Innovation Group: Margin Expansion

Innovation’s (ITG.LSE) interim results showed a strong improvement in underlying profitability. Subsequent deal flow across software and business process services (BPS) suggests the margin expansion trajectory is well set to continue. Successful conversion of a strong pipeline, particularly in the US, should set the stage for significant further earnings growth.


Strong improvement in underlying profitability
From a financial standpoint, the main feature of the H1 results was a significant improvement in underlying profitability. Sales grew by 5% year-on-year (8% constant currency) but adjusted PBT grew by 32% to £9.6m. This was driven primarily by a c 200bp year-on-year improvement in BPS gross margins to 39%, as well as good cost control. It was also achieved despite a drop in high margin software licensing sales from £2.8m to £1.3m. Deal flow since then suggests a robust uptick in licensing in H2. The pipeline is healthy, although increasing demand for Software as a Service (SaaS) may result in a more steady build of recurring revenues vs a step up in one-time licence sales. BPS gross margins are also typically seasonally stronger in H2. Therefore, Innovation looks on track to deliver a third consecutive year of 20%+ PBT growth.

Margin expansion trajectory set to continue
Management comments that customers increasingly understand the value-add of Innovation’s model, an assertion that is supported by contract extensions with AXA, a South African insurer and Enterprise Rent-A-Car, signed since period-end. While the US remained a drag on margins in H1, the company is seeing opportunities across both business process outsourcing (BPS) and software. A restructuring of its US operations should help improve the return on incremental sales. As a result, we believe the company’s margin expansion trajectory, which has seen adjusted EBIT margins expand from 5.7% in 2010 to 9% in 2012 and 10.2% estimated for 2013, look well set to continue into the low- and possibly mid-teens.

Valuation: Risk/reward still positive
Our estimates have not changed significantly, with the GVS acquisition and a nudge up to underlying margins broadly offsetting the rand currency headwind. Innovation’s 2014e P/E rating of 17x is towards the upper end of a broader peer group of UK and international peers, but is justified in our view, given the potential for upside to our estimates and further margin expansion. Delivery on management’s 2015 goal of 12-14% annual sales growth and 15% adjusted operating margin would imply an adjusted EPS of 2.7p, which, when applying a sector average P/E of 14x on these earnings, would imply a share price of 38p.

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