Weak conditions in the UK caused financial technology provider GBST to hit the downgrade button. Scrambling to adjust forecasts, brokers still consider the long-term outlook is secure.

-Revenue shortfall expected to be temporary and work pipeline solid
-Wealth management in the UK positive in the longer term
-Yet, concerns linger about the implied decline in the second half
 

By Eva Brocklehurst

Another weaker-than-expected outlook for FY17 has been offered, this time by financial technology provider GBST ((GBT)). The downgrade is attributed to four project deferrals in the UK, where weak operating conditions prevail, and a cancellation. The company has indicated it will not adjust its cost base in response, as it expects the revenue shortfall to be temporary, and the pipeline of work remains solid.

Given the company's inherent fixed cost leverage, compounded by its current elevated expenditure on R&D, the lack of services work has had a material impact on second-half profitability. Despite this, Deutsche Bank retains a Buy rating on valuation and expects momentum will improve materially in FY18. The stock is at five-year lows, despite solid revenue and client growth.

The company expects FY17 operating earnings (EBITDA) of $12m, materially below broker forecasts, with consensus previously around $19m. A minor positive, Deutsche Bank notes, is that the international capital markets division is expected to report an EBITDA profit in the first half, and this is a division that has been highly challenged over the past seven years.

Deutsche Bank makes material downgrades to FY18 expectations to reflect the trading update but still expects reasonable growth, driven by an improvement in services revenue. The broker remains attracted to the strong cash generating and capital-light business model.

Excessively Weak Guidance In Context of CoFunds Acquisition

RBC Capital Markets is cautious about the outlook given the company suggested the second half looks worse than the first half. The broker believes the guidance is particularly weak in the context of Aegon acquiring CoFunds. This was a significant deal for the company, which closed on January 3 after much delay.

The broker believes this explains a lack of work in the first half but significant work would have been expected some time in the second half. Guidance indicates this is not the case, as the segment will make a loss at the EBITDA level after R&D. RBC Capital Markets, not one of the eight stockbrokers monitored daily on the FNArena database, has downgraded to Underperform with a $3.00 target.

CLSA, also not one of the eight, downgrades to Outperform from Buy* with a $3.20 target. The broker notes the week guidance for the second half highlights a lack of leverage with clients and a reliance on lumpy services revenue, amplified by an uncertain macro environment in the UK.

The broker queries whether this is the first of more UK-related Brexit downgrades. Nevertheless, CLSA remains optimistic about GBST's long-term prospects and expects FY18/19 earnings to improve after completion of the Composer upgrade and the start of the CoFunds migration.

Problems Temporary?

Morgans also considers the problems temporary, driven entirely by unforeseen contract deferrals which hit at the same time as the company's peak IT development expenditure occurred, with the upgrading of Composer and the new Catalyst retail advisor product. In the short term, the broker notes there is no solution to the IT development cost issue as backbone system upgrades cannot be deferred.

IT costs are expected to remain high until the second half of FY18. The broker expects wealth management customer services revenue will build slowly, as customers can only defer system maintenance for so long before they hurt their own performance. The company is building a powerful global franchise as a supplier of core wealth management platforms and Morgans expects substantial long-term earnings growth. The broker retains an Add rating.

Earnings growth in Australian capital markets over the next five years looks challenging to UBS and structural headwinds remain a feature of the broker's base case for the segment. While conditions are subdued and additional investment and currency volatility will weigh on divisional earnings, the broker believes the longer term picture for UK wealth management is positive. The division continues to benefit from regulatory reforms which are driving a lift in advisor/D2C platforms.

Still, UBS is concerned about the extent of the implied second-half earnings decline in the UK. Continued weakness in the British pound is likely to have an impact on the company via offshore earnings translated back into Australian dollars and the potential for further project deferrals. UBS downgrades to Neutral from Buy, given the headwinds and uncertainty.

FNArena's database shows two Buy ratings and one Hold (UBS). The consensus target is $3.85, suggesting 23.9% upside to the last share price. This compares with $4.69 ahead of the update. Targets range from $3.40 (UBS) to $4.40 (Deutsche Bank).

* CLSA has a five level ratings system in which Buy is the top rating and Outperform a step below.
 

