Datatec — Focus on Westcon International

Since the sale of Analysys Mason in September 2022, Datatec operates through three divisions:

In this pre-close update, we focus on Westcon to update its progress since we last wrote on the division a year ago, including an analysis of its valuation.

Westcon is the group’s largest business, in terms of both revenue and EBITDA. The charts below show Westcon’s contribution to H123 revenue and gross profit from continuing operations. Of H123 EBITDA before central costs of $68.8m, Westcon contributed $51.5m (75%) compared to $18.3m from Logicalis International and -$1.0m from Logicalis Latin America.

The current management team (David Grant, CEO and Callum McGregor, CFO) assumed operational responsibility for Westcon in 2017, with the business positioned as an information and communications technology (ICT) distributor. Management’s strategy has been steadily to reposition Westcon as a specialist technology provider, offering an increasing proportion of value-added services, subscription and cloud capability in complex solutions for networking and cybersecurity vendors across Europe, the Middle East, Africa and Asia-Pacific. This is intended to drive Westcon’s EBITDA margins higher as management establishes Westcon as a leading technology provider in its markets.

Management’s ambition is for Westcon to be the leading value-added distributor for cybersecurity and networking vendors across Europe, the Middle East, Africa and Asia-Pacific.

Westcon is Datatec’s specialist technology distributor with c 3,500 employees, spread across 50 countries worldwide, with 15 logistics and staging facilities globally. The division works with more than 12,000 channel partners, including a portfolio of market-leading vendors, such as Cisco, Palo Alto Networks, Check Point, F5, Broadcom, Zscaler, CrowdStrike, Pure Storage, Extreme Networks, Juniper and AWS. The business distributes technology solutions across cybersecurity, network infrastructure, cloud collaboration and data centre, provides channel support services as well as financial solutions to Datatec Group customers.

Although it is listed in Johannesburg, the Datatec group has limited exposure to the South African market, with the equity story being a dollar-denominated global ICT play. This can be seen in the geographic breakdown of Westcon revenues. With good geographic diversification, Westcon has sizeable exposure to Asia-Pacific (26% of H123 revenues) and the Middle East and Africa (notably South Africa) at 13% of H123 revenues. However, the weight of both revenues and gross profit lies in Europe (61% of H123 revenues), with its principal territories including Germany, the UK and the Netherlands.

The global IT market is large (Gartner estimates IT spending at US$4.6tn in 2023) and complex, with roles defined by positioning in the value chain, as well as by territory, region and end-user client type. In terms of Westcon’s position in this market, it can best be described as an IT channel management organisation and distributor: a business that acts as an intermediary between vendors and resellers, service providers (SP) or systems integrators (SI) in the provision of software, subscription, cloud and hardware solutions.

Exhibit 3 illustrates the two-tier distribution model used by cybersecurity and networking vendors and Exhibit 4 shows how Westcon fits into the value chain.

As a specialist technology provider, Westcon supports the largest enterprise channel clients, as well as regional and national partners, SIs, SPs and resellers. However, Westcon does not directly serve the end-user of the technology, but almost exclusively serves another intermediary in the value chain. In H123, 53% of gross revenues were from resellers, 31% from SIs and 16% from SPs. As anything as a service (XaaS) grows in popularity, many value-added resellers are becoming managed service providers and we would expect the split of revenue by type of customer to shift more towards SPs from resellers. The division has a balanced customer mix, with 22% of gross revenue from the top 10 customers, 9% from the top 11–20 customers, 14% from the top 21–50 and 55% from remaining customers. Exhibit 5 shows some of Westcon’s partners in each category.

After a period of transforming the business since 2017, management has set out its strategic priorities for the next five years (Exhibit 6). We discuss in more depth how the company plans to meet the targets outlined in the chart.

The division markets itself under two brands, Comstor (for Cisco solutions) and Westcon (for other vendors) – see Exhibit 7. Although Westcon is an independent supplier serving a range of vendors, its key relationships remain concentrated. Cisco, with a relationship going back 25 years, accounted for 41% of H123 group revenues. Comstor is solely focused on Cisco, distributing the full suite of Cisco solutions to more than 100 countries globally. These include Cisco security, collaboration, data centre, enterprise networking and services (customer support for over 160 countries in 17 languages). Management estimates that Comstor consistently delivers higher growth rates than Cisco’s general distribution, partly due to expanding into new Cisco territories and partly due to gaining market share. Other vendors’ products are distributed under the Westcon brand, which offers dedicated or focused vendor teams for the market’s top-tier technology vendors in cybersecurity, advanced networking and collaboration (see Exhibit 9 for the different categories of vendors). Across the two divisions, cybersecurity is the largest contributor to revenue (Exhibit 8).

