EUR 850.00 For Business Accounts Only

Morningstar | Iress No Longer Overvalued Following Technology Sector Sell-Off. See Updated Analyst Note from 07 Jan 2019

Despite a lack of announcements since the interim result last August, the share price of narrow-moat-rated Iress has fallen by 21% over the past three months, which mainly reflects general technology stock weakness. At the current market price of AUD 10.81, the stock now trades slightly below our AUD 11.00 fair value estimate which implies a fiscal 2019 P/E ratio of 24. Superficially, this looks expensive relative to the P/E ratio of the S&P/ASX 200 index of just 14, and Iress needs to improve historically weak earnings growth to justify this premium. Over the past decade, the company generated an underlying EPS CAGR of just 2.8% but 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 within the wealth management businesses.

Iress is grappling with structural change in the investment management industry including the loss of market share by active fund managers to passive and automated investment products. This trend is reducing demand and fees for actively managed funds which in turn is impacting demand for Iress’ institutional software products. For example, prior to the change of its financial reporting layout in 2017, EBITDA from the financial markets division 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, for example, the group EBIT margin fell from 36% to 24%.

However, Iress is addressing its challenges and has significantly diversified away from its, previously core, financial markets business with divisional EBITDA falling from 68% of the group in 2010 to 34% in 2016. From a revenue perspective, the U.K. and Australian wealth management businesses have grown to 54% from 24% of the group and is a segment of the market which we expect 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 and has strong switching costs which underpin its economic moat.

At the 2018 result next month, we expect to see a continuation of the strong first-half performance into the second-half rather than a return to the sluggish earnings growth of the past decade. At the interim result, management maintained 2018 segment profit growth guidance of 3% to 7% on a constant currency basis, or 5% to 9% based on first-half foreign exchange rates, which implies AUD 131 to 136 million for the full year. This compares with our forecast of AUD 138 million, which implies a slight slowing of previous corresponding period growth from 13% in the first half to 7% in the second half. From a balance sheet perspective, we expect Iress to remain in good shape. Debt metrics are extremely comfortable with forecast net debt/EBITDA ratio of 1.2 and EBIT/interest expense of 24 as at Dec. 31, 2019. We expect Iress’ strong cash flow generation to drive improvement in these metrics over the coming years.

The increase in Iress’ exposure to the U.K. in recent years exposes the company to Brexit-related uncertainty and potential British pound weakness. Since the referendum in mid-2016, the Australian dollar has strengthened by 14% versus the British pound, but we don’t believe this is necessarily due to Brexit nor do we assume further material and sustained British pound weakness. Over the past 50 years, the AUD/GBP exchange rate has fluctuated around 0.50 and is currently around 0.56, a situation we expect to continue without materially impacting IRESS’ underlying earnings. 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. Prime Minister Teresa May’s proposal looks increasingly unlikely to proceed and it's likely that a second referendum will be held. However, we expect the country will carry on regardless of the political muddle and we don’t assume either a "remain" or "hard Brexit" outcome to materially impact Iress at this stage.