Datatec — Robust underlying performance across the board

Datatec delivered a strong operational performance across all divisions in FY21, despite the onset of the COVID-19 pandemic coinciding with the start of its financial year. The group delivered revenues of US$4.1bn, down 2.5% (a 0.7% fall in constant currency terms), with EBITDA of US$119m (2.9% margin), down 25% y-o-y. Excluding restructuring costs, adjusted EBITDA fell 11% yoy to US$141.0m (FY20: US$158.7m), with the FY20 comparator benefiting from a US$14m tax credit. The FY21 adjusted EBITDA margin was 3.4% (FY20: 3.8%). Nevertheless, through improved working capital management delivering strong operational cash flow, net debt fell from US$139.9m to US$60.9m. Underlying EPS (uEPS) was up 37% to US$0.136 per share (principally reflecting the reversing out of the restructuring costs of US$22.4m and the US$8.6m amortisation of acquired intangibles) and the group announced a ZAR1 dividend (c 7USc), offering a 3.4% yield.

The FY20 results were flattered by a multi-year Brazilian tax credit, together with accrued interest (c US$21.5m), with the FY21 results including COVID-19-related one-off restructuring costs (c US$22.4m) as well as foreign exchange losses of US$7.9m (FY20: US$1.7m) from emerging markets including Brazil, Argentina, Chile, Mexico, Indonesia and South Africa. FY20 revenues were restated, leading to a US$90.4m fall in FY20 revenues as the group recorded an increased proportion of revenues net rather than gross, with no impact on the P&L at gross profit or below.

Due to losses arising in Westcon’s Asian and South African operations (with no deferred tax assets) and in the UK, where deferred tax assets are only partially recognised at a low rate of tax credit, the FY21 effective tax rate was 77.4%, with tax of US$19.5m payable on PBT of US$25.2m. With an estimated tax loss carry forward of US$240.5m (a future tax benefit of c US$52.6m), management expects a significantly lower effective tax rate from FY22, as profits build at Westcon.

All told, the FY21 results highlight a resilient performance from Datatec. All three divisions (Westcon, Logicalis and Analysys Mason) were materially profitable, benefiting particularly from regional strength in Europe, in what remains an uncertain global environment.

With new auditors in place, FY20 revenues were restated to better reflect whether Datatec acted as agent (revenues to be reported net) or principal (revenues to be reported gross) in delivering different services, reflecting the increasing penetration of software & services and SaaS revenues (FY21: 47% of group revenues, versus 40% in FY20) across the group. FY21 annuity revenues represented c 10% of group revenues, rising to c 20% when contractual recurring revenues are included. The proportion of software-related revenues are expected to continue to increase in coming years, representing the majority of revenues in the medium term.

Underlying the restatement, there has been an element of judgment in determining whether or not Datatec acts as an agent or principal in the way it delivers certain services. Management concluded that where the software service is delivered entirely remotely by the vendor, or where there is no material ‘on-premise’ component, management will consider Datatec to be acting as agent and accordingly recognise revenue on a net basis. This change in recognition led to a US$90.4m fall in FY20 revenues (US$4.30bn previously, US$4.21bn restated), fully offset by a matching reduction in cost of sales, meaning that there is no change to the P&L for gross profit or below. However, as a result of the dip in revenues, FY20 gross profit margin rose by 0.4% to 17.6% (restated) compared to 16.8% in FY21.

As recognised by the revenue restatement, there has been a meaningful structural change in the business, with the acceleration in digitisation brought on by the COVID-19 pandemic driving increasing demand for software and services, and reducing the proportion of revenues from hardware reselling. Management’s vision is for Datatec to be a global leader in higher-margin, speciality ICT solutions, with the group seeing particular demand for software & services in networking, security and cloud infrastructure.

Logicalis benefited from the accelerated migration to cloud-based infrastructure, with software, annuity and professional services (together 55% of Logicalis’s FY21 revenues), overtaking hardware revenues (45% of FY21 revenues). Revenue fell by 14% to US$1.4bn (FY20: US$1.7bn), an 8% fall in constant currency terms. Logicalis recorded EBITDA of US$81.9m (FY20: US$123.9m), while adjusted EBITDA was US$96.1m, a margin of 6.6% (FY20: 7.4%).

