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Morningstar | Link Still Undervalued Following Solid First-Half Result

Narrow-moat Link Administration’s first-half results were broadly in line with our expectations, and we have maintained our fair value estimate at AUD 8.90 per share. We were surprised that the share price fell by 3% following the result, since we believe the company is performing well. Management’s outlook was vague but positive nonetheless, and cost synergy guidance was maintained, albeit skewed to the second half. We expect the decline in share price was caused by a combination of ongoing uncertainty about Brexit and Australian superannuation regulation, in addition to various slightly weak aspects of the result. However, the long-term outlook for the group is little changed by the first-half performance and, importantly, the United Kingdom Link Asset Services business is performing in line with expectations, and financial leverage is falling to comfortable levels.

We continue to believe shares are materially undervalued, trading at a current market price of AUD 6.86, which implies a fiscal 2020 price/earnings ratio of 16 and a dividend yield of 3.9%, or 5.6% including franking credits. This is attractive considering the strong competitive position of the company and our EPS CAGR forecast of 7% over the next decade.

The 191% increase in statutory net profit after taxes does not reflect the performance of the underlying business, as it included an AUD 178 million noncash gain related to the revaluation of the Property Exchange Australia investment. The statutory result also included a greater contribution from LAS, which accounts for about 40% of group EBITDA, but was only owned for two months in the comparable period. Excluding LAS, operating EBITDA fell by 3% due to weakness in the fund administration division related to client losses. However, we don’t expect client losses to continue, and we were impressed that the number of underlying superannuation accounts grew by 3.6%.

Despite a soft first-half performance and regulatory uncertainty, we continue to believe Link’s Australian fund administration business, which accounts for around 30% of group EBITDA, has good prospects. Investors have been concerned about the division since the federal government proposed changes to superannuation legislation with the release of the fiscal 2017-18 budget. Uncertainty has also increased after the release of the Productivity Commission’s review of superannuation and the Royal Commission into the financial-services sector.

Although the current round of legislation is likely to be approved by Parliament before the federal election, recent amendments mean it will be more favourable for Link than previously expected. For example, the period at which superannuation accounts will be considered dormant has increased to 16 months from 13. Management originally estimated the likely impact of the changes at about AUD 50 million, 10% of divisional revenue, or 4% of group revenue. However, this figure excludes the potential contractual compensation to which Link will be entitled. Although we’ve included management’s potentially conservative estimate in our forecasts, the actual impact is likely to be less. It’s also notable that the Royal Commission appears to be having unintended positive effects for Link, such as strong member growth for Link’s predominantly industry superannuation fund clients. This may be exacerbated if Labour wins the federal election, which is likely to be held in May 2019.

A lack of unpleasant surprises from LAS is reassuring considering the number of Australian companies that have destroyed shareholder value via similar large acquisitions in the U.K. in recent years. Considering Brexit uncertainty, the business is generating respectable mid-single-digit underlying revenue growth, albeit in line with our expectations. The sale of the CPCS division, which accounts for about a fourth of LAS, is a sensible move that exits a relatively low-quality business at a 16% profit on the 2017 acquisition cost and reduces financial leverage of the group.

Link’s recent decision to increase its investment in PEXA to 44% is a smart move that enhances the earnings growth outlook and diversification of the group. Management provided operating performance data that showed the strong growth being generated by the business and which has exceeded internal forecasts. However, we have maintained our valuation of PEXA, which is still at a relatively early stage of its business cycle. Although the Australian Securities Exchange also intends to create an e-conveyancing platform via its investment in Sympli, PEXA has a first-mover advantage and well-established relationships with state governments and the major banks, among others. As such, we think PEXA will probably develop a strong competitive advantage based on network effect, not dissimilar to the one enjoyed by REA Group.