Description

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT. YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. The company information, including financial and other company-related data, has been sourced from public materials produced and distributed by Softcat unless otherwise noted. The author believes the information to be generally accurate as of the date of publication.

Please see additional Important Disclaimers at the end of this analysis.

Background

Softcat is a best-in-class IT value-added reseller (IT VAR) with an exceptional growth track record, industry-leading profitability, strong cash flow generation, shareholder-oriented management with exemplary capital allocation, and a fortress balance sheet. The company is a UK-based value-added reseller of software, hardware, and services to SMEs, large enterprises, and public sector entities. It was founded in 1993 by Peter Kelly from his garden shed where he started the business by selling software via a catalogue to small- and medium-sized enterprises. He invested GBP 35k of his own money and called the company Software Catalogue. He changed the name to Softcat in 2000, and around this time became Microsoft’s largest mid-market reseller in the UK. In 2006 the company hired Computacenter veteran Martin Hellawell to be its CEO. Martin transitioned the company with a new strategy that focused on being an end-to-end IT infrastructure provider in the areas of workplace technology, networking, connectivity, cloud computing, and managed services. He also expanded the company beyond SMEs by winning large enterprise clients and entering the public sector. The company’s offering continued to grow from there. In 2010 Softcat started providing cloud computing services, and in 2014 they started offering big data business intelligence and managed print services.

In 2015 the company raised over GBP 150m in an IPO with a market cap of roughly GBP 470m. In 2018 they expanded abroad by opening their first international office in Dublin, Ireland. A year later they opened their 8^th office in Birmingham, UK, and in 2019 opened another office in Newcastle. By 2022 the company generated over GBP 2.5b in gross invoice income and had a market cap of more than GBP 2.5b, a 5x return since the IPO. Founder Peter Kelly remains the largest shareholder with close to 33% of the shares.  

Softcat has significant opportunity to continue compounding value for shareholders due to a long organic growth runway and substantial tailwinds. The most important industry tailwind is cloud adoption and migration from on-premise to off-premise IT environments, which is expected to grow the addressable market by HSD% to LDD% CAGR through the latter part of this decade, with some areas in particular expected to grow mid-teens to 20% on average per annum. For example, Gartner expects infrastructure-as-a-service to grow by 20% CAGR through 2027, while it expects infrastructure software and enterprise application software to grow at 13% p.a. over the same period. In addition to industry growth, management sees opportunity to continue taking market share while also increasing customer wallet share from ~20% currently to 60% over the long run. For reference, Softcat gross profit has increased by an average 16% p.a. over the past-five years, while the company has maintained best-in-class EBITDA/gross profit margins and robust cash conversion. And yet as of 5/16/24 the shares trade at a reasonable multiple of ~15x 2026 consensus EBITDA. This is a quality compounder available at a reasonable price, and as Buffett says: “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Overview

Softcat is a UK-based IT VAR whose activities range from plain vanilla IT resale to more complex design, implementation, support, and management of IT solutions. Solutions typically relate to customers’ core IT requirements across software licensing, workplace technology (desktop, laptop, mobile, print), networking (local area and wireless networks), security (firewalls, access control, cyber security, cloud and data center (server, storage, virtualization, backup/recovery, archiving, database and server hosting). The company has approximately 10k customers. Roughly 50% of revenue is from small and medium sized  businesses, 20% from enterprises, and 30% from the public sector. 95% of Softcat’s gross profit is from repeat business with existing customers. Software accounts for ~70% of the revenue on a product basis versus 30% hardware. Product revenue (software and hardware) accounts for ~80% while services comprise the other 20%. The mix has been shifting toward software and services over time:

The company sells almost exclusively in the UK and Ireland, but also has international offices to support its UK and Ireland based customers. Management also sees opportunity to expand more outside of the UK in areas like North America and the U.S. in particular, given vast white space and growth opportunities in those regions.

As of FYE’23 Microsoft accounted for a low-20% portion of Softcat’s business:

Growth Tailwinds

Softcat’s management aims for the company to generate double-digit annual growth in gross profit. In fact, the company has delivered a 20% gross profit CAGR over the past decade, of which half has come from increasing the customer base and half has come from selling more to existing customers. Management estimates they have penetrated ~20% of their addressable customer base. Its share of wallet is around 20-25% on average, up from 15% in 2020. They have a long-term goal of increasing average wallet share to 60% by driving mid-market customers to go “all in” with them while having enterprise customers concentrate on just a couple of solution providers. Below are some direct quotes from management on this important growth driver:

“We’ve got around 25% share of wallet of our customers. Our aim is to keep driving that figure up over time to be typically the leading partner for our smaller customers and one of the leading partners for our largest customers… we think we can grow that share of wallet threefold [from 20%], as we have many customers already with a much higher-than-average share of wallet who use Softcat as their preferred and primary partner.”