Westcon revenues rose by 5% to US$2.6bn (FY20: US$2.5bn), with constant currency revenue growth of 3.5%. EBITDA was US$44.8m, with a margin of 1.7% (FY20: US$40.0m, 1.6%). FY21 saw Westcon start to benefit from its multi-year investment in the modernisation of its service platform, systems and organisation. This helped the division deliver an increasing proportion of services from next-generation vendors, including Palo Alto Networks, Check Point, F5, Extreme Networks, Avaya, Broadcom and Juniper. Westcon is continuing to build its portfolio of category-leading security vendors, to enable it to offer full market coverage in this high-growth area.

Analysys Mason had a record year in FY21, with revenue of US$73.2m (FY20: US$58.7m), while EBITDA increased to US$10.2m (FY20: US$9.4m), with EBITDA margins falling to 13.9% from 16.0% in FY20. Although Analysys Mason is the smallest division, it remains important to the group. Management’s target is to grow revenues to US$100m over the next three years, with geographical expansion in North America and Asia-Pacific likely options.

Europe was the strongest region for the group in FY21, with Latin America the most challenged region. Both Logicalis and Westcon delivered higher revenues in Europe, with Westcon also seeing higher revenues in Asia-Pacific. The decrease in revenues elsewhere was attributable to the difficult trading conditions caused by the COVID-19 pandemic. Emerging markets such as Brazil, Argentina, Chile, Mexico, Indonesia and South Africa were affected by local currency weakness in FY21, which reduced their dollar-reported contribution to the results.

Looking ahead, although the COVID-19 pandemic continues to cloud the horizon, particularly in emerging markets, management expects the technology trends of FY21 to continue in FY22. Software and services are expected to grow as a proportion of sales, with the group continuing to focus on networking, security and cloud infrastructure. As a potential concern, we would note the global semiconductor shortage continues to have an impact on the entire technology value chain.

However, Datatec has a diversified mix of businesses, with a broad global presence, making it well-placed for a recovery. With FY21 net debt of US$60.9m, the group has a strong balance sheet to support growth and the increasing penetration of software and sales (FY21: 47% of revenues) means that the business is becoming less asset intensive and has made structural working capital improvements. That having been said, although Westcon benefits from significant operating leverage, as it grows it has an increased need for working capital that will reduce cash generation in FY22 over FY21. Project work slowed materially in FY21 as a result of lockdowns and travel restrictions, but we expect a degree of catch-up of major projects in FY22.

We have made some small changes to our FY22 and FY23 estimates following Datatec’s FY21 results, although the changes primarily reflect a slightly lower starting point in FY21 than we had previously assumed. However, notably we expect a 45% tax rate in FY22 (FY21: 77% effective rate), falling to 40% in FY23. We also assume that management revert to its policy of 3x uEPS dividend cover in FY22 and FY23 from 2x in FY21. Finally, with the anticipated growth of Westcon in particular, we conservatively assume weaker operating cash flow leading to increasing net debt in FY22 and FY23, of US$84m and US$113m respectively.

All three of Datatec’s divisions can now point to a track record of solid profitability. Despite this, the group currently trades on 3.0x FY22e EV/EBITDA and 12.9x FY22e P/E, reflecting its historical challenges rather than the current opportunity for sustained growth across all three divisions. Our belief is that this valuation is backward-looking and does not reflect the positive transformation of the business, its improved operational performance or its future growth prospects as the global economy recovers. This view is supported by the simple sum-of-the-parts analysis we highlighted in our initiation (Starting to unlock underlying value) as well as by comparison with peer multiples, where a blended multiple of 9x FY22 EV/EBITDA or 15x FY22 P/E would appear justified.

Although COVID-19 lowered Datatec’s trajectory in FY21, its core focus on software & services in networking, security and cloud infrastructure looks set to support growth for some time to come. Management remains focused on unlocking Datatec’s underlying value.