Description

Disclaimer: This report is the work of an investment adviser affiliated with the author. The report is the result of the adviser executing its investment strategy. The adviser holds a position in the security, however there is no assurance that the adviser will continue to hold the investment, or make an additional investment, and will not update the information to reflect future changes in the adviser’s assessment of the investment.

INTRODUCTION:

Datatec (DTC SJ) was written up last August by HoneyCreek, which we recommend reading, although we will provide much of the background in this piece as well.  The key reason for the new write-up is that the turnaround of Westcon International is happening in real-time, which we believe has reduced the risk of an investment in DTC and has made the risk-reward ratio very attractive. Moreover, as the turnaround of Westcon matures over the next 2 years, we believe there is an increasing likelihood that it could be sold, which management also alludes to on earnings calls.

Even without a sale of Westcon, we project 50%-100% upside in two years on the back of a recovery in Westcon, organic growth at Logicalis, and using historical EV/EBITDA multiples. A sale of Westcon increases the return above 100% in two years and converts DTC from a holding company into a pure play company in a higher quality business.  The attractive risk-reward has not been lost on the company, which has repurchased 10% of its own shares in the last 12 months and continues to do so.

Datatec’s business won’t cause many heart rates to go up and won’t inspire too many blog posts, but in our experience, that is sometimes quite a good thing.  Datatec is an integrator, distributor, and value-added-reseller of IT equipment, software, and services; it is an important partner to a number of vendors (Cisco being by far the largest), a market leader in the higher growth markets in Latin America, and is chiefly driven by overall IT services spend in its markets.  The company’s earnings have been meaningfully impacted by a botched SAP implementation in Datatec’s already less profitable distribution business (Westcon International) and Datatec’s shares are trading as though that unit will continue to incur meaningful losses into perpetuity. In reality, the losses at Westcon have come to an end as the segment reached run-rate profitability earlier this year.

If Westcon can be sold at book value (more later on why this is a pretty conservative assumption) then the current Datatec market cap values the remaining business (Logicalis) at less than 4x forward EBITDA.  We believe that Logicalis deserves at least an 8x multiple of forward EBITDA and that Westcon can likely be sold well above book value, implying well over 100% upside to the current share price.

We think this opportunity exists because Datatec is underfollowed and poorly covered by the sell side.  Almost the entirety of its operations are outside of South Africa, which is where the stock is listed and the majority of the investor base resides. We therefore believe the stock is not adequately reflecting the Westcon turnaround and future growth at Logicalis.   

CATALYSTS:

We see several events that should catalyze a repricing of the shares.  We believe Westcon is likely to be sold, crystalizing the very low implied valuation for Logicalis.  We also believe that after a sale of Westcon, shareholders will put pressure on management to dissolve the holding company structure and reduce corporate expense - there is also ample appetite in the global IT services space for an acquisition of Logicalis.  In the immediate term, the company will continue to buy back shares and will likely re-institute a cash dividend this fiscal year, which has been suspended since 2016. The cash dividend will matter to South African investors and should drive increased interest in the shares.     

BACKGROUND:

Jens Montanana founded Datatec in 1986 and has led the company ever since, operating it as a holding company.  Jens has shown a willingness to monetize meaningful portions of the business in the past, selling an organically grown telecom business to WorldCom in 2001 for $140mm, a significant sale considering the entire market cap of Datatec by the end of 2001 was just over $220mm, and selling Logicalis’ Australian business in 2004 to IBM for $66mm which also accounted for a meaningful portion of Datatec’s then $260mm market cap.         

In 2009 Logicalis combined its Latin American operations with those of local company PromonTecnologia to create one of the largest systems integrators in South America with the leading market share in the telco market.

Datatec grew EBITDA at a ~9% CAGR from 2009-2015 despite Brazil experiencing its worst recession on record from 2014-2016.  The company broadened its geographic presence and built a presence in Asia while also diversifying its focus area and developing expertise in cloud services and security.         