Key to driving the division towards gross revenues of $6bn is having a portfolio of best-in-class solutions that cover current and emerging technology trends. The company continually looks to add to its portfolio of high-growth, cybersecurity and cloud-based enterprise networking vendors; the chart below shows vendors signed up since FY20.

As Westcon has developed its relationships with strategic vendors such as Palo Alto, F5 Networks and Check Point as well as signing up more ‘born-in-the-cloud’ vendors, such as CrowdStrike and Zscaler, it has grown faster than the Comstor part of the business. Assuming that Westcon continues to add vendors, we would expect this trend to continue.

Overall, based on the division’s focus and capability for delivering emerging technologies, subscription, cloud and recurring solutions, it has won 30 vendor and industry awards so far in FY23.

The way in which end-customers are adopting technology is changing, with software making up a greater proportion of overall technology spend, and subscription and cloud-based services replacing one-off purchases of hardware and software. Solutions combining hardware devices, software and subscriptions are more complex to design, deliver and deploy. Subscription services and support contracts require efficient lifecycle management to ensure that renewals and upsells happen at the right time and that there is sufficient focus on customer retention.

Management expects the proportion of software-related revenues and subscriptions to continue to increase significantly in the coming years with the digital transition and the ongoing shift to the cloud, having already increased from 31% in FY19 to 44% in H123.

A key part of the restructuring process that started in 2017 was a focus on stabilising and improving the processing of transactions after a difficult ERP implementation. Taking control of the process from order entry to cash collection helped the division provide faster fulfilment of orders and better customer service, generate fewer errors, and have better visibility over and ultimately reduce working capital. The new medium-term target for 90% of transactions to be digitally enabled builds on this work and extends further across the business, encompassing the sales process, the relationship with vendors and the interaction with channel partners.

The division is keen to ensure it can support its partners as they shift from selling on a one-off basis to an as-a-service basis and meet their end-customers’ requirements for opex- rather than capex-type purchasing. It is also working to automate as many processes as possible to help it reach its target of converting 35% of gross profit to adjusted EBITDA (from 24% in FY22).

For several years, Westcon has provided two platforms for partners to manage their relationship with the company: 1) PartnerView, a platform where partners can browse and order online; confirm pricing, availability and delivery; and manage quotes, renewals, order tracking and history; and 2) BlueSky, a platform to support partners delivering and selling cloud products and services. Over the last two years, it has developed a single platform, PartnerCentral, for partners to buy and manage hardware, software and services in one place. PartnerCentral is currently being piloted by c 90 partners in South Africa, New Zealand and the UK, and roll-out to other English-speaking partners is expected in April followed by translations into other key languages such as French and German.

The platform includes vendor partner portals, partner learning, a hybrid cart (which supports physical and as-a-service offerings in one transaction), application programming interface and electronic data interchange management tools, partner reporting and insights, and various dashboards.

The division has focused on digitally enabling its sales processes, using digital tools to automate as much as possible, to drive better efficiency and productivity. Management has embedded the Technology and Services Industry Association’s land, adopt, expand, renew model into its processes and is focused on making sales processes more data driven than intuition driven. As an example of automation, its 1View Quote and 1View Order Entry tools allow a partner to configure a quote and then push it to the vendor without any input from Westcon. RenewView is a renewal automation tool fed by data from vendors to help partners manage renewal cycles.

Over the last three years, Westcon has invested in people and tools to better manage and analyse data on its vendors, partners and the market in general. By analysing what partners are selling, it is possible to present sales opportunities to both vendors and partners.

As a group, Datatec is committed to developing and executing a global responsible business strategy that includes consideration of the group’s social and community development responsibilities (‘our communities’), environmental performance (‘our planet’) and commitment to its people (‘our people’). While the board has set group-level targets, here we discuss Westcon-specific activity. The division has formalised its ESG programme and joined the SBTi Business Ambition for 1.5°C campaign, committing to reducing its emissions by 90% to reach net zero emissions by 2050 at the latest.

In FY22, the division established its own CSR policy. Its goal is to improve education for the next generation and to support local charities in the communities in which they operate. Westcon supports a variety of corporate and employee-led charitable initiatives, providing time and resources to improve the communities where its employees live and work.

