Our best inflation trade

Harry Dudley

Watermark Funds Management

A good value investor will buy cyclical stocks on high multiples at the bottom of the cycle. This is when earnings have troughed. Computershare (ASX:CPU) will soon deliver its lowest earnings per share in nearly a decade and this presents that opportunity. But we see FY21 as a trough year and believe this is a pivotal moment for a business with enormous upside exposure to short term interest rates. This makes it a key defence against inflation in a well-constructed portfolio.

Margin Balances

CPU's core operations require it to hold large amounts of cash for its clients. This can be for dividends before they are remitted to shareholders or consideration to be paid to shareholders of an acquired company. Balances have averaged around US$16 billion over the past five years. From that, US$16 billion CPU has collected nearly $1 billion of revenue (Margin Income) over the same time. Given costs are minimal for management of these balances, it falls nicely to the bottom line, at nearly a 100% profit before tax (PBT) margin. With near-zero interest rates globally CPU's Margin Income earnings have fallen 60% in two years.

Corporate Trust Services acquisition

In March this year CPU announced the acquisition of Wells Fargo's Corporate Trust Services (CTS) business. CTS's core operations are the collection and distribution of funds for trust structures, such as a pool of mortgages. The nature of this business sees it hold large amounts of cash for clients, similarly to CPU. We considered the deal well-timed and opportunistic. Firstly, Wells was being penalised by the US regulator due to misconduct issues in its retail bank, this saw it restricted in holding assets on its own balance sheet. Secondly, given the backdrop of near-zero interest rates, CPU would be buying CTS at a low point in earnings.

Margin Income contribution to CPU and CTS revenue

 


CTS acquisition sees margin balances double or more

A key outcome of the CTS acquisition is that CPU more than doubled its expected cash balances. With its market leading offering in trust services, CTS holds around $18bn of relevant cash balances. Management is also confident in recapturing another $6bn for CTS, currently managed externally. The transaction will see CPU's cash base grow at a minimum of 100% and up to 135% if it recaptures external funds (our base case). 

Source: CPU, Watermark

Rates bottoming, inflation expectations rising

At current interest rates, Margin Income earnings on these cash balances are uninspiring. This is due to global central bank intervention currently suppressing short term rates to stimulate growth. With rates artificially low and record stimulus injected into the economy, concerns are beginning to emerge on inflation. Inflation in the US is now set to reach more than 5%, the first time it has done so in 25 years. The strongest lever central banks have to pull against inflation are changes to cash rate targets. In the chart above, we highlight where we are today on the short-term rates journey, with future rates based on market expectations.

Earnings impact, key points

In our base case, CPU successfully gains the additional $6bn of balances externally managed. This sees its base cash balances in FY22 increase 135%.

  • If market expectations play out around short-term interest rates CPU has the ability to earn an additional profit before tax of around $415 million on its margin balances in FY25.
  • This is compared to the entire Computershare Group profit before tax of $460 million consensus has it delivering in FY22.
  • Looking at it another way, CPU's base business could have no growth and the group would deliver 90% PBT growth over the 3 years. This equates to an annual growth rate of 24%.
  • If inflation was to runaway CPU adds ~45% of profit before tax for every 100bps move in short term rates.

Conclusion

Computershare may be a boring business, but it holds significant upside potential. As inflation expectations continue to rise, we see CPU as a key beneficiary of short-term interest rates. We also consider our best position to protect a portfolio against any runaway inflation.

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Harry Dudley
Portfolio Manager
Watermark Funds Management

Harry is a portfolio manager at Watermark Funds Management. Prior to this, he was an Equity Analyst with Macquarie Equities, focusing on Australian banks, Infrastructure and Technology. Harry began his investing career in 2013 with IFM Investors...

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