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Morningstar | Link’s Cost-Out and CAS Integration Progressing Better Than Expected; FVE Increased to AUD 8.50

Narrow-moat-rated Link’s fiscal 2018 result was its first to include earnings from Capita Asset Services, or CAS, which was acquired for AUD 1.5 billion in November 2017 and has since been renamed Link Asset Services, or LAS. The 54% increase in revenue was mainly due to the eight-month contribution from LAS and was in line with our forecasts. Without LAS, revenue rose by just 2%, also in line with our forecast and affected by various factors such as client losses and the repricing of the Superpartners contract. However, the 57% increase in underlying net profit after tax, or NPAT, was much stronger than our 43% forecast, reflecting better-than-expected LAS margins and better-than-expected progress with cost-saving initiatives in the rest of the business.

We’ve largely maintained our revenue forecasts for the group but increased our EBITDA margin forecasts to around 29% from 28% on average, and increased the debt weighting in our weighted average cost of capital, to reflect the increasing likelihood of further acquisitions. These changes have driven a 5% increase in our fair value estimate to AUD 8.50, and at the current market price of AUD 8.02, we still believe the shares are undervalued. The market price and our earnings forecast imply a fiscal 2019 price/earnings ratio of 17, versus 18 at our fair value estimate. The market price also implies a dividend yield of 3.6%, or 5.2% including franking credits.

Link’s balance sheet is in reasonable shape despite the 90% increase in net debt to AUD 557 million, caused by the LAS acquisition. Although the LAS acquisition was significant to Link, debt metrics remain comfortable with a net debt/EBITDA ratio of 1.7 as at June 30, 2018, which falls to 1.5 if we assume a full year’s contribution of earnings from LAS. This is at the bottom of management’s target range of 1.5-2.5. The raising of around AUD 1.2 billion in new equity capital in fiscal 2018 has been a key factor in keeping gearing down; however, we doubt the current level of gearing will be sustained, as Link has indicated it intends to make further bolt-on acquisitions and has submitted a bid to acquire the 80% of Pexa it doesn’t already own.

We already incorporate Link’s 20% stake in Pexa into our financial model at its book value of AUD 128 million; however, it’s likely that Pexa's eventual sale price will be between AUD 1 billion and AUD 2 billion, meaning Link may need to find at least AUD 800 million if it is the winning bidder. Considering Link’s good track record at extracting value from acquisitions, and its long-standing shareholding in Pexa, we expect the company knows what’s a value-accretive price. We also like the idea of Link acquiring Pexa, as we expect the electronic conveyancing business will develop a strong network-effect-based economic moat within the massive real estate market.

Link’s share price has been volatile in recent months, most notably in May 2018 due to the proposed changes to superannuation legislation included in the federal budget. These changes are likely to result in a decrease in the number of superannuation accounts administered by Link, but we already incorporated the likely financial impact into our model at the time of the announcement. The Royal Commission into the financial services sector also casts a shadow on the superannuation industry, but we don’t see an obvious negative for Link at this stage, and it’s possible that the company could benefit from increased regulation of superannuation funds. The acquisition of LAS reduces the relevance of the Australian Fund Administration division to the group, which will fall to 33% of group EBITDA in fiscal 2019 from 54% in fiscal 2017. We expect the division to generate low-single-digit annual revenue growth and mid-single-digit annual EBITDA growth over the next decade.

We expect the 7% share price rise that followed the result was largely due to good progress being made with the integration of LAS. There’s a long list of Australian companies that have attempted to expand overseas via large, and often debt-funded, acquisitions, only to subsequently incur massive impairments after realising what they’ve bought. Wesfarmers and Slater & Gordon spring to mind as two relatively recent examples. It’s therefore understandable that the market’s been somewhat sceptical of the LAS acquisition, particularly as it was bought from a distressed seller. However, it’s been nearly a year since Link acquired LAS, and things appear to be progressing even better than expected, which is likely to be increasingly recognised in the share price.