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Brokers slashed forecasts as software service provider, Aconex ((ACX)) substantially downgraded revenue expectations for FY17, raising questions regarding the reliability of its growth outlook.

-Near-term outlook curbed but brokers retain ratings given the potential
-Concerns over management's depth of engagement with clients
-Existing business growth seen slowing to around 10%

By Eva Brocklehurst

Construction management software service provider, Aconex ((ACX)), has delivered a blow to investor hopes, substantially downgrading revenue expectations for FY17. The downgrade raises questions regarding the company's growth profile, predictability and momentum in the US and UK markets. Brokers slash price targets.

The company has cut its FY17 revenue forecast to $160-165m and its operational earnings (EBITDA) forecast to $15-18m. These estimates are down -8% and -30% respectively at the mid points compared with prior guidance. A slower conversion of new clients in the US and UK, amid the political uncertainty, has been cited as the main cause of the downgrade.

Impact To Linger

Morgan Stanley expects the impact to linger but retains its Overweight rating given the earnings power inherent in the business. Still, the issues are whether this is a one-off, whether the 20% long-term revenue growth rate is achievable and whether the company is still truly a global story.

Morgan Stanley opts for lower growth in FY17, but does not believe the company has downshifted from a 20% growth profile for the longer term. The question for Morgan Stanley is: how can a business with 72% of revenue booked in from July 1 miss expectations twice (first time at AGM)? The broker understands the cumulative nature of any miss in earnings forecasts but suspects volatility in user-based agreements has increased.

The pressure on US and UK growth is not a competitive issue, in the broker's opinion, and the company's service remains a clear product of choice for the world's largest projects. The broker takes heed of two clues to a possible rebound in sales: weighted contract length and bookings growth. The company has indicated a higher proportion of long-term contracts, which should boost contract length and, if new work is longer dated, it should imply the slowdown in bookings would be less pronounced.

Deutsche Bank is concerned by the apparent lack of visibility by management in downgrading guidance that was less than three months old. This adds to existing concerns surrounding poor operating leverage and inconsistent cash flow. Although the reasons given for the weakness are plausible, the sudden nature of the shortfall raises questions for the broker around the depth of engagement the company has with its clients.

While the company's software is world-class, as is evidenced by the strong customer list and consistent channel feedback, Deutsche Bank believes the path to achieving a globally dominant product with strong recurring earnings remains uncertain. Moreover, confidence in management has been severely dented. Deutsche Bank retains a Hold rating, cutting its target to $4.50 from $6.80.

Conject Below Expectations

Macquarie also sticks with a Neutral rating. The broker notes the first half includes a full contribution from the Conject acquisition and commentary suggests the performance of this business has been below initial expectations, with revenue affected by changes to recognition policy and integration disruptions. Assuming flat revenues from Conject implies, the broker expects a slowdown in the existing business growth to around 10%.

The stock has fallen a long way but the broker continues to believe in the medium-term growth prospects, although concedes there is little valuation support even at current levels. Delivery of medium-term revenue growth targets and the significant margin expansion that is typical of software-as-a-service will be need to be demonstrated.

Near-term Catalyst Difficult To Find

A near-term re-rating is unlikely and a catalyst difficult to identify, Credit Suisse asserts, given the market is likely to be sceptical about the value of new enterprise agreements and management credibility has been reduced. The broker retains its Outperform rating despite the decline of 45% in the share price, continuing to envisage potential upside in the long-term at current levels. This is because the company has a first-mover advantage and a large addressable market.

The main change since the AGM in October, UBS observes, is the lower-than-expected performance in the Americas. The broker notes, at the time of the FY16 result, the 72% of FY17 revenue is contracted implied a further $49.3m of new revenue required to meet the mid point of prior guidance. Hence, the new guidance implies $35.8m is now required on a full year basis, which equates to a -27% decline in new revenue expectations.

Given the apparent slowdown in revenue expectations, UBS has reduced confidence in the FY18-19 guidance of 20-25% per annum growth and the EBITDA margin of 17-22%. The stock is not expected to outperform with such uncertainty. UBS retains a Hold rating and downgrades its target to $3.40 from $8.00.

