Datatec — Strategic review to unlock embedded value

The negative impact of the COVID-19 pandemic was relatively short-lived for the IT services sector. After the immediate transition to remote working, customers started to plan for longer-term digital transformation, with demand focused around public/hybrid cloud infrastructure, security, software-defined networking, cloud-based unified communications, remote collaboration tools and analytics.

Not only are end-users looking to accelerate the implementation of digital technologies, but they are also increasingly open to outsourcing the management of this infrastructure/application stack, driving greater annuity revenues and improving margins for service providers with the appropriate expertise. This factor appears to have principally benefited the scale players (ie those with a diversity of customers, a broad product range, strong vendor relationships and robust balance sheets), leaving smaller IT services companies at a competitive disadvantage.

With a diversified mix of businesses, a broad global presence and a strong balance sheet, Datatec has been well-placed to benefit from the recovery in global IT spending. Software and services (including annuity income) has continued to grow as a proportion of group sales (FY21: 47% of revenues) and, with management expecting many of the technology trends of FY21 to persist in FY22, the group retains its strategic focus on networking, security and cloud infrastructure.

After 2020, which could be characterised as a year of largely tactical IT investment in reaction to the COVID-19 pandemic, Gartner is projecting worldwide IT spending will total US$4.2tn in 2021, an increase of 8.6% from 2020, or 6.4% in constant currency terms (July 2021). Gartner is expecting companies to become more strategic in their digital transformation initiatives as the economy recovers, targeting investment in technologies with a clear business rationale.

Despite the COVID-19 pandemic continuing to cloud the horizon, particularly in emerging markets, Gartner projects IT spending to grow year-on-year in every region globally. Gartner’s growth projections also indicate continuing emerging market currency weakness relative to the dollar, with constant currency growth c 2.2% below nominal growth rates. As Datatec reports in dollars, any emerging market currency weakness will provide a marginal drag on its results.

Recognising the resilience of the industry’s performance, share prices across the IT services sector have risen strongly following the initial impact of the pandemic, with investors increasingly recognising the sector’s defensive growth prospects both during the pandemic and as it abates. The average share price of Logicalis’s and Westcon’s peer groups (Exhibits 1 and 2) has risen by c 30% since the start of 2021.

This strong trading across the sector has driven corporate activity, including:

Private equity has also been a visible buyer in the UK, with recent deals including:

Looking back at Datatec’s long-term track record, there is a history of management making strategic disposals that have delivered attractive shareholder returns. Firstly, in 2004, Logicalis Australia/New Zealand was sold to IBM for US$66m; then in 2017, Logicalis SMC Netherlands was sold to DXC for US$42m; and most recently, in 2017, Westcon Americas was sold to Synnex for US$644m (US$630m paid in cash on closing, together with a US$14m earnout), with Synnex also taking an initial 10% stake in Westcon International for US$30m. These final two transactions led to special dividends of ZAR24 (US$1.72) per share being paid to shareholders in 2018 and 2020, contributing materially to the group’s total shareholder returns.

Turning to Datatec, all three of its divisions can point to a track record of solid profitability with the group’s core focus on software and services in networking, security and cloud infrastructure expected to deliver strong growth as the global economy recovers.

Despite this, to date the group appears to have been overlooked by the market as peer multiples have recovered post-COVID-19. Datatec currently trades on 2.8x EV/EBITDA and 12.0x P/E in FY22e, while our peer group indicates that a blended multiple of 12.8x EV/EBITDA or 20.8x P/E in FY22e could be justified. Our firm belief is that Datatec’s low relative valuation is retrospective and does not reflect the positive transformation management has achieved, Datatec’s improved operational performance since 2018 (64% EBITDA CAGR FY18–21) or the group’s future growth prospects. This view is further underlined by a simple SOTP analysis (below), which highlights the group’s embedded value in a sector actively targeted by private equity.

The announcement of the strategic review confirms that management remains committed to unlocking this underlying value on behalf of shareholders.

Focusing on peer valuations, Datatec’s broad comparator universe has seen an uplift from the COVID-19 pandemic, enjoying further multiple expansion as investors have recognised the sector as a safe haven with defensive growth characteristics as fears over the pandemic start to abate. We look at each of Datatec’s three principal businesses separately.

