We recently reviewed Link Administration (ASX:LNK) in order to gauge whether a re-rating in the shares back to pre-COVID-19 highs is on the cards. In doing so, the key factors we considered were: i) The challenges and opportunities within LNK’s divisions, ii) The potential for cost savings to mitigate the declining revenue profile and iii) The implications from an overly-geared balance sheet.
LNK is a provider of technology-enabled administration, securities registration and asset services, for listed and unlisted corporate entities as well as pension and superannuation funds globally. The Company has five operating divisions. The main contributors to both revenue and earnings are the Retirement & Super Solutions (RSS) and Corporate Markets divisions. In addition, LNK has a 44.2% ownership interest in Property Exchange Australia (PEXA), an electronic property settlement company.
Challenges and Opportunities Within the RSS Division
Redemptions relating to Early Release Of Superannuation (ERS) are expected to result in meaningful account losses, which would be negative for the Company. This is especially from the viewpoint that LNK’s average revenue per member has been declining prior to the COVID-19 outbreak. Since June 2016, the average revenue per member has declined from $59 to ~$53 as of June 2019. This performance is disappointing from the viewpoint that levels of both recurring revenue and cash flow generation are high for the division.
Nonetheless, we consider that there is potential earnings upside for the division from two sources:
i. Upcoming super fund administration tenders. LNK has a strong chance of success with regards to any tenders that it bids for. In particular, competing providers have shown limited capacity to service larger “mega” funds. Accordingly, LNK is considered as the administration provider of choice for the larger “mega” funds. The Company also has the best track record in administering larger funds and offers the lowest risk.
ii. Potential for industry consolidation. Regulatory changes in recent years, coupled with the potential for significant superannuation withdrawals and the incumbent trend of customers moving to the larger industry funds is likely to increase pressure on relatively small superannuation funds to merge with larger funds.
Cost Savings Program Behind Schedule
In light of revenue pressure over the short term, the Company has been proactively managing costs and resources. Prior to withdrawing guidance for FY20, the Company was targeting $50m of annualised savings by FY22. However, the progress on achieving cost savings has been slower than expected. At the time of the 1H20 results release in February, the cost savings program (‘Global Transformation’) was running 3- 4 months behind schedule. This has slowed further as a result of COVID-19.
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The other challenge in achieving the targeted cost savings is that this is likely to be limited by increased superannuation administration member activity. In particular, increased member activity from switching and project-related activity including the ERS initiative. Over the long term, there is still potential for further cost savings. These opportunities are from a rationalisation of premises, greater use of work-from-home, and reduced travel expenses.
Gearing Above Target Levels – Is an Equity Raising Likely?
Gearing (on a net debt to EBITDA basis) is currently 3.0x and above the target range of 1.5x – 2.5x. In light of the high level of gearing, one market concern is the possibility of an equity raising to reduce debt levels. However, it appears that an equity raising would be a low priority for management. This is given that the Company has stated that it “will remain comfortably within its debt covenants”. Further, refinancing risk is low (the next refinancing is due in January 2022) and interest costs appear favourably low (interest cover is ~15x on an operating EBITDA basis).
Instead of seeking an equity raising, the Company appears to be looking to reduce gearing levels via a rebound in earnings, strong operating cashflow, conserving cash and freeing up capital by leveraging PEXA (which is currently ungeared). In addition, there appears to be a risk to short-term dividends. Further, while the 1H20 dividend of 6.5c was fully franked, LNK expect that future dividend payments will have a reduced level of franking. This is reflecting the increased weighting of non-Australian based earnings.
Despite the shares seemingly entering ‘value’ territory, we struggle to find any real reason to be invested in LNK, aside from a capital return from PEXA potentially driving additional interest in the stock over the coming 12-18 months.
Excluding the benefits from the cost savings program and adjusting for a range of acquisitions and divestments, the underlying earnings growth outlook highlights negative growth in the existing businesses, with only modest growth (around mid-single digits) expected in FY22.
In terms of the potential earnings upside for the RSS division from winning tenders and industry consolidation, we note that these are more longer-term benefits given the potentially elongated timeframe (around completion of fund mergers/review of existing administration providers and tender process) as well as the fact that the Company will have to incur substantial upfront costs in order to migrate and service additional members in the event that it secures a new tender.
Further, the benefit to group earnings in coming years from such opportunities is significantly less than what is was in previous years, given that the RSS division now accounts for ~30% of overall EBIT, compared to >50% in FY17.
LNK shares appear to have found good support near $4 and are starting to break free of the consolidation that has been under way since mid-June. For the short term at least, we expect the share price to head higher. There will naturally be some resistance near the June peak around $4.80. If it can push beyond that, then it will likely encounter strong resistance again near $5.30.
Michael Gable is managing director of Fairmont Equities.
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