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Morningstar | Iress Well Positioned for Royal Commission Fallout; Fair Value Estimate Increased to AUD 11.80

Narrow-moat rated Iress reported a reassuring 2018 financial result that showed steady progress in line with our expectations. Both revenue and NPAT were within 1% of our forecasts, but we were encouraged by the performance and outlook for the Australian wealth management and U.K. lending divisions, which compose 31% and 7% of segment profit, respectively. We have slightly increased revenue growth forecasts, but our 2019 group segment profit forecast of AUD 151 million is largely unchanged and remains in line with management's guidance of AUD 146 to 153 million. The bulk of the 7% increase in our fair value estimate to AUD 11.80 per share is due to the roll forward of our financial model.

Iress is well placed to manage key short-term risks, including the potential consequences of Brexit in the U.K. and the Royal Commission fallout in Australia. Iress’ U.K businesses compose about one third of group profit, but clients are largely domestically focused and unlikely to experience a material direct impact from Brexit. Irrespective of the Brexit outcome, customers increasingly need Iress’ software and data to help improve productivity and remain competitive. Australia is a similar story, with the Royal Commission likely to result in more compliance and administration requirements and an increasing need for Iress’ products.

We weren’t surprised that Iress’ share price rose by 4% following the result, considering the stock’s relatively safe-haven characteristics in a volatile market. At the current market price of AUD 12.84, we think the shares are fairly valued. The market price implies a 2019 price/earnings, or PE, ratio of 26, versus 24 at our fair value and a 2019 dividend yield of 3.7%, or 3.9% including franking. Our fair value implies a yield of 3.9%, or 4.1% with franking.

We have reduced our 2019 franking estimate to 10% and to 35% thereafter, reflecting a growing contribution from overseas businesses, which is in line with management's guidance. The high proportion of recurring earnings underpins the sustainability of the dividend, despite a likely drop in the payout ratio to below 100% of statutory NPAT from 2020.

Iress performed well in 2018, with all six divisions reporting revenue growth and a respectable group revenue growth rate of 8%, or 6% on a constant currency basis. Importantly, the group EBITDA margin expanded, albeit very slightly to 27.4% from 27.0%. This is significant as the EBITDA margin contracted in each of the previous seven years as management reinvested and repositioned the portfolio. Similarly, underlying EPS growth of 7.6% was one of the strongest results in the past decade and provides further evidence that the business is evolving as we expect. This partly reflects management’s strategic decision to transition away the structurally weak financial markets division, which composed 68% of group profit a decade ago but just 25% in 2018.

Segment profit from the Australian wealth management division, which composes 31% of the group, grew 7% due to robust demand for wealth, superannuation, and data analytics products, which we expect to continue. Revenue from the APAC Financial Markets business, accounting for 25% of group profit, was flat and profit unsurprisingly fell a couple of percent. This reflects structural challenges facing the active fund management industry that are likely to continue. U.K. wealth management, composing 24% of group profit, performed very well, with segment profit up 13% and reflecting new customers and similar industry dynamics to the Australian market. South Africa and U.K. lending, representing 11% and 7% of the group, respectively, also benefited from a range of factors but fundamentally from a need for technological solutions in a rapidly evolving financial services sector.

We are not concerned about management’s decision to combine the APAC Financial Markets and Australian wealth management divisions. We don’t usually like reorganisations of financial reporting as it often reflects an attempt to confuse investors and detract from weak underlying performance. However, despite the reorganisation of Iress’ reporting in 2017, and the weak performance of the APAC Financial Markets division, we agree that the evolution of the industry means it’s logical to combine the two divisions.

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 and was 94% in 2018. We also expect cash flows to benefit in 2019 from the completion of the Melbourne and Sydney offices. This will enable financial leverage to remain relatively low, and we are not concerned by the 6% increase in net debt. Credit metrics remain very strong, with a net debt to EBITDA ratio of just 0.6 and an EBIT to interest coverage ratio of 19 in 2018, both of which we expect to gradually improve over the next decade. The strong balance sheet raises the prospect of acquisitions, which we consider to be likely, but aren’t included in our forecasts at this stage.