Equity Research Sample 3 September 2012

Iress Ltd
Iress Ltd (IRE:ASX) provides system solutions to the financial sector with a focus on financial markets and wealth management. It operates in Australia, New Zealand, Canada and South Africa. Performance in line with market conditions and expectations Release of half yearly statements to June 2012 show that revenues are up 3% on 1H11 to $103.2m, but down on 2H11 by 0.8%. Reported profits have decreased to $19.7m, a 9.2% drop on pcp. Factoring out strategic charges for the period, underlying profit is at $27.8m. Diverging segment opportunities Stable revenue through recurring subscriptions to information services is the backbone of the company, but is lacking growth in the current market. The wealth management segment, on the other hand, should see growth in both revenue and profit. Outlook Management anticipates <10% decline in profit for FY2012, and capex is estimated to be marginal. IREs dominant market position in financial market systems solutions and low growth prospects for the market leave it in a precarious position. Revenues are expected to see little growth from the financial markets segment but wealth management will likely pick up some of the slack as it is less exposed to market volatility. Efforts to expand into overseas markets and into the wealth management space are necessary, but bring their own risks. Valuation & Dividends The target price, based on a blended valuation of a discounted dividend model (DDM) and EV/EBITDA multiple, is at $7.99. This is a premium of 7.2% to the current share price. Therefore, a BUY recommendation is placed on the stock. IRE resumed paying a dividend in 2011 and announced an interim dividend of 13.5 per share (90% franked). This represents a payout ratio of 87.5%.
A$/share

IRE Share Price

8 7.5 7 6.5 6 May-12

Jul-12

ASX:IRE RIC: IRE.AX BBG: IRE.AU Information Technology

Company Data Price (A$) 52-week range (A$) Market capitalisation (A$m) Shares outstanding (m)

7.45 5.93-8.22 956.80 128.41

12 month target price/share: $7.99

Kosta Sinelnikov kosta.sinelnikov@gmail.com 0422 168 720

Note: Please read the disclosure statement on page 7 of this report. 1

Financial Summary
2010 Profit & Loss Sales revenue EBITDA Depr & amort EBIT Net interest Pre-tax profit Tax expense Net profit Balance Sheet Cash & equivalents Receivables Investments Inventories Other current assets Total current assets Property, plant & equipment Intangibles Other non-current assets Total non-current assets Total assets Payables Borrowings Other current liabilities Total current liabilities Loans & borrowings Provisions Other non-current liabilities Total non-current liabilities Total liabilities Net assets Equity Reserves Retained earnings Minority interests Preferred capital Total shareholder equity Statement of Cahs Flows EBIT Net interest Depr & amort Tax paid Operating cash flow Payment for plant & equipment Acquisitions Asset sales Investing cash flow Dividends paid Equity raised Net borrowings Financing cash flow 2011 2012E 2013E

Equity Research Sample 3 September 2012

2014E

180 79 -15 64 3 67 -17 50

205 81 -23 58 2 60 -19 41

200 75 -24 51 2 53 -16 37

210 79 -30 49 49 -15 34

225 87 -32 55 55 -17 39

99 11 3 113 4 33 22 59 172 13 14 27 6 1 7 34 138 76 28 34 138

49 16 2 67 7 45 50 102 169 16 14 30 10 1 11 41 128 76 29 23 128

53 18 2 73 10 50 52 112 185 18 15 33 15 1 16 49 136 76 33 27 136

50 20 2 72 15 57 55 127 199 21 15 36 18 1 19 55 144 76 32 36 144

45 20 2 67 20 70 57 147 214 25 15 40 23 3 26 66 148 76 35 37 148

64 3 -15 -13 76 -4 -2 -6 -44 -44

58 2 -23 -31 55 -7 -3 -50 -52 -52

51 2 -24 -19 51 -8 -5 -13 -53 -53

49 -30 -12 59 -5 -7 -12 -53 -53

55 -32 -17 68 -5 -3 -8 -56 -56

Source: company data, proprietary estimates

Equity Research Sample 3 September 2012

Market conditions weigh on results

Half yearly statements to June 2012 show that revenues are up 3% on 1H11 to $103.2m, but down on 2H11 by 0.8%. Reported profits have decreased by to $19.7m, a 9.2% drop on pcp. Factoring out strategic charges for the period, underlying profit is at $27.8m. The current slump in financial markets is largely affecting service providers as customers seek to reduce costs and headcount. Financial market volatility on macro news is scaring investors away. Equity trades, options and CFDs are all down compared to a year ago (see monthly trading volumes below).

ASX Monthly Volumes

30,000,000 25,000,000 No. of Trades 20,000,000 Equity trades 15,000,000 10,000,000 5,000,000 0 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Options CFD contracts

The past year has seen a number of brokers merging or being swallowed up by competitors (e.g. Intersuisse and Austock, BBY and Stonebridge, Bell Potter and Southern Cross). The newly created entities will be seeking out synergies and cost savings to remain competitive in a tough market environment. This is likely to result in shrinking demand for Iresss product offering. Earnings per share dropped to 15.43 cps from 17.22 for 1H11, a fall of 10.4%.

