Description

Thesis

Indeks Bilgisayar (Indeks Computer) is Turkey’s largest IT distributor.  Despite a strong operating track record (19% CAGR in tangible book value + dividends since 2003) and high returns on capital (40% average pre-tax return on capital since 2003), Indeks sells for only 5x adjusted P/E, while appearing to sell for 8x P/E.  The company’s devoted founder Mr. Erol Bilecik is aligned with shareholders via his 36% ownership, and a Polish private equity firm has a 26% stake (to which it has recently been adding) along with board representation.

Indeks background

Indeks was founded in 1989 by Mr. Bilecik and currently employs nearly 300 people.  The company distributes IT products (e.g., desktop PCs, laptops, servers, printers, software, and household electronics) from over 200 brands (e.g., Apple, Samsung, Oracle, Microsoft, Intel, Canon, Seagate) to over 7,500 companies (e.g., system integrators, dealers, retailers) in the Turkish supply chain.  Indeks is the market leader with nearly 25% share and has grown its revenues over 20% per annum since 2009.  The #2 company is Arena Bilgisayar (also publicly-listed) with 11-12% share, and the #3 company is the Ulker Group (also owners of Godiva) with 10-11%.  Size is important in distribution because the more products a distributor boasts, the more customers it attracts, which in turn leads to more products and more customers, and so forth.  Ultimately this leads to an economies of scale advantage as the fixed costs in the business, which although small as a % of revenue, are quite large as a % of gross profit.

Below are the past 10 years of Indeks revenues, gross profit, operating profit, and returns on capital (I have deconsolidated the company's 60% stake in Datagate discussed below).  Margins have declined the past few years due to the rapid growth of mobile products such as Apple which have gross margins of 3.5-4.5% as opposed to 5.5% with other IT products.

Datagate

Indeks owns 60% of Datagate Bilgisayar (Datagate Computer), a hardware components distributor.  Only two years ago, Datagate was losing money and nearing the point of liquidation by management, when it reached an agreement with a Turk Telekom's mobile phone arm Avea to distribute its mobile phones throughout southwest Turkey.  Avea is Turkey’s third-largest mobile phone operator (behind Turkcell and Vodafone) but is the fastest growing, having increased its market share from 16% in 2007 to 25% today.  Avea had been working with two companies to distribute its mobile phones throughout its retail stores in Turkey but was not pleased with their overall performance.  Avea took notice of the IT distribution capabilities and financial strength of Indeks and believed that Datagate, as its subsidiary, could succeed similarly in the distribution of mobile phones.

In July 2014, Avea granted Datagate a five-year exclusive mobile phone distribution contract for 26% of Turkey’s geography.  The remaining 74% of Turkey would continue to be served by the two existing distributors, both less qualified and less financially capitalized than Datagate.  Financial strength is imperative in this industry because distributors must finance the large upfront cost of mobile phones, while end customers buying the phones pay them off monthly over an average of twelve to eighteen months.  A distributor short on cash would buy fewer phones to distribute, leaving Avea with fewer customers.  Since it makes little sense for Avea to continue employing weakly-capitalized distributors and for the strongest distributor to cover only 26% of the country’s geography, Datagate is likely to gain a commanding share of Avea’s distribution in due course.  Turkcell successfully operates with 2 distributors (down from 5), while Vodafone has only 1 (down from 4); there is little reason for Avea to have 3.  As a result, Datagate’s earnings are likely to rise materially from their current level as the company’s geography expands across Turkey.

Datagate is a very simple business: Avea tells Datagate how many phones to purchase from OEMs such as Apple and Samsung, so Datagate takes no inventory risk.  All the purchasing is done in Turkish lira, so there is no currency mismatch that an emerging market IT distributor may have when buying in U.S. dollars (a risk relevant to Indeks).  And, unlike an IT distributor which must collect payment from thousands of different resellers, Datagate has one strong counterparty in Avea.  Thus the business has very little operating risk.  The reason Avea outsources it is so that that it can focus on improving its infrastructure and marketing its product while Datagate coordinates the purchase and logistics of mobile phones to 700 different stores as well as the sale of phone credit to customers via software.  In return it pays Datagate a certain fee per phone.  Datagate is now selling its receivables to pay down debt (which is all guaranteed by Avea) and will soon be in a net cash position.

The company currently earns 15-18m per year (7.5x P/E), a figure which could increase if Datagate earns distribution rights over more regions.  By mid-2017, Datagate’s receivables will have paid down all debt and Datagate could likely become a double-digit dividend-yielding stock given limited re-investment opportunities.  The major risk to this business is without a doubt customer concentration and the question of what happens after the expiry of the initial contract.  I believe it is more likely for Datagate to win more regions as opposed to lose the contract as switching distributors can be disruptive, an issue Avea faced when initially hiring Datagate.

Other assets

As of June 30, 2016, Indeks has a net cash position of nearly 20 million.  However, in addition to the cash generated by its operations, Indeks expects to receive nearly 100 million TRY within the next 8 months.  In 2006, Indeks purchased a piece of land for 15m USD.  In 2013, this land was sold to a developer and will generate a minimum of 65 million USD for Indeks (88 million before taxes).  The company has thus far received less than half of the proceeds (as per the agreement), leaving at least 33m USD to be received by May 2017 at the latest.  At current exchange rate (1 USD = 3 TRY), this is nearly 100 million TRY. The beauty of the arrangement is that it is struck in USD with a credible counterparty (Seba Construction).  Thus, any depreciation of the Turkish lira is somewhat offset by the dollar-denominated land deal.  Management plans to pay 50% of the total proceeds via special dividends.

Valuation

Indeks revenue growth will likely slow to approximately 10% per year as a function of maturation at Datagate (as a reminder, consolidated in the figures Indeks reports but not in my figures above) and general IT trends in Turkey.  Indeks aims to grow overseas to supplement this growth.

Risks

There are various risks with an investment in Indeks apart from the customer concentration risk at Datagate discussed above.  The first is macroeconomic/political and relates to the Turkish lira.  In case of a currency depreciation, 1) an investment in TRY will translate to fewer USD, EUR, or any other base currency, and 2) as an IT distributor into Turkey, Indeks is buying in USD while the end customer thinks in terms of TRY.  As the TRY depreciates vis-à-vis the USD, these products become more expensive for customers.  Fortunately, FX depreciation is partially mitigated by the land deal struck in USD; if the TRY weakens, Indeks will receive more TRY.

The second risk is mismanagement.  Distribution margins are slim and misjudging inventory trends can be costly.  This concern is alleviated by Indeks' successful history in this business.

The third risk is attempts at growth outside Turkey, which the company has planned.  Management is conservative, so I do not expect them to take undue risk in this endeavor.

In the case that the business becomes permanently impaired, it could be worth no more than tangible book value, which is significantly lower than where it trades today.

Catalyst

FCF generation, incoming cash from real estate, significant dividends