Why you should add IT services stocks to your portfolio

It’s time you added IT services stocks to your portfolio, says analyst Ian Munro from CCZ Statton Equities.

Why should investors consider ASX stocks in the IT services space?

The technology services industry is a diverse and dynamic space and there are a myriad of listed companies offering solutions to corporates to help them win share as consumers change the way they transact and interact.

There has been a significant surge in corporate investment into digital assets including websites, apps, content mediums, sales platforms and market analytics. This year
around one fifth of a large corporate CIO’s budget was allocated to digital, next year this is predicted to increase to one third.

What is driving this increased corporate spend on digital?

Brands are judged more through their online platform and corporates are realising the value in having dynamic and engaging customer facing applications. There is a clear ROI from digital assets as a means to lower the cost of customer acquisition and be more responsive with products and services that increase a customer’s lifetime value.

At the very least, this is seen as a complement to shrinking returns from a physical footprint.

What market trends will drive demand in the IT services space?

Digital spend continues to grow unabated and is predicted to continue as new technologies become more commonplace including device connectivity, machine learning, blockchain and crypto currency based transactions. Depending on the sub-segment, technology service companies driving this change are growing by anywhere from 10% to 25% per year at the moment.

Technology services companies that consult in these areas and project manage digital solutions for clients are in high demand, driving revenue growth. The real kicker comes for companies that also provide the back end integration and delivery process, synchronising new technologies with incumbent enterprise systems and platforms. Typically, we see a corporate spend 30% on the front end tech spend and 70% on the back end integration.

Are these stocks undervalued by retail investors?

Investors in general are chasing technology software growth and returns can be eye watering, especially when future market share gains are capitalised without thought to potential new entrants and shifting market dynamics. Behind this excitement is a set of technology services companies, generating a high quality of earnings, consistent cash flow and with clear benefit from consulting and integration of new technologies. They have established track records servicing Australia corporate and Governments on multi-million, multi-year consulting and project engagements and are increasingly in demand from offshore buyers for these reasons.

There has been a lot of M&A in the market- four of the Aussie IT services peers have been acquired in recent years – Oakton (ASX:OKN) was acquired by Dimension Data, UXC Limited (ASX:UXC) by Computer Science Corp and ASG (ASX:ASG) by Japan’s Namura Research which later took over SMS Management and Technology (ASX:SMX).

We have seen these offshore acquirers buying companies to extend their service offering into a wider customer base and build a platform for larger project work, more befitting of a multi-national.

It has not been all smooth sailing for the multi-nationals, $73m of Oakton’s $171m acquisition price was recently written down by Dimension Data. The average acquisition EBITDA multiple of 12x represents a healthy premium to where some of their remaining listed peers trade.

What stocks are doing well in the space?

IT service management company DWS (ASX: DWS) has been around for 20 years and continues to remain relevant to a long list of blue chip corporate and government clients. A recent digital focussed acquisition has created the growth engine for the business, backed by a strong balance sheet and reliable earnings stream. DWS has delivered between 12 and 14 cents earnings per share every year for the past 10 under the current CEO, with a consistent yield.

Multi-national acquisitions in the mid-market have also left gaps in the servicing of local clients, particularly in the mid sized engagements, creating opportunity for the likes of DWS and RXP Limited to grow market share (and attract key staff). The market is not giving any valuation premium for RXP Limited’s (ASX:RXP) latest acquisition of creative agency The Works. With a macro tail wind on user experience and content delivery the partnership with a creative agency cements their position as one to watch and management have confidently published budgets for the next 12 months backing up their strategy.

IT services is a very active market at present – Melbourne IT (ASX:MLB) has grown selectively through acquisitions and are increasing customer numbers and share of spend in both the enterprise and SMB segments. This leverages the higher spend on digital and the additional of new acquired competency in app development, search engine optimisation and social media consulting. MLB has been a pure trade into the digital sector growth, as reflected in the firm but not overpriced valuation.

Ian Munro is a senior analyst and co-founder of the Melbourne desk for brokerage house CCZ Statton Equities. CCZ specialises in emerging company research, targeted at investors looking to achieve superior risk adjusted returns.

Ian adopts a fundamentals-based, yet innovative approach to valuing businesses, drawing upon investment experience locally and abroad, including a wide network of private and listed company contacts. A product of the Melbourne Business School, prior roles include UBS Global Asset Management (London) and National Australia Bank.