Description

This is an event trade with a quick upside between 10% and 48%. If the deal fails I expect a loss in the short term, but, I don’t believe this loss will be permanent.

Datatec (DTC.JSE, DTC.LSE) competes with Ingram Micro, Tech Data, Arrow and Synnex. I recommend this write-up to members who have good knowledge of the industry as they will be well positioned to gauge the probability of the deal succeeding.

EV CALCULATION

Before describing the bet I want to get the EV calculation out the way. In the calculation I use the South African listed price as the liquidity is much higher in South Africa. (Note, that the LSE price usually trades at a discount to the South African price and could be a better entry point for smaller positions.)

Price (ZAR)         R55.80

USDZAR               13.35

Price (USD)         $4.18

#shares                 211

Mcap                     $  882mil

NetDebt                 $  252mil

EV                          $1 134mil

THE BET

Datatec is an ICT solutions and services company operating in over 70 countries. It is listed on both the South African (DTC.JSE) and London Aim market (DTC.LSE). The two main divisions are

• ·         Westcon-Comstor (Value added distributor): Revenue = $4.5bil, EBITDA = $72mil (TTM)
• ·         Logicalis (IT Solutions+Service): Revenue = $1.6bil, EBITDA = $78mil (TTM)

On April 9, 2017 Datatec announced that they are in exclusive talks to sell a “major share of Westcon’s operations for a consideration of more than $800mil”.

https://www.profiledata.co.za/brokersites/NedbankPrivateWealth/sharedata/scripts/sens.asp?id=288004

The EV for Datatec is $1 134mil which means you are buying Logicalis and the remainder of Westcon for a lousy $334mil. This seems way to cheap.

What is logicalis worth?

Logicalis is forecast to make $84mil for the year ended Feb2017. Using a peer based 5-9x EBITDA multiple implies a value between $420mil and $756mil for Logicalis.

Potential Returns

 The bull case return is 48% and the bear case return is 10%. I target a 30% using a $600mil value for Logicalis which I derive below.

These returns ignore potential capital gains taxes and the value of the Westcon operations which are not sold. These values are currently unknown and I assume they net each other out.

RISKS

The big risk to the trade is that the takeover talks fail and Westcon does not get sold. I am willing to take this risk as the industry is overtraded and needs to consolidate. Given the industry dynamics, the sale of Westcon to a competitor makes perfect sense.

There have already been a few mergers. Last year (Sep2016) Tech Data bought Avnet for $2.6bil and HNA (a Chinese conglomerate) bought Ingram Micro for $6bil (Feb 2016). I know the Ingram’s deal is not really a consolidation trade, but, at the time of the deal HNA expressed a desire to make more acquisitions in this space.

I am managing the risk of a “failed acquisition” using Google Alerts and carefully following industry commentary. I look forward to hearing the views of VIC members on the viability of this deal.

For the moment I think the following article does a good job covering the ground and identifying potential suitors.

http://www.computerdealernews.com/blog/westcon-comstor-sale-spins-a-cautionary-tale/54088

WESTCON-COMSTOR

Westcon-Comstor is a value added distributor (VAD). Comstor (42% revenue) is mostly Cisco which makes it attractive to potential suitors.

Competitors include

• ·         Ingram Micro, Revenue = $42bil
• ·         Tech Data, Revenue = $26bil
• ·         Arrow, Revenue = $24bil
• ·         Synnex, Revenue = $14bil

(Westcon, Revenue = $4.5bil)

Revenue

Westcon is about to report a disapointing year on 22May2017. Revenue guidance for the year ended Feb 2017 is shown below. 

Sales are guided to fall by 7%.

There was a big slowdown in the EMEA region resulting from disruptions from the final stages of a SAP implementation. SAP implementations also hurt Europe. Management are confident of a rapid recovery in sales.

North America was hurt by softer Cisco and Avaya sales and GP’s were under pressure. Short Cisco?

EBITDA

EBITDA is expected to be down by 34%.

What is striking is the large central costs that eat up more than half the EBITDA. This is ridiculous and a clear indication of the poor economies of scale. It seems obvious that Westcon would be better off in the hands of a competitor who can rip these costs out.

Valuation

Datatec are negotiating to sell Westcon for $800mil. If one slashes central costs and normalises EMEA for the SAP disruption then a $150mil of EBITDA is definetly achievable. Paying $800mil for this earnings power seems very fair to me.

LOGICALIS

Logicalis is essentially a IT consultancy operation offering IT solutions and supporting IT infrastructure.

In order to better understand the nature of the business I have set out some of the revenue splits below.

Revenue by Geography

• ·         North America          31%
• ·         LATAM                      20%
• ·         EU                             32% (mostly UK)
• ·         Asia-Pacific               11%

Revenue by Vendor

• ·         Cisco                      50%
• ·         IBM                        11%
• ·         HPE                          6%
• ·         Other                    33%

Valuation

The following table presents the historic results of the Logicalis operation

The business grew strongly until 2015. The growth was hurt in 2016 by issues in the UK and this business is currently being restructured.

I think a 7.5 multiple is fair (IBM = 9.5). This values Logicalis at $600mil. From the calculations above this should result in a 30% return.

CONCLUSION

The IT distribution industry is overtraded and is consolidating. Westcon does not have the economies of scale of compete. There are obvious costs that can be eliminated in a merger and it makes perfect sense for a competitor to buy Westcon.

Catalyst

Imminent finalisation of a deal.