Xchanging (XCH) has been in the throes of a transformation since before its founder and chief executive, David Andrews, signed off with a major profit warning in 2011. There's further to go, but profits are on an improving trend and the business outsourcing firm has just enjoyed a better-than-expected third quarter. It's winning plenty of new business, profit margins are higher and, with net cash expected to approach £100m, the shares look increasingly undervalued.
- Better-than-expected third quarter
- New products gaining traction
- Profit margins improving
- Shares trade at a big discount to rivals
- Big contracts ending
- Competition risk
Each of the company's four divisions - insurance, which supplies Lloyd's of London, financial services, technology and procurement - has brought in extra work since June. Procurement has done particularly well. After losing £1.3m in the first half, largely down to a lower-margin contract renewed by BAE Systems, it has signed up Diageo and Severn Trent and extended a deal with L'Oreal. These help build critical mass in the US and the impact will soon be obvious.
A new software product designed for the insurance industry had a breakthrough in the States, too. Everest Re has just become the first US firm to buy Xchanging's new insurance software, Xuber. It's used by insurers, reinsurers and brokers to manage quotes, administration and claims. Xchanging has made it simple for over 130 customers to migrate from legacy products to the new - and high-margin - software. And there's interest in Netsett, an insurance settlement service trialled with insurer RSA.
Transforming Xchanging may have another two years to run, but a lot of the hard work has been done. It bosses have tagged the period until 2015 as "Going for Gold", and stripping out costs and inefficiencies is already rebuilding margins. Exiting larger contracts such as a UK HR deal with BAE Systems, and so-called enterprise partnerships - especially an alliance with Deutsche Bank - is shifting the emphasis (and risk) away from a few big customers to lots of smaller contracts, too.
XCHANGING (XCH) | ||||
|---|---|---|---|---|
| ORD PRICE: | 136p | MARKET VALUE: | £328m | |
| TOUCH: | 135-136p | 12-MONTH HIGH: | 151p | LOW: 115p |
| FORWARD DIVIDEND YIELD: | 2.1% | FORWARD PE RATIO: | 12 | |
| NET ASSET VALUE: | 78p | NET CASH: | £90m | |
| Year to 31 Dec | Turnover (£m)† | Pre-tax profit (£m) | Earnings per share (p) | Dividend per share (p) |
|---|---|---|---|---|
| 2011 | 529 | 39.1 | 8.0 | nil |
| 2012 | 528 | 46.3 | 10.4 | 1.0 |
| 2013* | 528 | 51.1 | 9.9 | 2.5 |
| 2014* | 467 | 51.4 | 10.1 | 2.6 |
| 2015* | 479 | 55.0 | 11.2 | 2.8 |
| % change | +3 | +7 | +11 | +8 |
Normal market size: 3,000 Matched bargain trading Beta: 0.8 *Liberum Capital estimates (underlying profits & EPS) | ||||
If, as analysts at broker Espirito Santo expect, costs trough next year at £14.5m, underlying operating margins should widen from 8.2 per cent in 2011 to 12 per cent, then keep going. And when the transformation is complete, the broker expects earnings to have grown between now and 2018 by over 20 per cent a year, almost twice the pace of rivals. Despite that, Xchanging's shares trade on a markedly lower rating than similar companies.
Given the ongoing restructuring, Espirito strips out the contribution of the Deutsche Bank and BAE contracts, as well as one with the London Metal Exchange, which ends next year, even though new contracts are likely to fill the gap. Taking Xchanging's £90m net cash into account, Xchanging trades on a ratio of enterprise value to operating profit of just 6.3 times; for peers it's more than 10. Using both the peer group multiple, and Espirito's 2014 forecast values Xchanging shares at 180p, 32 per cent above their current price.
Adopting the more traditional PE ratio only reinforces the argument. Strip out net cash, worth over 38p per share, and Xchanging trades on just 9.7 times earnings estimates for 2014. Compare that with fellow outsourcing firm Capita on over 17 times, IT services group Cap Gemini on 13 times and financial software rival Fidessa on a forward PE ratio of 23. What's more, analysts at Liberum Capital believe that spending its cash on acquisitions could swell Xchanging's EPS by 60 per cent.
