The recently-released results for Computershare (ASX:CPU) for the 12 months to 30 June 2022 (FY22) was slightly ahead of expectations. However, while market expectations for both strong margin income (from global rate rises) and weaker operational earnings had existed prior to the release of the FY22 result, the extent of the mix change caught the market by surprise.
The recent share price weakness reflects market concerns that: i) The earnings upgrade cycle is coming to an end as interest rate cuts from FY24-26 begin to be priced in to fixed income markets and that ii) The group faces earnings pressure should interest rate rises stall, given the current reliance on margin income for earnings growth.
We have previously recommended CPU successfully in The Dynamic Investor. So, we recently re-visited the fundamentals to assess whether there is scope for a sustainable recovery following the recent sell-off in the shares.
Computershare is the only integrated global provider of share registry administration services, with operations in most major markets. Registry maintenance provides a stable revenue stream (but with more volatile, yet higher-margin corporate actions business also a contributor). The Company manages customer cash balances, on which it generates an interest margin that is exposed to global interest rate movements.
Key Fundamental Drivers
Strong FY23 Guidance Reflects Further Growth in Margin Income from Higher Interest rates
The Company has provided guidance for management EPS (mEPS) in FY23 to be US90.0 cents per share (+55% on FY22). The FY23 mEPS guidance was above consensus estimates. Margin income is stronger than expected because bond yields have been rising faster than inflation. This has also allowed the balance sheet gearing to reduce earlier than expected.
Importantly, there is upside risk to margin income in FY23, as the yield conversion on the average headline cash rate is only about two-thirds. sCPU expect to increase the conversion rate to 90% by FY24.
Performance of Underlying Business Mixed
While margin income was the obvious standout feature of both the FY22 results and FY23 guidance, the FY22 result highlighted subdued revenue in a number of divisions. Excluding margin income and the CCT acquisition, revenue in 2H22 declined by 7%. Some of this weakness can reasonably be attributed to volatile capital market activity during the period, with prospect for little recovery in 1H23. Revenue headwinds continue to weigh on Mortgage Services (-10% in 2H22), Bankruptcies (-55%) and Corporate Actions (-23%).
The most material of these is the Mortgage Services division (which accounts for 22% of revenues excluding margin income). While the Company is working to shift the business model for the Mortgage Services division towards sub-servicing (lower margin and capital intensity), revenues seem unlikely to turn around quickly given a soft near-term outlook for originations and foreclosures.
The 2H22 period also saw some EBITDA weakness, predominantly in the Issuer Services and Employees Share Plans divisions. Excluding margin income, the Company is guiding to further pressure in FY23 (5% vs FY22 levels due to corporate action volumes anticipated to be lower and employee share plan transaction volumes to remain volatile). This suggests that EBIT excluding both margin income and CCT would be below the depressed levels seen in FY20, when markets were very weak.
Extension of Cost Savings Program Can Support Earnings
The Company has also extended its cost savings program to continue offsetting cost pressures. The Company continues to face elevated cost pressures with many of the Company’s operations based in US and UK,. These are seeing higher inflation pressures than in Australia. Proforma cost growth of ~5% is expected in FY23. It is likely that these cost pressures will spill over into FY24.
In particular, CPU continues to evaluate further opportunities for the cost savings program to extend to a ‘Stage 4’, with a new employee driven cost-out initiative also starting in US Mortgage Servicing. In addition, the cost savings program has been extended by two years to FY26 with an additional annual cost savings targeted relating to UK Mortgage Services and the operations transformation program.
Reduction in Gearing Occurring Quicker Than Expected
The balance sheet has recovered from the increase in gearing to 2.02x (on a net debt to EBITDA basis) as at 31 December 2021. This occurred as a result of the increase in debt to fund the CCT acquisition (which was acquired from Wells Fargo for $US750m).
Gearing fell to 1.64x as at 30 June 2022. This is below the target range of 1.75x – 2.25x. It was largely as a result of improved margin income, but also as a result of substantial free cashflow generated in FY22. In the absence of any further acquisitions, gearing is expected to decline further by the end of FY23 given that operating cashflow is typically strong and is likely to be supported by higher margin income. Asset sales also have the potential to reduce the gearing level even further.
The strong gearing position presents the Company with a degree of flexibility to target further Merger & Acquisition opportunities (in particular expansion in Governance Services and Corporate Trust) and/or capital returns to shareholders (most likely in the form of special dividends).
The de-rating in CPU shares following the release of full-year result appeared unjustified, as: i) There is balance sheet optionality (for M&A and/or capital returns), ii) The Company has growth options other than margin income from higher rates (in particular in the Employee Share Plans, Mortgage Servicing and CCT divisions and from an extended cost savings program); and iii) There is potential for Margin Income to be higher over the short term as the conversion rate of the average headline cash rate increases to 90%.
The shares have recovered from the sell-off and are currently trading on a 1-year forward P/E multiple of ~18.5x, which we still consider to be attractive in light of recent trading levels and an EPS growth profile of 24% over FY22-25 on a CAGR basis.
Computershare first peaked in April and then eased back. After recovering and making an intra-day all-time high in July, it then fell away quite quickly. CPU then bounced off the bottom of its recent trading range. It is now in the middle of the range. This means that a better entry point would be if it can pull back to the lower part of the range around $22.50 – $23 for a bit longer and demonstrate some support. Otherwise an upside break above $26 would be the other opportunity. A break under the $22.50 support level would be a negative sign and that could lead to a pullback towards $20. For the moment, it is best to observe price action for a few more days.
Michael Gable is managing director of Fairmont Equities.
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