Softcat’s growth is fueled by industry megatrends including digitalization, cloud and hybrid infrastructure and cybersecurity. Digitalization consists of enabling or improving processes by leveraging digital technologies and digitized data, moving to a digital workplace, and increasing collaboration. Cloud and hybrid infrastructure comprises the shift from on-prem to cloud to provide greater flexibility and efficiencies. Cybersecurity relates to protecting enterprises from cyberattacks and data management.

The growth opportunities are underpinned by important industry drivers. Value added resellers (VARs) are intermediaries between technology vendors like Microsoft and end-user clients in the private and public sector. They sell software, hardware and services, provide technical expertise, and help design, procure, implement, and manage IT infrastructure. IT vendors can choose to sell their products either directly to the end user or indirectly through the channel, which includes VARs and distributors. Vendors use VARs to promote their products, gain market access and deal with large numbers of customers, which they are not set up to do themselves. Most vendors use the channel or a combination of the channel and direct sales for larger enterprise customers. End users, especially small- and medium-sized businesses, benefit from expert advice, being able to deal with one or a small number of VARs covering multiple vendors (simplifying billing) and lower prices than they might pay themselves, as VARs share the benefit of their purchasing power.

Generally, no vendor of software or hardware wants to build up direct sales capability targeting every single segment and geography, and no seasoned business IT buyer that already deals with 80+ vendor products wants to procure directly from a huge number of vendors without pre/post-sales support. Also, with the increasing complexity of technology being deployed (software, private cloud, analytics), small- and medium-sized organizations struggle to understand what their real needs are. These are the gaps a VAR fills. In effect, a VAR is a relationship business whose value add is driven by consultative sales. Major vendors like Microsoft understand the value of such relationships to land, retain and expand customer footprints. Relationships often start as pure resell and then expand to incorporate design and/or implementation.  

Best-In-Class Profitability

Softcat also generates industry-leading profitability. They generate an impressive roughly $47k gross profit per customer, which has expanded considerably over the years. The chart below shows Softcat’s customer base and gross profit per customer since 2007:

It highlights an important dynamic in which gross profit per customer increases as the customer relationship ages, thereby creating considerable operating leverage from customer maturation:

EBITDA / gross profit margins expanded from ~20% in the early 2000s to 40% by 2012, above which management reinvests excess profit to drive growth rather than allow margins to continue expanding:

Despite intentionally capping margins to prioritize reinvestment and growth, Softcat’s margins are nonetheless best in class by a long shot. The chart below shows how much higher Softcat’s margins are as of 2018 compared to its peer group:

Profitability is uniquely strong as management has kept the business focused on its core UK market whereas peer IT VARs have in many cases built widely diversified geographic footprints with expansive cost bases. The organic UK focus has enabled Softcat to enjoy considerable operating leverage with share gains and cross-sell / up-sell to the existing customer base. And management has been particularly efficient in managing the cost base with regard to account executives and technical support staff.

Competition

Softcat has been gaining share over the years:

And there is significant runway to continue taking market share given a high degree of industry fragmentation. In the UK, the top-10 resellers account for ~40% of the market. Softcat has approximately 10% of the VAR market (c5% share of addressable spend):

Management & Capital Allocation

Softcat recently transitioned its leadership team. Graeme Watt was CEO until 2023, at which point he transitioned into Non-Executive Chairman. He joined Softcat in 2018, having previously served as SVP of the EMEA region for Tech Data Corporation.

Graham Charlton is CEO. He joined Softcat in 2015, and before that was Finance Director at comparethemarket.com. Katy Mecklenburg is CFO. She joined in 2023. Before Softcat she was Interim CFO at ASOS, and before that Group Controller at Inchcape.

The balance sheet is net cash and management is entirely focused on organic growth. Below are some direct quotes from management that highlight their sensible capital allocation approach:

“There could be an opportunity for us to accelerate that build inorganically, but we don’t need to do that. And it would be a very high bar… the likelihood is that we’ll continue to build organically… and we do not need to do any M&A to continue to support our UK customers… around M&A, I mean, as we’ve kind of stressed, it’s an organic first strategy that we’re pursuing.” 

Conclusion

Softcat is a high-growth compounder operating in an industry with significant structural tailwinds. It generates best-in-class profitability due to strong execution and efficient headcount management, which translates into robust cash conversion. The strategy is focused on value creation through organic reinvestment in the core UK market, where there is substantial opportunity to continue gaining share and extracting operating leverage with customer maturation via cross-sell, up-sell, and wallet share increase. And the balance sheet is rock solid. As of 5/16/24 this fast growing high quality compounder is available at a reasonable 15x 2026 consensus EBITDA, which provides investors an opportunity to take Buffett’s advice and “buy a wonderful company at a fair price.” 

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herein.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers, directors, and other associated parties, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaim any liability for investment losses that you may incur under any circumstances.

Catalyst

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