Citi also downgrades its target sharply, to $4.95 from $8.69, but retains its Buy rating. The broker considers the market reaction excessive and there is a low probability of a further material downgrade. First half guidance implies robust second half expectations, which may prove challenging, and medium-term growth could be affected by shifting political landscapes and slower customer uptake.

Citi does point out that the company's visibility on the full year ordinarily increases at the first half result. For example in FY15 the company had 78% of FY16 contracted revenues, which increased to 97% at the first half result. Citi expects a similar outcome for FY17, although acknowledges the company's Connected Cost offer is not contracted, so visibility this year may consequently be slightly lower.

There are three Buy ratings and three Hold on FNArena's database. The consensus target is $4.05, suggesting 32.4% upside to the last share price. This compares with $7.72 ahead of the downgrade. Targets range from $3.40 to $4.95.
 

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Data centre operator NextDC has been sold off sharply but brokers believe the company's position has been greatly misunderstood.

-Investors nervous about new wholesale supply coming to market
-Yet, content companies remain dependent on operators to aggregate services
-Has the share price fall made NextDC an acquisition target?
 

By Eva Brocklehurst

Data centre operator NextDC ((NXT)) has been sold off sharply in recent months and the stock is now at a compelling entry point, brokers believe. They assert that the company's position has been greatly misunderstood.

Morgans attributes a large portion of the slump in the share price to rising market interest rates, which lowers valuation. A second part to the problem lies with confusion over market dynamics. While the former is justified, the latter confusion is misplaced and creates a buying opportunity.

The broker points out that the company does not compete with the likes of Microsoft Azure, Amazon Web Services, Google Compute Engine or Alibaba Cloud. Rather, many of these names are customers and their success will continue contributing to NextDC's evolution. Microsoft, for example, generates around 90% of its total revenue from distributors, which add value by bundling services on top of the Microsoft offering.

The broker suspects investors are nervous about new wholesale supply coming to the market, yet international operators have always used a combination of co-location and wholesale, or owned, facilities. Despite content companies having their own facilities overseas, and in some cases in Australia, they remain dependent on operators to aggregate their services and put them close to the channel or end user.

At current levels Morgans believes investors are paying for the success in the build up of the company's base data centres and paying nothing for the new facilities.The broker looks back at 2014 and notes this was a good time to buy the stock, as investors panicked on hearing about pricing pressure from B grade facilities and it was later proved that the company's value proposition was unique.

The main risk to the share price relates to the rate of sales and whether this levels off, slows or accelerates, in the broker's opinion. Faster customer demand would lead to an appreciation of the share price because of a higher fill rate. Conversely, slower demand may disappoint relative to market expectations.

The business is very capital intensive, so the ability to access funding on an ongoing basis and utilise debt effectively is the main operational risk. The broker believes the company has the balance sheet capacity to handle substantially more debt and self-fund expansion through operating cash flow from the base buildings. Morgans upgrades to Add.

Deutsche Bank also observes NextDC has underperformed recently and this is driven by a sharp increase in risk-free interest rates which reflect the stock's perceived quasi-utility characteristics. Competition concerns, a lack of catalysts and significant recent equity issuance have exacerbated the outlook.

The broker expects competitive concerns are largely overdone and the sensitivity to increased rates is reduced after the recent de-rating of the stock. Deutsche Bank finds the valuation compelling, with NextDC trading at a 28% discount to its peers, on an ungeared asset basis.

This broker also contends new entrants to the market target customers with different data storage requirements such as backup data and they also possess higher risk profiles. Hence, the risk factor for the company is expected to be repriced more favourably over time.

The company has raised a significant amount of equity capital in the past year, which has increased exposure and allocation for existing equity holders. Deutsche Bank observes this produces fewer incremental, motivated purchasers of the stock to provide share price support. Coinciding with risk-free rates and competitive concerns, this contributes to the recent weak performance.

Deutsche Bank notes a significant amount of new capacity in absolute terms and the company does not generally announce anchor tenants, so the potential for positive catalysts for the new data centres remain somewhat limited over the next 12 months.

Citi follows a similar theme. The broker does not believe the proposed entry of AirTrunk into the Australian data centre market will have a material impact on NextDC. Demand is expected to absorb the potential expansion, and new supply is expected to be added incrementally and rationally.

