Description

SoftwareOne (SWON) is a global software VAR and the largest reseller of Microsoft products. It is a founder-led business with over 30% insider ownership.

The business is growing revenue at a >10% organic CAGR and over 80% of gross profits are recurring. Its high-teen EBITDA margins are expanding and convert to cash at close to 100%. Over 30% of its market cap is in net cash. 

I won’t claim that there’s anything special about SWON or that it’s a particularly great business. The VAR space is competitive and faces persistent margin pressure from both clients and vendors. But as a growing business with sticky revenue and healthy cash generation I don’t think SWON's equity deserves to trade at a 50% discount to peers. Today’s 5.5x EV/EBITDA and nearly 10% free cash flow yield to equity is too cheap.

The issues are fairly straightforward:

1. Management credibility has been damaged following 3 guidance revisions since 2019. This was, I believe, a case of an inexperienced public co. mgmt team over-promising out the gate. The new CFO came from Lonza and has made clear that hitting current guidance (his figure) is obligatory.

2. Mix has shifted in recent years from license to subscription sales, and from reseller commissions to service revenue, depressing margins during the transition. A lack of divisional reporting hasn’t helped, but will be rectified later this week at the H1 results.

3. ~40% of gross profits derive from MSFT software reselling, a clear risk despite the fact the relationship appears healthy and SWON is gradually diversifying away from MSFT.

Business Overview

I’ll assume you are familiar with the VAR model. SWON provides comprehensive software mgmt services for SMID and enterprise clients. It has 100% software exposure and zero hardware sales.

Revenue is split 50/50 between two reporting divisions: Software & Cloud (reselling) and Solutions & Services. Historically SWON revenue was overwhelmingly skewed to Software license sales, and the firm struggled to attach service contracts in what is a brutally competitive sector. As infrastructure has been shifting from on-prem to the cloud, SWON has been scrambling to adapt. Over the last 4 years it has transitioned from license to subscription sales while simultaneously increasing its attach rate such that sales are now 50/50 between the two divisions vs. 70/30 in 2018. 

Given the high contribution margins of software reselling, currently 62% of gross profits come from Software while just 38% come from the more labor-intensive Solutions & Services. In total 80% of gross profit is recurring. Additionally, 70% of gross profit is generated by 20% of clients due to the fact that cross-sold clients spend 8x more on average. You can interpret this customer concentration in positive and negative ways, but it’s undeniably positive that multi-product clients are growing at a faster rate than single-product clients.

By 2023 100% of software sales will be subscription. Software reselling revenue is growing at a mid-single digit CAGR while Solutions revenue is growing at a high-teen CAGR (again fueled by cross-selling to existing clients). Adjusted EBITDA margins for the group are ~25%. Divisional margins will be disclosed for the first time at the interim results on August 25th.

SWON has 65k clients, with revenue skewed heavily to Europe at 65% of total.

Management

The business was founded in 2000, initially becoming a Swiss market leader before executing a series of acquisitions to establish a global footprint. In 2015 KKR acquired 25% to fund further acquisitions in preparation for a 2019 IPO that went off at CHF 18/share.

By 2021 KKR and the heirs of one of the co-founders who died had largely exited.

Today the co-founders own ~32%:

• (11%) Daniel von Stockar – Board Chair 

• (8%) Rene Gilli – joined 2005 via acquisition, board member

• (10%) Beat Curti – joined 2006 via acquisition, resigned from board 2020

• (2.5%) Patrick Winter – died 2018 as CEO; heirs still own 2.5%

The CEO, Dieter Schlosser, joined SWON in 2012 and the CFO, Rodolfo Savitsky, joined in 2021 from Lonza after the longtime CFO retired. One of Savitsky’s stated priorities is to improve investor communication and divisional disclosures. Additionally the COO, Alex Alexandrov, joined in 2017 from Thomas H. Lee Partners and appears to be the driving force behind the strategic growth of recurring service revenue. Alexandrov has a strong reputation and notably got an inside look at SWON as a pre-IPO investor before deciding to join full time. The LTIP is based 75% on gross profit growth and 25% on relative TSR.

Guidance has been revised downward three times since the 2019 IPO. This has led to a credibility issue and mgmt seem laser focused on achieving the following current targets:

Here is the CFO in March, talking about the looming inflection in operating leverage:

“Operating leverage is very important as the business is expected to grow at mid-teens in the midterm. As we double click on the operating expenses, roughly speaking, the expenses are equally distributed across sales and marketing, operations and G&A. ... As you can imagine, the operating leverage on the G&A cost is very high. In high-growth companies such as SoftwareONE, these admin areas have had to grow at an accelerated pace to support the largest case. I am convinced that SoftwareONE has reached the size where we can start to optimize our spending in admin functions. The good news for a high-growth company is that productivity initiatives do not mean capping jobs, but rather growing expenses significantly below sales or gross profit growth.”