This division has c 3,500 employees, with 47% in Europe, 33% in Asia-Pacific, 18% in MEA and 2% in North America. Westcon training programmes help promote an inclusive workplace and ensure the health and safety of employees. Currently training is being provided to staff to help them understand the division’s ESG strategy and a Sustainability Employee Resource Group has been set up. Westcon’s ‘Level up’ programme is designed to enhance the ability of interns, graduates and apprentices to follow their chosen career path.

As a distributor, Westcon has limited control over the emissions generated by vendors and partners. However, it has committed to setting a net zero strategy across its entire value chain. Partners are increasingly asking for ESG data when seeking quotes, and Westcon is working with its vendors (which have varying levels of maturity regarding ESG strategies) to provide this information. It has established baseline scope 1, 2 and 3 emissions and developed a five-year roadmap towards decarbonisation.

Weston has undertaken an audit of its top vendors, giving each of them a rating, and is developing a Supplier Code of Conduct that ensures sustainability best practices across the supply chain. Working with those vendors, it is able to provide them with data on what they need to do to improve their ratings.

Westcon has selected EcoVadis as its ESG rating platform. EcoVadis assesses the business over four main areas: environment, labour and human rights, ethics and supply chain sustainability. In FY22, EcoVadis conducted an independent gap analysis and outlined recommendations for a multi-year improvement plan. Implementation is underway and Westcon Europe has since received an improved score and a bronze rating. Since then, the Asia-Pacific region has received a bronze rating and the division is working on certifying the MEA region.

Specific initiatives to reduce emissions include recycling (internally and for customers), improving energy efficiency of logistics centres, using renewable energy, electrifying the car fleet and implementing and certifying operations to ISO 14001 standard (done for Europe, ongoing for Asia-Pacific).

The division continues to benefit from the IT trends that became apparent in FY21, including:

Worldwide IT spending is projected to increase 2.4% to US$4.5tn in 2023, compared to a small decline of 0.2% in 2022 (source: Gartner, 18 January 2023), which was mainly due to supply chain issues for technology hardware. In 2023, software is forecast to be the highest growth area at 9.3%, helped by strong growth in the SaaS software market (per Statista, +14% in 2022 and +17% in 2023), followed by IT services at 5.5%.

Westcon expects to see higher growth from its focus on networking, cybersecurity and cloud infrastructure. The cybersecurity market is forecast to grow 11% to $173.5bn in 2023 and at a CAGR of 11% over CY22–27 (source: Statista). While the network infrastructure market overall is forecast to grow at a CAGR of 3.9% over CY22–27 (Statista), cloud-managed networking is expected to grow at a much faster rate (market researchers quote 20%+ rates). The cloud collaboration software market is expected to see more modest growth, after the exceptional boost to demand during COVID, with a CAGR of 5.4% forecast for CY22–27 (source: Statista).

As mentioned earlier, the ICT market is complex and highly fragmented, with companies fulfilling subtly different roles in the value chain by geography, product segment and client base. As a result, it can be difficult to identify competitors and directly comparable companies to Westcon International. However, in Exhibit 12, we identify a number of companies which Westcon’s management team consider to be direct competitors in specific local or regional markets, with positioning based on revenue and gross margin. A number of these are public companies (eg Arrow, Exclusive Networks, TD SYNNEX) and included in our valuation analysis, but many more are private companies, with many private equity-owned (Infinigate owned by Bridgepoint, Ingram owned by Platinum, Redington owned by Phoenix).

The company believes its competitive advantages include the ability to manage global deployments and international business, its evolving portfolio of technology solutions, and its Partner Success programme, which focuses on helping its partners to be successful.

Following its restructuring in 2017/18, Westcon has delivered consistent annual rises in gross profit and EBITDA. The charts below track the division’s performance since FY19. Reported and adjusted EBITDA margins have increased over this period, and in H123 the company reported an adjusted EBITDA margin of 4.0% compared to 0.9% in FY19. As this included unrealised FX gains, our FY23 adjusted EBITDA margin forecast is 3.0%, reflecting the unwind of the gains in H223.