In 2017 Datatec agreed to sell the Americas business of Westcon to Synnex for $630mm in cash and a potential future earn-out (just settled at $14mm).   This changed the composition of the company from being largely a distributor in developed markets to being a services-driven systems integrator and value-added reseller with more than half of its profits coming from emerging markets.  The proceeds were distributed as a dividend with a scrip option with all non-paid out proceeds going towards share repurchases.  As part of the deal Synnex also purchased 10% of Westcon International, which remained with Datatec, for $30mm and received the right to acquire an additional 10% within a year.  That right has expired unused, but Synnex continues to own 10% of Westcon International.

As Datatec stock languished throughout most of 2018 after the Westcon Americas sale management took advantage by aggressively repurchasing shares using the proceeds retained as a result of the scrip dividend.     

Datatec is now made up of two key business segments: Logicalis and Westcon International.

LOGICALIS:

The majority of Datatec’s profits come from its Logicalis business.  Logicalis describes itself as a “multi-skilled IT provider that designs, plans, and supports impactful digital transformative solutions.”  Revenues are ~65% from the sale of products (hardware and software) and ~35% from services (1/3 consulting services and 2/3 long term managed services contracts).  There is a continuing shift from products to services (used to be 80/20) as part of a strategy to drive more recurring, predictable, and defendable revenue streams.  Gross margins on services revenue are ~40% while those on the sale of products are only ~15%. This strategy is easier to implement in markets where the large cloud, security, and software providers do not have large a large on the ground presence and Logicalis derives 50-60% of its EBITDA from Latin America, where it is one of the leading systems integrators, and ~20% from Asia.        

WESTCON INTERNATIONAL:

Datatec’s other key business is Westcon, an IT distributor with most of its revenue derived from Europe and with a presence in Africa and Asia.  Westcon sold its Americas operations to Synnex at 7.3x LTM EBITDA in 2018, but retained the rest of the business which was experiencing significant restructuring losses after an overly ambitious and poorly executed simultaneous implementation of SAP and outsourcing of various back-office processes to Romania.  The SAP problems prevented Westcon from being able to provide quotes for spot product sales and drove market share losses, while at the same time the company had to abandon its outsourcing plans and in many cases hire external consultants to perform redundant tasks at significant additional cost. While revenue only declined a couple of percent the segment turned to an EBITDA loss of $33.7mm in FY17 and $48.1mm in FY18 (restructuring costs of $13mm in FY17 and $17mm in FY18).  By the end of FY19 (February 2019), Westcon had reached EBITDA breakeven and is expected to be profitable in FY20.

We expended significant effort to understand the perception of Westcon by channel partners, competitors, and customers.  The very prevalent, and almost unanimous, view was that Westcon has strong share in its specific niches (unified communications, networking, security) and persistent relationships with many large enterprises, and that it should be able to regain its lost share and return to profitability with a >2% EBITDA margin.  It is a key Cisco partner and has a number of exclusive and semi-exclusive agreements with vendors which makes it a fairly attractive acquisition candidate.

WESTCON INTERNATIONAL SAP AND BPO PROBLEMS:

Westcon originally deployed SAP as its ERP system in its North American business in 2012.  That deployment encountered difficulties as well, though the company was able to get through them without very significant or prolonged disruption.  In 2014 Westcon began deploying SAP to other geographies, starting with New Zealand and moving on to Europe. SAP deployments have plagued many companies we have come across, including Westcon competitor Ingram Micro who experienced losses for 2 years in its Australian business because of a troubled implementation.  Westcon’s rollout of the system in Europe proved particularly troublesome and in some cases prevented the company from being able to quote some of its spot business. Westcon lost market share and saw its profits in Europe turn to losses.

What made matters worse was that Westcon had ambitiously tried to institute a program of outsourcing a number of back-office operations to Romania.  This was a mis-guided effort from the start and greatly exacerbated the SAP problems. Management eventually realized that the outsourcing initiative was ill conceived and largely abandoned it, but in doing so had to hire temporary workers to bring back the previously outsourced functions while still paying the Romanian firm.  

While this was all very poorly executed the issues are largely behind us and management announced on the FY19 earnings call that Westcon International has hit run-rate profitability.  The restructuring charges are complete, Westcon International revenues have rebounded to pre-SAP implementation levels, and FY20 should be a profitable year for the business.

