategic decision to maximise exposure to rising interest rates, which we consider to be sensible. However, we question the ability of management to consistently predict interest rates over the long term, and the margin income aspect of the business reduces earnings quality.

The fiscal 2018 result also benefitted from an upswing in corporate actions, such as the spinoff of Brighthouse Financial from MetLife and the Volkswagen class action, which we don’t consider to represent sustainable growth. To put this into perspective, of the USD 82 million increase in group EBITDA, we estimate around half of the increase was attributable to the growth in the corporate and class action businesses, with the remainder largely due to the mortgage services business. To some degree, the corporate and class action growth overlaps with the margin income growth as these businesses generate a relatively high proportion of earnings from margin income.

Fiscal 2018 was the first year that the business services division, constituting 39% of group revenue, overtook register maintenance, at 31% of group revenue, as the largest division in the group. This reflects management’s strategy of aggressively expanding the mortgage services business to reduce dependency on the mature register maintenance business. However, register maintenance still contributes a material proportion of group earnings and, despite a slight improvement in revenue growth in fiscal 2018 versus the prior year, constant currency revenue still fell 0.5%, marking a fourth consecutive year of similar revenue declines. Over the next decade, we only forecast revenue growth of 2% per year, but even this forecast will be optimistic if the current trend persists.

Similar to register maintenance, the employee share plan business, which constitutes 10% of group revenue, generated soft revenue growth of just 1.3% in fiscal 2018. Although broadly in line with our forecasts, the business was strongly supported by Hong Kong, where revenue grew 24%, in contrast to the other main contributing regions where revenue growth was either weak or fell. Although we expect the recently announced AUD 420 million acquisition of Equatex to provide a boost in the medium term, we continue to be concerned that Computershare’s growth seems so dependent upon acquisitions and that established businesses aren’t performing better. These concerns influence our long-term revenue growth assumptions.

Computershare’s mortgage services business continues to be the main "organic" growth driver of the group, although the extent to which growth is organic is debatable, considering that the business partly involves the acquisition of mortgage servicing rights. Nevertheless, the value of mortgages serviced by Computershare, the unpaid principal balance, increased 6% to USD 149 billion in fiscal 2018, driven by a 13% increase in the United States UPB to USD 81 billion but offset by a 10% fall in United Kingdom UPB to USD 68 billion. Although management maintained its U.S. UPB target of USD 100 billion, we continue to expect the company to keep growing beyond this target and for the U.K. UPB to stabilise from fiscal 2021 as mortgage servicing demand from the challenger banks offsets the runoff of the UKAR contract. Pleasingly, the mortgage servicing EBITDA margin increased to 20% from 15% in the prior year.

From a balance sheet perspective, Computershare remains in good shape with net debt falling 10% to USD 980 million as at June 30, 2018. Credit metrics also remain comfortable with a net debt/EBITDA ratio of 1.6 and will increase to around 2.0 following the Equatex acquisition in fiscal 2019, which is within management's target range of 1.75-2.25. The defensive nature of Computershare’s businesses should prevent the kind of shocks that could undermine credit metrics. Management continues to highlight its cost-out plans, which appear material, but it’s likely to be near impossible to verify if they’ve been achieved, considering the small magnitude of the cost savings relative to the total cost base.