The broker explains the current situation for NextDC as a converging of models. When the company listed it was providing secure facilities where retail customers could locate hardware/software infrastructure. Over time strong growth in cloud providers has meant the focus shifted towards a more balanced exposure between retail and wholesale customers. Around 60% of the company's FY14 revenue came from white space customers and Citi expects the wholesale/retail split to be around 50% currently.

One question the broker does ask is whether, given the recent share price fall, the stock is an acquisition target. Citi outlines two potential reasons to acquire NextDC and notes the global data centre industry has been consolidating. The first reason is global players that may be looking to expand their Australian footprint and the second is wholesale players looking to expand a retail offering.

There are six Buy ratings on FNArena's database. The consensus target of $4.49 suggests 48.3% upside to the last share price. Targets range from $4.01 (Morgans) to $4.90 (Macquarie).
 

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The AGM update from telco Vocus Communications has weighed heavily on estimates and several brokers urge caution be applied to the stock.

-Heightened competition compounds earnings issues specific to Vocus
-Is the stock a target for private equity?
-UBS questions long-term sustainability of NBN economics
 

By Eva Brocklehurst

Telecommunications provider Vocus Communications ((VOC)) has been marked down in recent months as the sector has de-rated and the company's AGM update has now weighed heavily on estimates. Several brokers urge caution be applied to the stock.

The company has provided specific guidance for FY17 for the first time, which includes earnings of $430-450m, underlying cash profit of $205-210m and capital expenditure of $186m. The guidance is generally below expectations and attributed to weakness in the recent acquisition of Nextgen, because of slowing sales following the announcement of the transaction.

CLSA questions the quality of the earnings base, with 50% of underlying net profit made up of cost items that are recognised below the line. The guidance is also considered low quality. The broker notes capital expenditure may increase going forward if the company decides to go ahead with the new undersea cable. CLSA is also concerned about the changes to ARPU (average revenue per unit) disclosure, delivered, in its view, without a supporting explanation.

The broker also estimates that around 20% of Nextgen revenue is not contracted. Churn also remains a risk, as disgruntled ADSL customers, affected by outages which appear to be specifically related to Vocus-based services, may choose to go elsewhere. CLSA, not one of the eight brokers monitored daily on the FNArena database, moves to Underperform from Sell. Target is $4.55.

Morgan Stanley believes the stock offers the highest risk/return characteristics in the sector, as a heightened competition is compounded by some specifics relating to Vocus. The broker remains a believer in the revenue growth opportunities that are ahead to the company as a vertically integrated telecommunications business in the NBN (National Broadband Network) infrastructure.

Yet there are changes stemming from the AGM which require the broker to revisit its fundamental view. Increased competition and consumer/retail broadband are negative for margins, returns and the future growth trajectory, in the broker's opinion. The acquisition of Nextgen has also meant several key management and board departures. This adds volatility to equity holder returns, Morgan Stanley asserts.

The broker downgrades earnings expectations sharply, reducing its target to $5.00 from $9.55 and downgrading to Equal-weight from Overweight. The broker believes investors should adjust their valuation framework to apply either lower target multiples and/or a higher weighted average cost of capital for discounted cash flow-based valuations.

Shaw and Partners believes management is not on top of the business. The broker takes the company's suggestion that earnings will be skewed to the second half to mean that there is some risk to the numbers, and now assumes the low end of guidance.

This broker also finds it hard to reconcile the monthly recurring revenue for the corporate business in the first quarter compared with the preceding quarter. Sales growth is suspected to have slowed and some issues with staffing and culture are evident. Shaw and Partners, not one of the eight monitored daily on the database, has a Hold rating and $4.65 target.

So, what is there to like? Citi already assumed market expectations were too high and the sell-off in the stock has pulled it further into Buy territory. The broker acknowledges confusion regarding where growth is being achieved and the gap between reported and core earnings.

Credit Suisse believes the stocks price/earnings multiple of 12.7x for FY17 forecasts does not reflect the growth opportunity in the core corporate business. The main risks to operations relates to voice exposure in the former M2 business. The broker envisages potential for the company to become a target of private equity if the share price remains at depressed levels for an extended period and retains a Outperform rating.

