No Shortage In Challenges For Spun-Off Recall

This story features RECHARGE METALS LIMITED, and other companies. For more info SHARE ANALYSIS: REC

-Acquisitions key to earnings expansion
-Heightened risks with new technology
-High churn potential
 

By Eva Brocklehurst

Newly listed Recall ((REC)) is off and running. The market's first impression of the player in information management, document storage and handling is of a quality business with good returns on capital. Former parent Brambles ((BXB)) hived off the business and listed the stock on ASX earlier this month. A large portion of revenues are recurring and contractual. Still, brokers remain lukewarm on the outlook and acquisitions are considered key to expanding earnings. The four brokers on FNArena's database? that have initiated coverage on the stock since the spin-off have delivered three Hold recommendations and one Sell. Price targets range from $4.07 to $4.53.

There is potential for both client growth and acquisitions in the market, as it's very fragmented. The company estimates there is 65% of the potential storage market that is yet to be tapped. Recall's position regarding this opportunity is strong, but there are challenges. Deutsche Bank notes that FY13 revenue declined because of lower customer transactions and lower paper prices. Paper prices? The company is affected because of the revenue it draws from the sale of recycled paper. JP Morgan also flags this issue, estimating that 4% of group revenue is derived from sales of shredded paper and there has been a 15% decline in realised prices over the last four months. A decline in new paper prices represents less demand on recycled paper.

The company has also made its debut with higher business development expenses on the balance sheet, following the unsuccessful attempt by Brambles to sell the business in 2012. Deutsche Bank expects growth will occur in FY14 but longer term thinks the company has to ensure it has a big presence in the digital storage space to offset any decline in physical storage volumes.

JP Morgan also thinks the physical storage industry is characterised by low growth and that's something the company has to address. The speed at which customers are switching to digital storage is unknown and this is the reason why JP Morgan does not wish to value the stock aggressively, retaining an Underweight rating. Moreover, the broker thinks translated earnings will be negatively affected by a strengthening US dollar. In pro-forma FY13, 40% of earnings was generated from the Australian business.

The two key revenue drivers – transaction services and organic box volumes – are facing structural difficulties, according to BA-Merrill Lynch. Recall should still benefit from acquisitions and gains from a market that's far from saturated when it comes to choosing independent information storage but, until such is certain, the broker is conservative about revenues and forecasts 2% constant currency growth. As records storage contracts typically last 13-15 years, and storage of certain documents is underpinned by regulatory requirements, a portion of the company's activity may be regarded in terms of an annuity. That's the safer side of the business.

What stands out for most brokers is the uncertainty regarding new technology. The company has three divisions: document management services, secure destruction services and data protection services. Besides the risk of converting clients to digital storage and increased scanning of documents there's the advent of cloud-based storage – which Recall does not offer. This could impact both Recall's records management and destruction businesses, in Merrills' view.

Furthermore, there is a risk that electronic signatures are adopted amongst core financial institution clients. Recall has a physical server storage service but the broker thinks this is of a limited scale. The legislative requirements for records storage provides some stability but this may be eroded if electronic signatures become more widely adopted. At present, the scanning risk is currently limited by the high cost to scan – $90 per box – compared with $3 per box for storage. Merrills also notes that, should the company attempt to build a cloud service, then it could suffer from poor returns, consistent with the experience of global peer, Iron Mountain.

The balance sheet has the capacity to sustain incremental acquisitions which could unlock material logistical synergies, in Macquarie's opinion. The broker expects the document storage industry to benefit from plenty of risk averse and disorganised customers. The unsuccessful sale process and the eventual de-merger lost the company some market share and Macquarie believes management needs to focus on regaining this share. The broker anticipates there will be some register turnover in coming months as investors re-evaluate the stock but, given the price on listing – it closed at $4.50 on the first day, the stock appears to have quickly found fair value.

On this score, Merrills also thinks there's a risk that both offshore and local institutions will have to sell down. The company's market capitalisation is only $1.4 billion or thereabouts and may be outside the mandate of offshore funds that are currently shareholders in Brambles. Brambles describes its registry composition as including 40% offshore institutions. Hence, in Merrills' view, the foreign segment looks most at risk of churn. While Recall will likely enter the ASX100 list automatically, given Brambles is an incumbent, at the next quarterly rebalancing of the index in March it may be dropped. If that becomes the case, Merrills thinks local institutions may also have to sell and it could take time for smaller cap managers to soak up this liquidity. The broker observes that offshore investors hold Brambles for the CHEP business, which has high barriers to entry, long-term growth options and high returns to attract them.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms