EUR 850.00 For Business Accounts Only

Morningstar | Iress Looking Overvalued as Interest-Rate Weakness Drives Market Higher. See Updated Analyst Note from 28 Jun 2019

Narrow-moat-rated Iress’ share price has performed well this year, rising 26% to AUD 13.98 per share. However, the company has announced little recently, and we don’t think the share price rise is supported by a material improvement in the earnings growth outlook. We maintain our fair value estimate at AUD 11.80 per share and consider the stock to be overvalued. We think Iress’ share price growth is more reflective of broader equity market--and particularly technology stock--strength, which is partly being driven in Australia by interest-rate weakness. Over the past two years alone, the Australian 10-year government bond yield, widely regarded as the "risk-free" investment rate, has collapsed from 2.6% to a record low of 1.3%.

Our fair value estimate implies a fiscal 2020 price/earnings ratio of 21 versus the market price-based P/E of around 30, which is near its highest level for a decade and well above the P/E ratio of the S&P/ASX 200 index of 17. Over the past decade, the company generated an underlying EPS compound annual growth rate of just 2.8% and our valuation assumes a CAGR of 8.1% over the next decade, largely on the expectation of margin expansion, driven by a combination of revenue growth and operating leverage in the wealth-management businesses. Management expects 2019 segment profit growth of 6%-11% on a constant-currency basis or 3%-8% excluding the benefit from accounting policy changes, which aligns with our 7% forecast.

Iress faces several challenges due to structural changes in the wealth-management industry. For example, the growth of passive and automated investment products continues to negatively affect traditional active fund managers and their demand for Iress' software products. Prior to a change in its financial reporting layout in 2017, EBITDA from the financial markets division, which is highly exposed to active fund managers, fell at a CAGR of 5.6% in the six years to 2016 and continued to fall in 2017. This earnings weakness was accompanied by a decline in profit margins, which also weighed on group margins. Between 2010 and 2017, the group EBIT margin fell from 36% to 24%.

In the wealth-management sector, robo advice and passive investments are also affecting demand for traditional relationship-based financial planners. In Australia, which still constitutes 56% of the group, industry disruption has been exacerbated by the recent Royal Commission into the financial services sector, which reflected badly on the ethical behaviour of financial advisors and the value they create for clients. In the superannuation sector, low-fee industry funds have also benefitted from the Royal Commission and continue to win market share from retail funds. The insourcing of investment functions by increasingly dominant industry funds is also affecting the active-management industry.

Iress has responded to negative industry trends by diversifying away from its previously core financial markets business in Australia, where divisional EBITDA has fallen from 68% of the group in 2010 to around 25% in 2018. In contrast, U.K. and Australian wealth management revenue has grown to 55% from 24% of the group, a segment of the market which we consider is likely to grow. We expect demand for holistic personal wealth-management advice to remain strong despite the rise of robo advice and passive investment products, which won’t appeal to all clients and can be incorporated into holistic advice anyway. Iress’ deep technology stack and broad product suite means it offers significant productivity benefits to wealth managers, switching costs underpinning its economic moat.

Iress’ expansion of its U.K. businesses increases exposure to Brexit-related uncertainty and foreign currency weakness. The Brexit situation remains extremely uncertain, with the original "leave" campaign only achieving 51.9% of the vote in 2016 and the country remaining extremely divided on the issue. The resignation of Prime Minister Theresa May and the recent success of the Brexit party in the European elections indicate that pro-Brexit MP Boris Johnson is most likely to become the next prime minister. However, Johnson is still likely to struggle to leave the European Union in October 2019 as he hopes, and the pro- and anti-Brexit support remains pretty evenly split. Despite the potential for an economic downturn in the medium term, we don’t expect the issue to materially affect Iress in the long run. In the short term, the U.K. business may even experience some temporary benefit from Australian dollar weakness, although this isn’t incorporated into our forecasts.

From a balance sheet perspective, Iress remains in good shape. The capital-light nature of the business means cash conversion (unleveraged, pretax operating cash flow/segment profit) is strong, at 94% in 2018, and supports the sustainability of the dividend. We also expect cash flows to benefit in 2019 from the completion of the Melbourne and Sydney offices. Credit metrics remain very strong, with a net debt/EBITDA ratio of just 0.6 and an EBIT/interest coverage ratio of 19 in 2018, both of which we expect to gradually improve over the next decade, barring acquisitions. The strong balance sheet raises the prospect of acquisitions, not included in our forecasts.