While the Nextgen weakness was disappointing, in the company's defence the broker notes it has been going through a period of extended transition in ownership and the performance is expected to improve now the Vocus sales force can start selling the Nextgen network.

While consumer broadband subscriber growth had slipped, it was impacted by a Telstra ((TLS)) wholesale provisioning issue, which the company says has now been resolved. Credit Suisse also defends the company's accounting, noting disclosure has improved, with reported consumer broadband ARPU revised lower because of an error with the prior calculation.

Deutsche Bank retains a Buy rating on valuation grounds. The broker acknowledges that while the issues facing Vocus in isolation are not that significant, combined they suggest a level of caution should prevail regarding the operational performance.

The broker reduces revenue forecasts for the Australian consumer business, Nextgen, and the corporate and wholesale businesses. Additional costs are now forecast for migrating existing customers to the NBN. Capital expenditure assumptions are also increased FY17. The net impact is a reduction to Deutsche Bank's earnings per share estimates of 12-35%.

UBS, disappointed with the Nextgen performance, and the loss of a $17m fibre build contract, questions the long-term sustainability of NBN economics. The broker welcomes the additional disclosures by Vocus but envisages risks to both broadband profitability per subscriber during the NBN transition and gross costs.

The broker also notes declines in legacy voice could also be accelerating, as voice revenues are set to fall by another $30m in FY17. The broker considers the stock cheap when taking account of FY17 price/earnings and enterprise value/EBITDA metrics. Yet these ignore capital expenditure growth, maintenance costs and other cash impacts. However, longer term, the stock's free cash flow yield is more appealing although this also assumes the capital expenditure profile eventually normalises.

In this company's defence, UBS notes heightened NBN concerns may have meant the sector has lost its lustre but as Vocus is largely a re-seller it should not suffer the same degree of adverse impacts as other platforms, although there remains some risk to customer economics post NBN. Additionally, the second order impacts of the NBN are a concern for the broker, such as increased competition and accelerated declines in legacy products.

It is not entirely clear why some of the acquired business of Nextgen appears to be struggling while internally the company's sales continue to improve, but Morgans suggests a bottleneck in customer provisioning and, hence, the organic growth profile has slowed.

The company has taken a number of steps to address its sales problems and remains confident it can re-build momentum. Nevertheless, the broker believes it will take time for the earnings trajectory to stabilise and investor confidence to return. The business is complex and the broker suspects the investment market struggles with all the moving parts.

FNArena's database shows four Buy ratings and two Hold. The consensus target is $6.08, suggesting 39.2% upside to the last share price. This compares with $8.08 ahead of the AGM. Targets range from $4.46 (Morgans) to $6.85 (Citi).
 

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Accounting software business MYOB is shaping up as a key player in the cloud but brokers are acutely aware that competition in that area is heating up.

-Accountants a key distribution channel and platform for growth in SME applications
-Potential for downward pressure on margins, as SaaS typically generates lower margins
-First mover advantage in the cloud ceded to Xero amid competition from new entrants
 

By Eva Brocklehurst

Accounting software business MYOB ((MYO)) is shaping up as a strong player in the cloud, with clear strategies to deliver long-term growth from the transition to online connected services. Cloud adoption is entering a new phase which should benefit the company and play directly to MYOB's key strengths, Ord Minnett believes.

The broker envisages the company will, in the medium term, maintain its market leadership position in accounting software, while delivering a high proportion of recurring revenue. The company's 2016 guidance includes revenue in line with its historical trends, an earnings margin of 45-50% and an R&D/sales ratio at the upper end of the 13-16% range.

Ord Minnett likes the company's approach to practice management, believing this will be the next battleground for accounting software vendors. The company has over a 60% share of accountant businesses, with a low risk, incremental cloud transition solution which fully integrates a client's existing desktop. MYOB now has around 400 engineers, with R&D expected to cost over $55m in FY17. Ord Minnett finds it hard to reconcile investor concerns that under Bain's majority ownership, MYOB has under-invested in its business.

Deutsche Bank also notes the emphasis on accountants, as this industry is considered to be important in influencing decisions by small to medium enterprises (SMEs) about purchasing accounting software, with 87% of these businesses naming their accountant as a key advisor. Field surveys indicate 69% of the accountants recommended MYOB product for clients.

Hence, the broker believes accountants remain a key distribution channel and a powerful platform for growth. The company's cloud-based Advanced product is now the main driver behind growth in enterprise solutions and contributed roughly half of sales in this area in the year to date. Advanced is expected to make up more than two thirds of sales in 2017. Deutsche Bank considers the stock's valuation attractive relative to both domestic and international peers and retains a Buy rating.

Credit Suisse recently initiated coverage on the stock with an Underperform rating. The broker accepts the company is a beneficiary of the shift to cloud-based services and estimates the domestic revenue of the three largest operators in the local market grew by 40% between 2013 and 2015. Still, competition will accelerate and is expected to put the company's market share at risk.

While MYOB has enjoyed a high margin by industry standards and relative to global peers, Credit Suisse currently models a flat margin profile and envisages potential for downward pressure, given software-as-a-service (SaaS) typically generates lower margins than traditional software. The broker finds the stock's valuation stretched relative to forecasts and believes the market may be pricing in a (unlikely) benign competitive environment. A sell-down of the Bain stake may also weigh on the stock.

UBS has questioned whether growth is becoming vulnerable, given a potential lift in bond yields. MYOB is a quality company, and has an incumbent position and recurring revenue which underpins its business, yet the broker considers its long-term profile depends very much on its penetration of the cloud and retention of market share.

Credit Suisse estimates MYOB has around 80% share of SME desktop accounting software users but this base has entered a terminal decline and the company is no longer actively pursuing SME desktop license sales.

In a relative sense the company is playing catch-up in the cloud and has ceded first mover advantage in online solutions to Xero ((XRO)). Credit Suisse notes that while MYOB has largely filled out its product suite and is having success with conversions, it remains well behind Xero in terms of share and net additions.

The broker estimates MYOB's share of the cloud accounting software market as of June 2016 was around 28% versus 58% for Xero. While closing the gap is not impossible and the broker acknowledges the company's strategy is sound, it will become increasingly more difficult as penetration of this market increases, given churn is low. The company also faces increasing competition from new entrants, as both Sage and Intuit have been actively promoting their online solutions in the Australian market and pricing aggressively.

The company has, historically, had a dominant position in accounting software for the SME and accounting practice segments. The three largest players in the domestic market are MYOB, Xero and Reckon. Revenue for these three increased by around 40% over 2013-2015. MYOB was listed on ASX in May 2015 following two periods of private equity ownership. Bain Capital retains a 59% stake.

FNArena's database shows three Buy ratings, two Hold and one Sell (Credit Suisse). The consensus target is $3.93, suggesting 12.5% upside to the last share price. Targets range from $3.20 (Credit Suisse) to $4.40 (Deutsche Bank).
 

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Enterprise software provider TechnologyOne continues to tick all the right boxes, although some brokers suspect the stock price is becoming a little heady.

-Stock considered high quality but valuation appears challenging
-Cloud expected to make up largest portion of revenue by 2020
-UK shifts to profitability, small acquisitions expected in FY17
 

By Eva Brocklehurst

Enterprise software provider TechnologyOne ((TNE)) continues to tick all the right boxes, although some brokers suspect the stock price is becoming a little heady.

The company produced a strong FY16 result, 1% above the top end of guidance, largely because of a lower tax rate. No guidance was provided but Morgans would not be surprised if the company guides to 10-15% profit growth at its AGM in February. The stock is considered high quality but the broker finds the valuation challenging.

Even a great business can be a poor investment if you pay too much, Morgans asserts. Price momentum is strong but this should eventually weaken and at that point the broker believes it will be time to exit the stock. The broker acknowledges that cheaper capital has pushed equity risk premiums lower but believes, even on relative grounds, the stock looks expensive.

The consulting division was the weak spot in the results but initial licence fees and annual licenses were up 20%, while cloud computing provides a robust long-term outlook for the company. Longer term, the company expects pre-tax profit margins will move back towards 30%, although commentary regarding potentially achieving 40% appears optimistic to Morgans. Operationally, the company appears in a strong position and the main risk relates to market sentiment, the broker suggests.