Diverging segment opportunities

Stable revenue through recurring subscriptions to information services is the backbone of the company. This area isnt expected to show any growth in the next 12 months unless markets sizably improve. The wealth management segment, on the other hand, should see growth of around X% per annum in revenue, according to company guidance. This is logical as it is less exposed to financial market conditions and has a vast superannuation industry to tap into. Financial markets revenue rose only modestly (1%) for the half year, while wealth management revenues were up 8.7%. A push is being made into other geographical segments as well in order to cementing future growth opportunities. A number of acquisitions have been made in South Africa, Asia and the UK. The high dollar does remain a worry as it would impact on earnings derived from overseas. If it retreats back down to the 0.80 USD level, then the acquisitions could prove to be well-timed as relatively cheap growth and diversification moves. Below is a breakdown of recurring subscription revenue by different segments.

Equity Research Sample 3 September 2012

Source: Company data

Cost controls necessary for sustainable profitability

In light of the current market and expected slow growth, management needs to address P&L issues and implement tighter cost controls. The biggest expense is employee related, which has increased faster than revenue (see table below).

Revenue growth vs Employee expense growth

Revenue growth (%) Employee related expense growth (%) 24.4% 21.9% 21.7% 14.0% 9.4% 6.0% 3.8% 4.8%

2008

2009

2010

2011

The increase is largely a result of growth outside of Australia through acquisitions. A cost blowout in non-Australian operations could be doubly painful for margins if the Aussie dollar was to retreat below current levels with the major currencies.

Equity Research Sample 3 September 2012

Dominant market position

IREs dominant market position in financial market systems solutions and low growth prospects for the market leave it in a precarious position. Deep market penetration means that rival services have more potential for high growth. It is helpful to remember Porters Five Forces model here to see whether market position, and hence sizable profits, are sustainable. The threat of new entrants is low as the costs of switching to another service could be high. Competition within software of the kind provided by IRE in Australia is low as it is the dominant player, with over 90% market share. The threat of new entrants is rising, as UK-based Fidessa Group is making a foray in the Australian market. Any headway made by Fidessa could spell more new entrants and higher competition, but this will only become apparent in 2013-14.

and a strong balance sheet

A net cash position allows the company to look for further acquisitions and continue returning capital to shareholders through dividends. Zero debt on the balance sheet also gives room for the company to finance any large (>$50m) acquisitions to further diversify its services offering. The current ratio is at 2.4 thanks to the large cash and cash equivalent assets on hand. Cash flows from operations, up by 52.2% on pcp, will likely be returned to investors through stable dividends.

Outlook
Management anticipates <10% decline in profit for FY2012, and capital expenditure is estimated to be marginal. Revenues are expected to see little growth from the financial markets segment but wealth management will likely pick up some of the slack as it is less exposed to market volatility. Efforts to expand into overseas markets and into the wealth management space are necessary, but bring their own risks. Trading for the rest of 2012 will suffer due to continued poor conditions and difficulties in the client base. Client cost reductions, downsizing and consolidations will be fundamental in driving revenues lower, but this should be tempered by reasonable conditions in other segments.

Valuation
The target price is a blended valuation of a discounted dividend model (DDM) and EV/EBITDA multiple. IRE resumed paying a dividend in 2011 and announced an interim dividend of 13.5 per share (90% franked). Due to the sensitivity of a DDM and the difficulty in forecasting future dividend policy, an EV/EBITDA multiple is also used. The DDM is a two-stage model and values Iress at $7.39/share. The first stage is characterised by zero growth in dividends for 3 years, with the second stage assuming growth of 5% in perpetuity. Cost of equity is estimated at 11.4% (risk-free rate 5.0%, market risk premium 8.0%, beta 0.8). For the other part of the blended valuation, a target EV/EBITDA multiple of 13.5 is used. The implied value per share for IRE within the multiple model is $8.58. On a comparative basis to similar companies, IRE is undervalued. Its current EV/EBITDA ratio of 11.9 is lower than that of ASX-listed Computershare, US-listed Factset and UK-listed firm and potential new entrant to the Australian market, Fidessa (see chart on next page). Given IREs dominant market position but also the current state of financial markets, a middle-of-the-pack multiple is used.

Equity Research Sample 3 September 2012

EV/EBITDA
Iress

Computershare

Factset (US)

Fidessa (UK)

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

The blended valuation (50% DDM, 50% EV/EBITDA) gives a 12 month price target of $7.99 per share.

Risks to valuation
Downside risks to the valuation include financial market risks, regulatory changes, further consolidation within target markets, new entrants and a stronger AUD.

Equity Research Sample 3 September 2012 Disclosure This report does not constitute financial advice. The material contained herein has no regard to the specific investment objectives, financial situation, or particular needs of any reader. Information published is solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. All data, figures and statistics are based on information obtained from sources believed to be reliable, but are not guaranteed as being accurate. Readers should not regard it as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without notice and the author is not under any obligation to update or keep current the information contained herein. The author accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this report.

Copyright Kosta Sinelnikov 2012 7