Westcon generated strong revenue growth of 16% y-o-y in H123 (constant currency growth 23%). The business saw strong demand for cybersecurity and network infrastructure (up 22% and 16% respectively). Reflecting the currency impact of the strong US dollar versus sterling and the euro, gross profit declined 1% y-o-y resulting in a 1.7pp decline in gross margin to 9.5%. Foreign exchange hedging gains reported within operating expenses ($12.8m realised gains, $19.3m unrealised gains) meant that EBITDA increased 66% y-o-y, with the EBITDA margin increasing 1pp to 3.2%. Adjusted EBITDA (the main adjustment was for $12m in share-based payments) increased 84% y-o-y and the adjusted EBITDA margin increased by 1.5pp to 4.0%.

Semiconductor shortages and supply chain issues continued to constrain the division’s ability to deliver orders, resulting in another increase in the backlog (+95% y-o-y, +18% h-o-h) as per Exhibit 15. Software in the backlog tends to be part of a larger order that also includes hardware and cannot be installed until the hardware is available. Semiconductor availability has started improving and freight costs have fallen, and management believes that the backlog is likely to start to unwind through the course of H223. The division managed working capital well during the period (see Exhibit 16), with net working capital days reducing to 16 from 22 in H122 and divisional net debt reducing by $63m y-o-y. The main benefit came from suppliers, particularly Cisco, extending payment days. We expect that as the delivery of hardware by vendors speeds up, they will start to reduce the payment days offered to Westcon, but this is likely to be offset by Westcon not needing to hold as much inventory and being able to invoice for finished projects.

As discussed above, Westcon had a high level of backlog entering H223. As supply chain issues start to recede, we expect Westcon to be able to ship more hardware to customers, which in turn will enable related software and services to be delivered. We maintain our net revenue growth forecast of 12.9% for FY23, moderating to 5% in FY24 and FY25 to take into account the uncertain economic environment.

One of the company’s medium-term targets is to grow gross revenue to $6bn by FY27. The company generated gross revenue of $4bn in FY22, which would imply a target CAGR of 8.4% over FY23–27. If gross revenue grows at the same rate as net revenue in FY23, this would imply a CAGR of 7.4% for FY24–27 compared to our conservative 5% forecast for FY24 and FY25.

The division has also set the target to convert 35% of gross profit to adjusted EBITDA. In FY22, the conversion rate was 24% and we maintain our forecasts for it to increase to 32% in FY23, 30% in FY24 and 32% in FY25. Assuming that gross margins are not likely to rise above a normalised level of 10–11% (as vendors and partners are aware of this margin), this would imply adjusted EBITDA margins rising to 3.5–4.0%.

In August 2021, management engaged Lazard & Co as part of a strategic review to address the persistent gap between Datatec's valuation and the perceived value of its underlying assets. Under the strategic review, the board has been considering options including private equity participation, joint ventures, international listings, divisional asset unbundling and other value-creating structures. We quantified the size of the opportunity in our note, Strategic review to unlock embedded value, published on 31 August 2021. Since then, Datatec has sold Analysys Mason and returned the £135m proceeds to shareholders in the form of a special dividend in December 2022.

We have updated the valuation we undertook a year ago. We have principally drawn Westcon’s peer group from North America and Europe. For the current year, Westcon’s peers have average gross margins of 10.1%, with EBITDA margins of 4.4%, compared to our estimates for Westcon of 9.5% and 3.0% respectively. The peer group trades on average multiples of 0.4x FY1 and 0.3x FY2 sales and 8.3x FY1 and 8.1x FY2 EV/EBITDA. Applying these multiples to Westcon, factoring in Datatec’s 92% economic interest (8% is held by SYNNEX), indicates an enterprise valuation for Datatec’s interest of c US$1.07bn based on sales, or US$776m based on average EBITDA, our preferred multiple. The valuation has risen from $1.02bn and $630m respectively since we wrote about Westcon a year ago; while valuation multiples have come down, this is more than compensated for by higher revenue and EBITDA forecasts.

To put this valuation in context, Datatec’s enterprise value (based on the H123 net debt figure) is US$512m, well below the valuation for Westcon International, even before considering the worth of Logicalis.

Westcon’s management has delivered a strongly improving operational performance since 2018, despite the impact of the COVID-19 pandemic in FY21/22. Assuming that operating performance improvements continue, with EBITDA margins rising towards 4.0% in the medium term, Westcon represents an increasingly valuable asset within Datatec, whose value is not fully recognised by shareholders.

We expect Datatec’s peer group discount to narrow materially over time, but recognise that full closure of the discount to fair value may require further simplification of the group’s corporate structure. Management remains committed to unlocking this underlying value.