Asset manager Northern Trust differs, noting the company has some of the strongest operational dynamics in the region and a three-year average invested capital growth rate of 10%, as well zero debt. The company also has a long history of returning excess cash to shareholders and this should make for a compelling investment, particularly on weakness, in the firm's opinion.

Long-term dynamics are compelling, particularly in the licensing and cloud division. Cloud services have also exceeded Northern Trust's forecasts, with the original expectation of breaking even in 2017 now estimated as a $1m profit. The cloud division is expected to make up the largest portion of revenue for the company by 2020.

While the enterprise value to earnings valuation may appear higher on face value, the analysts believe recent broker upgrades in the last month have been on the basis of target valuation multiple upgrades, with very little earnings upgrades yet being incorporated into estimates. It goes without saying that Northern Trust, not one of the eight brokers monitored daily on the FNArena database, has a Buy rating.

The results provide further evidence of the company's strong track record and, given the benign organic growth environment facing many industrial stocks under coverage, UBS believes TechnologyOne warrants a premium valuation. Yet, with a view to the multiples on which the stock trades, UBS believes this is largely reflected in the current share price.

Macquarie is more upbeat and envisages considerable leverage will be realised once new products contribute to the bottom line over the next few years. The broker acknowledges the risks associated with migration to cloud services but believes a premium valuation is warranted, given the opportunity to up-sell clients to a higher value solution. Cloud services fees now total $16m in annual contracted value. Given the cloud revenue model Macquarie expects revenue to lag annual contract value by around 12 months.

The broker notes the UK business has also shifted towards profitability one year earlier than expected and has reached critical mass with 40 clients. With the company having secured preferred supplier status from the federal government the broker expects smaller agencies will now follow suit in FY17. Macquarie also expects the company to make small strategic acquisitions to add functionality to its cloud development in FY17.

The result was more mixed than Bell Potter expected, with revenue 2% higher and earnings 2% lower. The main reason for this at the earnings level was a higher-than-expected loss in the cloud segment, although this was mostly made up for by lower-than-expected amortisation and tax. The final dividend of 5.09c was in line, while the special dividend of 2.00c was below the broker's forecast.

Bell Potter downgrades forecasts for earnings per share in FY17 and FY18 by 2-3%, driven by reductions in margin forecasts because of increased marketing and corporate costs and lower profit forecasts from the cloud. The broker still expects growth in pre-tax profit of 17% in FY17 and 20% in FY18. Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, retains a Hold rating and a $5.75 target.

The database shows one Buy rating and two Hold. The consensus target is $5.92, suggesting 3.5% upside to the last share price. Targets range from $5.71 (Morgans) to $6.30 (Macquarie).
 

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Telstra has sparked speculation among brokers as to what it intends with its capital allocation strategy review.

-Will the new strategy support the current dividend or involve a re-basing of the dividend lower?
-Strategic shift away from new growth businesses and a re-focus on domestic
-NBN earnings gap remains the key issue for most brokers
 

By Eva Brocklehurst

Telstra ((TLS)) will undertake a review of its capital allocation strategy over the next 6-12 months and expects to update the market at the first half result in February. The announcement, at an otherwise steady-as-she-goes AGM, provoked keen interest from brokers as they mull just what the outcome of the review might contain.

The company has also announced a strategic shift away from new growth businesses, meaning it will not, for the time being, make large-scale consumer investments in Asia. Part of the company's review of its capital allocation will include obtaining feedback from debt and equity stakeholders.

Telstra has previously identified that the National Broadband Network (NBN) will affect recurring earnings by $2-3bn between FY15 and FY22. FY22 is a key year because this is the first year which excludes one-off NBN payments and could likely be used as the base for the company's dividend policy. Telstra expects $3bn in strategic investments will drive a $500m improvement to earnings by FY21.

Deutsche Bank suggests investors will appreciate the company's willingness to canvass various options surrounding capital allocation. Yet, while the uplift from the $3bn investment sounds good in principle, the broker is cautious about the revenue benefits, given the telecommunications sector has not been successful at monetising increased data consumption and new services. The broker cites evidence in the relatively stable average revenue per unit (ARPU) in mobile and fixed data.