MARKET VALUATION:

Logicalis’ competitive peer group from the below is Cancom, Computacenter, Proact in Europe and Sonda in Latin America.  These trade at 7-12x forward EBITDA and 14-25x forward net income. Logicalis’ most frequent direct competitor is Dimension Data, another global, SA-based IT services firm which was acquired by NTT (Nippon Telegraph & Telephone) in 2010 for 11.9x LTM EBITDA.    

Given industry trends and the potential for significant synergies, we feel that Logicalis could warrant a 10x+ EBITDA price in an acquisition, possibly a fair bit above.  

Westcon’s competitors trade fairly in line, with a couple of outliers, at ~7x EBITDA and ~1x book.       

Logicalis Public comps (systems integrators and VARs):

Logicalis deal comps:

Westcon public comps (IT distributors):

DATATEC VALUATION:

The SOTP valuation below shows the FY2018 to FY2023 EBITDA bridge and valuation based on EBITDA multiples.  Since Datatec’s fiscal year ends in February the company should be trading based on its FY2023 estimate in the middle of CY2022, so we think of the below as a 3-year return from today.

The SOTP above is based on EBITDA multiples, but we have triangulated on the valuations above through a variety of methods.

Westcon:  Westcon currently has book value, excluding intercompany debt, of $180mm (there is also ~$110mm of net debt at Westcon).  We believe today the company is worth at least 1x book value, which would imply $290mm of enterprise value ($180mm of equity value + $110mm of net det), or ~6x FY2023 EBITDA.  We conservatively assume that Westcon does not accrue any additional enterprise value through 2023. Based on comparable transactions, Westcon could realistically be sold for well above 7x EV/EBITDA.

Logicalis:  We are ascribing a valuation of 8x forward EBITDA for Logicalis, towards the bottom of the valuation range for its competitors.  That implies a ~13x forward P/E based on ~$60mm of FY2023 Net Income, and ~10.5x EV/EBITDA-Capex, reasonable and fairly conservative multiples.  Logicalis’ ROIC more than supports these multiples, as we can see over the past decade:

Logicalis has seen its ROIC increase into the 20s then decrease as it built working capital for a very large telco contract.  ROIC is expected to increase over the next few years as that working capital unwinds. Datatec’s overall ROIC was kept down after 2012 by Westcon underperformance and this has masked the stronger returns at Logicalis.  Given Logicalis’ high-teens / low-twenties returns on its invested capital, and growth potential, we believe that Logicalis individually warrants a valuation that is 1.5x-2x its invested capital, which we estimate at ~$500mm at the end of FY2019.

Corporate:  We are ascribing a negative enterprise value to the corporate expense, conservatively making the assumption that it continues into perpetuity.  While this may be the case, if the company was acquired this would clearly be a synergy. And even if only Westcon is sold there is a very strong case to be made that the company no longer needs such holding company central expenses with only a single, much smaller business segment.     

Historical trading:  Datatec historically has traded around 7.5x EBITDA, and that was when the majority of its EBITDA came from the lower margin and lower return Westcon business.  We believe this supports an ~8x EV/EBITDA valuation for Datatec in the future even if the company remains a South African-traded public company indefinitely.

DTC (JSE) historical trading multiple:

CEO OWNERSHIP:

Jens Montanana is the second largest shareholder of Datatec and while he has been both a buyer and a seller in past years, it is his purchases that have generally been very well timed:  Jens’ purchases in 1H’2014 were followed by a 50% increase in the shares over the next year and Jens’ purchases in late 2015 and early 2016 were followed by a 40% increase over the next year.  Jens has more recently increased his shareholding meaningfully by taking a scrip dividend after the Westcon Americas sale in late 2017.

SUMMARY FINANCIALS:

SHAREHOLDING:

Catalyst

CATALYSTS:

We see several events that should catalyze a repricing of the shares.  We believe Westcon is likely to be sold, crystalizing the very low implied valuation for Logicalis.  We also believe that after a sale of Westcon, shareholders will put pressure on management to dissolve the holding company structure and reduce corporate expense - there is also ample appetite in the global IT services space for an acquisition of Logicalis.  In the immediate term, the company will continue to buy back shares and will likely re-institute a cash dividend this fiscal year, which has been suspended since 2016. The cash dividend will matter to South African investors and should drive increased interest in the shares.