Gamble of the week: an undervalued outsourcer

published 12 November 2010

Although perhaps best known for its sponsorship of the Oxford-Cambridge Boat Race, Xchanging is also pretty adept at helping is clients to sail through treacherous waters. It is a pure-play business process outsourcer, enabling corporations and governments alike to get more from their services at a lower cost. Outsourcing is nothing new, but even so, it is still a growth industry expanding at 5%-10% a year.

And Xchanging is good at it. The group has secured many blue-chip companies, such as Allianz, Deutsche Bank and Eon, under long-term agreements. Its activities include invoice processing, payroll and procuring office supplies. The top-ten clients equate to around half of its business, and first-half revenues were split as follows: 54% from Britain, 23% from Europe, 17% from the Americas and 6% from Asia.

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So why has the share price fallen? Sentiment is weak, partly because growth rates for 2010 have slipped by three percentage points to 4%-7%, as customers remain cautious and delay signing new deals. But perhaps the most significant issue has been the City's concern over the way Xchanging has accounted for its £83m purchase of India's Cambridge Solutions back in 2008. Sure, allegedly shifting profits from below to above the line is not quite playing with a straight bat. Yet in the grand scale of things, it's chicken-feed. This involved less than 1% of revenues, and there is no cash impact.

Analysts have pencilled in 2010 turnover and underlying earnings per share of £784m and 16.1p respectively, rising to £838m and 17.6p in 2011. That puts the stock on p/e ratios of 8.2 and 7.4 for the next two years. It also has £3.5m of net cash. I'd value the firm on an eight-times EBITA multiple, which, after adjusting for the £36.7m pension deficit, gives an intrinsic worth of 215p a share.

Possible banana skins include the fact that managing long-term contracts can be tortuous although the associated revenue visibility certainly compensates for this. BAE Systems, which is one of Xchanging's largest accounts, is cutting costs, so there may be some fallout from this. And competition is hotting up, although the likes of Capita and Serco, who are also having problems with order flow, trade at much higher premiums. In short, with cash-strapped clients increasingly turning to outsourcers to help deliver better and cheaper services, Xchanging looks a sound choice.

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.