UBS forecasts recurring earnings to fall to $9.8m post the NBN completion, although assumes a one-year delay and that FY23 will be the first year which excludes any one-off NBN payments. The earnings improvement expected, combined with around $800m in productivity gains, fills around $1.3bn of the $2-3bn gap, in the broker's calculations.

Based on the broker's projected earnings profile and capital expenditure forecasts, Telstra could better sustain its earnings per share of around 31c if it deployed up to $2bn in excess cash flow for additional share buy-backs. UBS estimates the buy-backs could also reduce the annual dividend burden by $125m. The broker's current mobile forecasts assume capital expenditure normalises in FY24 to 14% of sales. However, if assumptions are increased to 16%, UBS estimates that only a 29c dividend would be sustainable.

Several brokers raise the hypothetical scenario of Telstra securitising recurring NBN payments, crystallising the value of long-term receipts in return for a lump sum payment. Telstra is entitled to recurring payments for leasing its infrastructure to NBN for 35 years from the date of the initial deal. Given these payments are also guaranteed by the federal government they could be viewed by some investors as a government backed annuity, UBS suggests.

Telstra could also deploy the proceeds for buy-backs which would reduce its nominal dividend load. UBS also suggests, hypothetically, if Telstra were to divest its recurring NBN payments, it could exacerbate issues around the NBN earnings gap and place pressure on the dividend profile. The broker wonders whether investors might, in that instance, de-rate the remainder of the stock.

Credit Suisse is of the opinion that the review will lead to fundamental changes to the company's capital management strategy. The main issue is to address the gap between the current 31c dividend and recurring earnings per share and the broker highlights the risk that the review leads to a re-basing of the dividend to a lower, more sustainable, level.

The broker concurs that Telstra could consider a relatively radical capital management strategy which involves securitising, effectively pulling forward future NBN infrastructure receipts. Telstra could then use the proceeds to either support the dividend or make a large one-off capital return, in order to smooth the transition to a lower underlying dividend.

At present, Credit Suisse maintains its dividend forecast for FY17-19 but looks to revise the longer-term forecast upon receiving clarity on the outcome of the review. The broker retains a Underperform rating, believing the key operating risk relates to high levels of competitive intensity across all the company's product lines.

Macquarie notes a retraction of the Asian consumer growth strategy is consistent with increased investment in the domestic business. Telstra will continue to pursue international expansion through global enterprise services and network applications and continue to expand its Asia-Pacific submarine cable network. The broker suspects the capital review may unlock some value to shareholders, but is sceptical it will transform the underlying earnings challenge for Telstra.

Macquarie agrees a key component could involve options to realise value from the NBN payments stream, in particular the $1bn in annual receipts, and possible solutions may involve the sale of some of the revenues contracted under the infrastructure services agreement, securitisation, and/or an in-specie distribution.

Macquarie envisages Telstra will be able to sustain its dividend, albeit with little margin for error given the challenges of the NBN earnings gap. The $1bn targeted for cost reductions will be spread out across the entire group and the broker expects this to be particularly important, allowing Telstra to defend its profitability in the low-margin NBN business.

Macquarie acknowledges filling the NBN earnings gap will require good execution in the number of areas, including mobile and productivity/cost reductions as well as turning around the negative contribution from new business ventures. The broker still envisages Telstra will offset most of the NBN impact, although underlying earnings could still fall to around $9.5bn by FY22.

On the other hand, the AGM commentary has underscored Citi's view that the NBN earnings gap is too big and will require the company to pull back on its dividends as it earnings fall. Citi retains a Sell rating alongside a $4.50 target.

Goldman Sachs welcomes the greater clarity around the capital expenditure program and, in continuing to view this as a largely defensive investment, believes there is less scope to drive incremental market share gains compared with previous investment programs.

The broker also notes a significant cost component and an increased focus on generating returns from existing subscribers by up-selling to higher price points and cross-selling. Goldman Sachs, not one of the eight brokers monitored daily on the FNArena database, retains a Neutral rating and $5.50 target.

The database contains five Hold ratings and three Sell. The consensus target is $5.03, suggesting 2.0% upside to the last share price. Targets range from $4.50 (Citi) to $5.55 (Ord Minnett). The dividend yield on FY17 and FY18 consensus forecasts is 6.4% and 6.5% respectively.
 

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