IT Services

About the author:

Nick Harris
Author name:
By Nick Harris
Job title:
Senior Analyst
Date posted:
09 December 2013, 9:37 AM
Sectors Covered:
Telecommunications, Technology and Financial Services

With AGM season now over IT services sector expectations have been reduced and it looks like we've hit rock bottom. 

1H14 will mostly be down year-on-year which doesn't come as a surprise. More importantly, for the first time in years, we have seen positive outlook commentary from management. This is consistent with our view that 1H14 is the bottom of the cycle and that FY15 should be a good year for IT services.

We upgrade our sector view to overweight and expect the larger, more liquid names of SMS Management (SMX) and UXC Group (UCX) are likely to run first with others to follow.

Here are our four key picks in the IT Services sector to add to portfolios:

SMS Management (SMX)

SMX is one of the largest most liquid ASX listed IT companies and is typically considered by the investment community to be led by an experienced and credible management team.

They have a largely fixed cost base and therefore very strong operational leverage. Consequently an increase in billable hours (utilisation) increases revenue and this incremental revenue falls straight through to the bottom line.

We estimate every 1% increase in utilisation increases NPAT by A$1.5-2.0m. If SMX is able to increase its utilisation from 80% to its 90% target, NPAT would increase by A$17m (or double).

We also note that the CEO, Tom Stianos, acquired 100,000 SMX shares on market. For context this more than a year of his after tax salary and, in our view, a very positive sign. He now owns 2.8% of the company so has skin firmly in the game.

UXC Group (UXC)

UXC has attractive characteristics of relatively defensive earnings (70% of its business is ERP or long lead time work) with the balance consulting work.

After recent share price weakness UXC now looks attractively priced to us and has very healthy EPS growth in the coming years despite not being as strongly leveraged to staff utilisation.

UXC's acquisition of Keystone (a ServiceNow reseller) also adds what we consider to be an attractive growth leg to the business and should accelerate EPS growth which make UXC an attractive EPS growth story.

Oakton Limited (OKN)

Is cycling through significant structural changes (the balance of on-shore and off-shoring of staff). We think OKN is nearing the end of what has been a ~5 year process which means it should return to earning growth (as they have recently guided).

OKN also has strong leverage to Federal government spend which is ~20-22% of revenue. While we acknowledge that governments are looking to cut costs, in our view, the most likely way to do this is through outsourcing to industry experts who can produce services at a better price by being more efficient.

Data #3 (DTL)

DTL has, in our view, one of the highest quality management teams in the sector. This can be seen through their best in sector Return on Equity.

Importantly for equity investors DTL is cheap in our view, offering an impressive 16% free cash flow yield and supported by a strong net cash position.

We also believe DTL has strong leverage to an IT replacement cycle whether it's on or off premise (legacy computing versus cloud computing). Customers will look to technology experts such as DTL to help them select the best alternative. In many cases chose a combination of on and off premise which means DTL is connected to the replacement cycle whether it be capex or opex.

More information

If you are interested in any of these stocks, please contact your nearest Morgans office.

Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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