Broker tips: Xchanging, AMEC, IQE,

Business process outsourcing (BPO) specialist Xchanging held a conference call this week to clarify some accounting issues that were concerning the market, but questions remain on other fronts, Panmure Gordon reckons.

"Questions remain, particularly on its largest customer BAE as well as its ability to grow in the short term, with the acquisition of Cambridge more problematic than first anticipated," the broker said, explaining its decision to cut 2010 and 2011 earnings estimates by around 8% to 9%.

That puts Panmure Gordon's estimates below the company's own guidance range, but the broker notes the guidance "has sometimes been poor in the past."

Panmure Gordon is sticking with its "hold" recommendation, though it concedes the shares look cheap "on current spot multiples". The issue for Panmure Gordon is whether the company can deliver value in an environment where "growth looks increasingly difficult to come by and with creditability still low."

The conference call threw some light on how problematic the Cambridge Solutions acquisition has been. "Due to aggressive profit recognition from the previous management team, this means some of its contracts will now be run off at nil margin, with onerous lease costs also adversely impacting cash flow for up to three years," Panmure Gordon explained. Cash restructuring costs will wipe out most of the free cash flow this year, "which is very disappointing and almost unheard of for a BPO business," Panmure Gordon added.

With no detail forthcoming on the outlook for the BAE contract - believed to account for up to 20% of revenues - the broker does not feel "there is enough upside potential [to] justify taking a large position."

Margins were lagging at AMEC in the first half of 2010 but the engineering and project management group beat expectations on revenue growth, Nomura Securities said.

"The weakness [in margins] came primarily in Natural Resources and Power, with a non-contributing acquisition and the company facing further pricing pressure from clients," the Japanese broking house said.

Full year margin guidance has been lifted, the broker noted, and the company has stated its confidence in delivering above its 8.5% target for fiscal 2010, "implying a fairly significant 120bp [120 basis points] sequential uplift into the second half."

Nomura has stuck with its "buy" recommendation for the stock and its 1050p price target, but said the company's order backlog will need lifting by the year end and management will have to deliver on its promise to improve margins to justify the positive rating.

IQE, the world's largest merchant supplier of compound semiconductor wafers to the global wireless, consumer electronic, light emitting display and solar cell markets, is releasing results next week, and while FinnCap is not expecting things to have changed much since the July update, the second half of the year may present a brighter story.

"IQE's highly operationally geared business model means the three key valuation drivers are wireless market expansion, wireless market share gains and application innovation for III-V materials. News on the former two will be dominated by discussions surrounding handset shipments, attachment rates and supply chain rationalisation. The latter will largely depend on positive indications from management surrounding optoelectronic applications," observes FinnCap analyst Dr. Paul Cornelius.

"Positive segment financial reports on the non-wireless business streams within the high-growth VCSEL, CPV and LED space and a positive update on the emerging 50Gbit/s optical link devices, with Intel et al, should be seen as an early indicator of preparing compound semiconductors for the mainstream," Dr. Cornelius argues.

The IQE share price has hit FinnCap's previous price target, set in January, of 25p. "Using the current PER [price/earnings ratio] of 21.5x results in a new fair value estimate of 29.4p," based on the broker earnings per share estimate of 2.4p for fiscal 2011.

The "buy" recommendation is left unchanged.