Description

EOH is the largest IT service provider in Africa. It generates over R16.5bil of revenues from 100 operations which employ over 11 500 people.

The share price has declined sharply from R180 to R20 a share. A new management team has been hired and this idea is a bet that they can restructure the business. I think it’s an easy double from here with many catalysts.

It is important to undestand that because of it’s scale and broad scope EOH is at the heart of most large companies in South Africa. It is not that easy for these businesses to switch IT providers. Given the resilience of the revenues and business model EOH is to cheap at 3 times EV/EBITDA.

Valuation

*The adjustments to EV are discussed below.

Management guided that they expect the “restructured” business to generate EBITDA of R1.2bil on revenues of R13bil. This implies a 3.1.

Old Business Model: Serial Acquirer

The "old" EOH was a serial acquirer. It used expensive paper to buy IT operations from entrepreneurs. EOH could do no wrong and the share rose from R10 in 2010 peaking at R180. (Aug, 6 2015)

Following the peak the share began to fall. Investors became increasingly concerned that the old business model was no longer viable as the share price declined. As the concern rose the share price fell further, the classic negative reflexive cycle.

Doubts about the business model were compounded by high levels of public sector corruption in South Africa which implicated SAP, McKinsey and KPMG amongst others. Even though only 12% of EOH’s revenues came from the public sector rumors of corrupt practices hurt the share price.

EOH was founded by Asher Bohbot the long time CEO. He owns 6.5mil shares. While he did not sell a single share and vigorously denied the rumors of corruption. it became increasingly clear that he no longer had the credibility needed to run EOH. In June 2018, a new CEO, Stephen van Coller was hired to forge a new path for EOH.  The share price was R43 a share.

In February 2019, the disastrous Microsoft news hit the market. Microsoft ultimately terminated it’s partnership agreement with EOH after a whistle blower reported EOH to the SEC. The market panicked and the share fell to R10 even though revenues from re-selling Microsoft products were only R30mil. The market was very concerned that other large IT companies would also terminate their partnerships with EOH? (This article provides some of the background to these events https://www.itweb.co.za/content/KBpdgvpPKNGvLEew)

New Business Model: Corprotisation + Efficiency Drive

Today EOH it is an IT company consisting of 100 businesses entities with over 2 700 clients. It’s systems and services are pervasive with tentacles in most large South African businesses.

The goal of the new management team is to corprotising the business and to deal with the obvious fallout of continuously buying IT entrepreneurs and allowing them to run their operations independently.

For those who want more details on the turnaround plan I recommend watching the December 2018 results presented in April 2019. https://78449.themediaframe.com/dataconf/productusers/eoh/mediaframe/29027/indexl.html

I will highlight some of the salient points.

• Tightening Corporate Governance. A potential near term catalyst.
•  Splitting the business into three divisions and scaling “EOH owned IP.”
• Exit loss making public sector contracts and review the required metrics for future contracts.
• Sell operations which dot no fit. Management are targeting proceeds of R1bil which will be used to repay debt.
• Centralize the collections function and reduce debtor’s book from R5bil to R4bil.
• Switching the incentive scheme. The previous incentive scheme emphasized revenue growth at any costs. The new incentives focus on cash collection and profitability.
• Centralize treasury function. Cash balances were inefficiently scattered across all the operations. The centralization of cash balances should boost the interest earned on these balances.
• Central procurement of equipment in order to benefit from bulk discounts and rebates.
• Rationalizing space to cut rental costs by R150mil per annum. EOH currently have 20m2 per employee. The target is 9m2 per employee.
• Tax efficiency. Even though EOH made a loss it still paid tax. PWC have been hired to restructure the organization to ensure tax efficiency.
• Restructuring African. The operations do well, but, cash is often trapped by shortages of currencies or restrictive exchange controls.

New Organisational Structure: Brief Notes

In the latest presentation management provided guidance for the 6 months ended July 2019. The table below doubles the guidance to give a feel for the annual sustainable profit. The table also contains forward looking margin targets to give a feel for the potential upside.

 Some observations

• Revenue declines from R16bil to R13bil as operations are discontinued or sold.
• ICT is the cash cow. It’s a very broad business. The largest customer represents 3% of revenue.
• Nextec contains many of the struggling public sector contracts. EOH have already recognized losses R380mil and have guided for a further R240mil loss for the year ended July 2019.
• IP, this sector shows the results from EOH’s own IP. In the old structure the division only contained three* operations generating revenue and ebitda of R600mil and R120mil. EOH believe that this business can grow revenue to R2.3bil with over R400mil in EBITDA by scaling existing** “owned IP” into other geographies and clients.

* CCS, Sybrin,EMID **Syntell,XDS,DENIS,Dataworld,Symplexity,VILT

Conclusion

Bottom line. EOH consists of over 100 IT operations providing essential services to corporate South Africa. Revenues are generated from a broad base of clients and services and are very sticky.

Yes, EOH was a serial acquirer. The old management team were only interested in the next deal allowing the acquired companies to be run independently. Given this back drop I think it seems obvious that corporatization and efficiency drive will benefit from some easy wins which should boost market confidence. The emphasis on cash conversion and the repayment of debt will also help market confidence.

I don’t believe these easy wins are fully reflected in the low rating which I expect to double as the market gains confidence in the turnaround plan.

Catalyst

- ENSAfrica, a large South African law firm, was hired to investigate the possibility of corruption wrt public sector contracts. This report will be issued on 31 May 2019 and the finding communicated to the market in June 2019. I expect that the report will find isolated incidences of corruption which have already been dealt with by EOH. Also, remember revenues from the public sector are only 12% of total revenue.

- June 2019 analyst day which will highlight the IP sector which management belive can be scaled.

- Announcements about operations which have been sold.

- October 2019 full year earnings announcement which hopefully show progress in the turnaround strategy.