Description

Tech Data is one of the largest IT distributors in the world. Having invested in a number of tech companies over the years, we have become convinced of the value that TECD provides – a link between IT vendors and customers in general but in particular small and medium businesses (SMB) which are harder to reach by vendors and which are the focus of TECD. TECD is a slow grower (low to mid-single digit) but generates a significant amount of FCF (between $200 and $250 million per year on average). The valuation is undemanding trading around 10x FCF. Our downside is protected by the strong balance sheet (net cash position). The company has been a good capital allocator being a disciplined acquirer over the years and using its cash flows to repurchase shares when they view it as undervalued. They have a good track record of being more aggressive when the stock goes lower and less aggressive when the stock is higher.

There have been a number write-ups of IT distributors in the past so I will focus this analysis on why this is an interesting time to invest in TECD. I would suggest interested readers check former write ups of TECD, IM or CDW for more details about the business or industry. Key differentiators for TECD compared to other distributors are 1. Diversification – truly end to end offering 2. 61% of sales from Europe and 3. Focus on small and medium businesses (SMB). The company is managed to maximize ROIC, not margins.  In fiscal 2016, TEDC had ROIC of 13% vs its estimated cost of capital of 9%. We have spoken with former employees who have described the entire culture is centered around maximizing ROIC.

The current EV is around $2.1 billion and the company generates around $225 million of fcf. So you are buying into a stable and diversified (see more below on this), slowly growing, and highly cash generative business for around 9.5x FCF.

We believe that a reasonable target price for the stock is around $100 per share in a couple of years. We assume EBITDA between $380 to $400 million per share in 2018 which translate into around $250 million in FCF. Applying a 12x multiple, adding $400 million of FCF generation for the upcoming 2 years and adding the current net cash position gets us to around $100 per share in 2 years.

We also should note that these businesses have strategic value. Ingram Micro has recently announced its sale to a Chinese company (the deal has not closed yet). The background of the merger in the proxy is interesting as it reveals a number of interested parties to buy the company.

A couple of events have recently had a negative impact on the stock creating an interesting entry point.

1.      On April 28, 2016, another IT distributor, Avnet released disappointing earnings and prospects. In particular, Avnet’s Technology Solutions division announced constant currency year over year growth of negative 12.9%. The negative growth is due to weakness in legacy IT hardware – storage and servers. These products represent a significant portion of Avnet’s business. It is important to note that Europe did better than the rest of their geographies. This is relevant to TECD because 60% of TECD business is in Europe. Avnet closed down 6.2% that day.  TECD was also down around 2.5%.

2.      Following Avnet’s report, on May 1, 2016, Citibank downgraded the entire sector. Their thesis is that the cloud is challenging all the IT vendors because it impacts sales of legacy IT hardware. TECD closed down 5.5% following this report and down 10.2% since the close prior to Avnet’s report.

These 2 events have significantly lowered investor expectations for TECD which reports on May 26, 2016 setting up an attractive entry point for the stock.

We don’t believe all IT distributors are created equal. Given TECD significant diversification including exposure to high growth area, we don’t believe that Avnet’s recent results should be interpolated to TECD. While we agree that legacy IT hardware is challenged, it represent around 20% of TECD sales and is offset by TECD’s fast growing cloud division which is around 18% of sales. CDW which we consider a much better peer for TECD because of the breadth of its offering recently reported Q1 results that highlighted constant currency growth of 3.5%. The company in particular highlighted its diversity as a reason for this growth. We expect a similar result for TECD. In other words, Avnet is heavily exposed to a declining part of IT spending. That doesn’t mean that all IT distributors have this issue.

While we don’t typically play the earnings game, there is another interesting dynamic taking place here with regard to currency. When the company reported Q4 numbers, they gave Q1 guidance that assumes year over year constant currency sales growth of low to mid-single digits in US and Europe and an average US dollar to Euro exchange rate of $1.08 to Eur 1. What’s interesting is that during the quarter, the average exchange rate was around 1.12. Given that around 60% of TECD business is in Europe, this difference of exchange rate is meaningful and is likely to cause the Company to beat its EPS guidance. It’s also likely that the Company will provide guidance for Q2 based on a higher exchange rate. For reference point, Q4 European operations constant year over year growth was 11% but was flat in US$. Some of the currency headwinds that have obfuscated TECD progress in Europe are reversing and will now provide a tailwind for the business.

In conclusion, we believe some recent industry noise has created an attractive entry point to purchase a well-run, stable, highly cash flow generative business with a great balance sheet at an attractive price.

Catalyst

fcf generation

buyback

earnings release