Capital allocation is vanilla and arguably not optimized. No debt (undrawn CHF 470m revolver), 6-8 bolt-on acquisitions annually to build out service capabilities, a 30%-50% dividend payout ratio, no buybacks and <1% p.a. SBC dilution. Annual capex of CHF 35m goes towards an app-based marketplace ecosystem which may or may not be money well spent.

There is a circa CHF 80m equity stake in Crayon from a 2018 investment that has appreciated substantially and is gradually being sold-down.

Unit economics in shift to SaaS

As revenue has shifted from license to subscription and from commission to services, SWON has experienced the classic headwind to margins. Here are the mgmt-provided unit economics of a typical client shifting from license to subscription at SWON:

• Client goes from paying $3.6k over 3 years for a license to paying $720/year subscription (i.e. a 5-year payback to the vendor)

• For a license SWON received a 5% p.a. commission and 2.5% retention bonus 

• For subscription SWON receives $15/month ($3 license commission and $12 attached services)

This model delivers a 2x revenue uplift to SWON as clients elect or more commonly are required to select a service component to their subscriptions. Although lower margin, absolute earnings are higher from Year 1, and are of course smoother / less cyclical:

Valuation

This year SWON will generate just under CHF 1bn of gross profits and CHF 200m of unadjusted EBITDA (CHF 240m on mgmt’s adjusted basis). Net income of CHF 125m translates to 0.80/share. 

I grow revenue at a 10% CAGR and hold margins flat. On 8x FY25 EV/EBITDA the equity is worth CHF 23/share. This equates to 17x reported earnings (13x cash-adjusted) and a 7% FCF yield. You can discount this back at whatever rate you like.

Competitors trade at higher multiples. SWON competes against not only VARs but also consultancies, system integrators and cloud implementers. Comps from the IPO prospectus include Softcat, Cancom, Bechtle and CDW. These firms have similar growth trajectories and margin profiles, although their exposure to hardware sales makes them more cyclical. Additionally Bechtle and Cancom are more exposed to DACH (70%/100% of sales vs. 33% at SWON).

Here are current comp valuation multiples vs. SWON:

This broker chart is a bit dated but the relative positioning remains:

Using 8x EV/EBITDA still provides a healthy discount to peers, some of which are clearly higher quality businesses. At today’s CHF 13/share entry price you can pick your multiple for an IRR of 10%-27%. 

This valuation sense-checks against the low end of guided targets. Gross profit today is ~60% software and 40% solutions, but if guidance is to believed here is what FY25 will look like:

10x earnings for a growing business with >80% recurring revenue and extremely sticky clients is far too low, and leaves a large margin for error.

Unsurprisingly given the cash balance, the LBO math looks highly compelling:

Finally, today’s valuation is compelling even in a scenario with zero revenue growth and flat margins:

• Assume flat revenue and EBITDA across 2021 to 2025, meaning in FY25 the business will generate CHF 1bn sales, 200m EBITDA, 150m FCFE

• Cumulative CHF 600m FCFE will bring cash to a silly CHF 1.0bn by FY25

• Today’s 2.0bn market cap / 1.6bn EV will become a 1.0bn EV

• At today’s share price this implies 1.0x EV/sales, 5.0x EV/EBITDA and 14x earnings (6.7x cash-adjusted earnings)

• At this valuation and with its cash hoard SWON would get acquired

Risks

• MSFT products represent ~50% of revenue with annual contract terms (October).

• EU represents 65% of group sales and is facing a potentially severe recession

• Poor divisional reporting begs the question: what are they hiding? This will be partially addressed at the 1H22 results when divisional EBITDA is disclosed.

• Disintermediation - cloud deployment makes self-service or vender-service logistically easier, conceptually threatening the VAR model.

• They might do something stupid with their cash

• Working capital - SWON administers CHF 14bn/yr of client software spending, much of which passes through its books but is not reported as revenue under the IFRS 15 ruling on agent spending. There is a theoretical risk here.

Catalyst

Reporting of division-level EBITDA at the 1H22 results. Notably this was pulled forward from YE22 to 1H22 at the 1Q results in May, suggesting confidence around the underlying figures.

Possibility of introducing a share repurchase program.

Cash building up.