Logicalis has an international peer group drawn principally from North America and Europe (Exhibit 1). These businesses have average FY1e gross margins of 22.4% and EBITDA margins of 8.1%, comparable to our FY22 estimates for Logicalis of 25.4% and 6.5% respectively. We avoid comparing sales multiples as these are complicated by differing policies internationally to recording revenues net or gross. The core peer group trades on a mean EBITDA multiple of 13.5x FY1e and 12.3x FY2e. Applying these multiples to Logicalis (working set out in Exhibit 4) leads to an enterprise value of c US$1.4bn. Allowing for minorities (principally a 35% share of Logicalis LatAm), we estimate that Datatec holds a weighted c 80% economic interest in Logicalis, implying a mid-range enterprise value of US$1.2bn. This compares to Datatec’s current group EV of US$462m.

As with Logicalis, Westcon’s peer group (Exhibit 2) is principally drawn from North America and Europe. The average gross margin for Westcon’s peers is 9.5%, with EBITDA margins of 3.4%, compared to our FY22 estimates for Westcon of 11.3% and 1.9% respectively. Setting aside sales multiples for the reasons stated under the Logicalis paragraph, the peer group averages 9.6x FY1e and 9.1x FY2e EV/EBITDA. Applying these multiples to Westcon International (working set out in Exhibit 4) would indicate an enterprise value of c US$600m. Factoring in Datatec’s 92% economic interest (8% is held by Synnex) indicates a valuation for Datatec’s interest of c US$550m.

Analysys Mason’s peer group (Exhibit 3) is weighted towards North America over Europe, as this is where the majority of consultancies are listed. The peers indicate average FY1e gross margins of 42.8% and EBITDA margins of 18.0%, compared to our FY22 estimates of 43.2% and 15.1% respectively. The peer group trades on a mean EV/sales multiples of 3.6x and 3.3x, and average EV/EBITDA multiples of 18.1x and 17.0x for FY1e and FY2e, respectively. Applying these multiples to Analysys Mason (set out in Exhibit 4) indicates an enterprise value of c US$210–280m, falling to a mid-range valuation of c US$210m once Datatec’s 82% economic interest is accounted for, with the remainder held by the consulting partnership.

Applying the mean EV/sales (where relevant) and EV/EBITDA multiples from each of the core comparator groups above, it appears that the current market valuation implies a significant discount to Datatec’s peers. We do not believe this level of discount is justified as, based on peer multiple analysis, a valuation for either Logicalis or Westcon alone would be worth more than the current entire group enterprise value.

By our calculation (Exhibit 4), having adjusted the three divisional valuations for minority interests, applying a nominal 10x EV/EBITDA multiple to group central costs (which we estimate at c US$15m for FY22 and FY23) and applying a subjective discount of 30% (to allow for sovereign risk, the conglomerate structure and other discount factors), the group SOTP valuation is still multiples of Datatec’s current share price.

If the group’s embedded value can be effectively unlocked, our SOTP analysis points to the potential for the group’s valuation to more than treble from current levels.

We recognise that there are a number of specific risk factors relevant to the equity story, including sovereign risk, emerging market exposure and currency risk, limited institutional investor liquidity, a lack of peers on the Johannesburg Stock Exchange, with direct peers listed in Europe or North America, high (but reducing) exposure to a single vendor (Cisco) and the conglomerate discount. We would also note that, although recovering, group EBITDA margins (Logicalis – 7%, Westcon – 2%, Analysys Mason – 15%) remain below their respective peer group averages for FY22.

However, we also recognise that management has delivered a strongly improving operational performance across all three business lines since 2018, despite the impact of the COVID-19 pandemic in FY21, delivering an EBITDA CAGR FY18–21 of 64% and 43% CAGR in EPS FY19–21. The group has a strong balance sheet with low net debt (FY21: US$61m), which has delivered strong cash generation and allowed management to restart dividends (FY21: 3.4% yield).

Although listed in Johannesburg, Datatec has negligible exposure to the South African market, with the equity story being a dollar-denominated global ICT play. Despite this, Datatec is valued at a substantial discount to its global peer group, currently trading on 2.8x EV/EBITDA and 12.0x P/E in FY22e. It also trades on a 64% discount to our SOTP valuation. Given Datatec’s historical performance and medium-term growth prospects, we do not believe that this valuation discount is fully warranted.

With management clearly positioning Datatec as an international investment story, and assuming a continued strong operating performance, we expect the peer group discount to narrow materially over time. However, we also 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.