Datatec — Westcon is key to unlocking upside potential

Datatec operates through three divisions: Westcon International (Westcon), providing specialist technology distribution through two principal brands, Westcon and Comstor; Logicalis, providing IT services; and Analysys Mason, which provides management consultancy and research.

We do not believe that Datatec’s group value fully captures the sum of its parts. Reflecting this same belief, in August 2021, management announced that Lazard & Co had been engaged 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,

In H122, Westcon delivered 62% of group gross revenues and 37% of group EBITDA, with EBITDA margins of 2.2% at Westcon versus 5.7% for Logicalis and 16.3% at Analysys Mason.

Following its restructuring in 2017/18, Westcon has delivered consistent annual rises in gross profit and EBITDA (Exhibit 9) but is only now starting to deliver on its full potential. We have therefore decided to focus this pre-close update on Westcon International, to record the progress the business has made over the last few years and outline its potential for continued recovery.

Management’s ambition is for Westcon to be the leading technology provider, delivering channel enablement and services for software subscription and cloud delivered value-added solutions for networking and cybersecurity vendors across Europe, the Middle East, Africa and Asia-Pacific.

Westcon is Datatec’s specialist technology distributor with over 3,000 employees, spread across 50 countries worldwide, with 18 logistics and staging facilities globally. The division works with more than 11,000 channel partners, including a portfolio of market-leading vendors, such as Cisco, Palo Alto Networks, Check Point, F5, Broadcom, Zscaler, Crowdstrike, Avaya, Extreme Networks, Juniper and AWS. The business distributes technology solutions across cybersecurity, network infrastructure, unified communications, data centre solutions and channel support services.

The division markets itself under two brands, Comstor (for Cisco solutions) and Westcon (for other vendors).

The global IT market is large (Gartner estimates IT spending at US$4.5tn in 2022) 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 or system integrators in the provision of software, subscription, cloud and hardware solutions.

As a specialist technology provider, Westcon supports the largest enterprise channel clients, as well as regional and national partners, systems integrators, service providers and resellers. However, Westcon does not directly serve the end-user of the technology, but almost exclusively serves another intermediary in the value chain (Exhibit 8).

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 is 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 (H122: 2.2%) and expected to rise to 3.0% in the medium term as management attempts to establish Westcon as a leading technology provider in its markets.

Datatec’s H122 group revenue rose 15% (against a weak comparator) to US$2.26bn, with EBITDA up 24% to US$75m and underlying EPS surging 113% to 8.3 US cents. Group net debt rose to US$152.5m since the business absorbs cash as it grows, and with elevated inventory levels.

Despite supply chain constraints, in H122 Westcon’s revenue increased by 12% to US$1.4bn (H121: US$1.2bn), reflecting strong demand for networked cloud computing, remote access solutions for virtual office environments, unified collaboration and enhanced network cybersecurity. Gross margins increased to 11.1% (H121: 10.8%) driving gross profit up 16% to US$155m (H121: US$134m). EBITDA increased by 61% to US$31.0m (H121: US$19.2m), as margins rose to 2.2% in H122 versus 1.9% in H121 with improving operating leverage.

Following its restructuring in 2017/18, including the disposal of Westcon Americas to SYNNEX in September 2017, management has focused consistently on improving Westcon International’s profitability through revenue growth and margin expansion, coupled with a restructuring to reduce costs and transforming the business model, as well as tight cost control.

Westcon’s backlog rose significantly in H122 as semiconductor shortages and supply chain constraints meant that Westcon was unable to satisfy digitisation-driven demand for new technologies to enable increased cloud usage. Given these issues remain ongoing, the backlog is expected to increase in H222. We expect to see further progress from Westcon in FY23, with continued organic growth supported by the unwinding of the backlog and margin expansion by effective cost management, as well as the continuing growth of software and SaaS revenues.

Although it is listed in Johannesburg, the Datatec group has negligible 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 (25% of H122 revenues) and the Middle East and Africa (notably South Africa) at 13% of H122 revenues. However, the weight of both revenues and gross profit lies in Europe (62% of H122 revenues), with its principal territories including Germany, the UK and the Netherlands.

Although Westcon is an independent supplier serving a range of vendors, its key relationships remain concentrated. Cisco, with a relationship going back more than 20 years, accounted for c 42% of H122 group revenues (Exhibit 12).

Westcon International’s business unit 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 180 countries in 17 languages). Comstor consistently delivers higher growth rates than Cisco’s general distribution, due to its technical expertise and investments in systemic integration with Cisco, as well as commercial process automation with channel partners.

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. Through its focus on the vendors’ core solutions and emerging subscription and cloud technologies, H122 sales growth rates within Westcon for Palo Alto Networks, Check Point, F5, Extreme Networks, & Juniper Networks actually exceeded those achieved by the vendors themselves. As a result, these vendors recognise Westcon as “Best Distributor” in a number of operating markets.

In H122, Westcon concluded contracts with a number of the fastest growing and most highly acclaimed cyber security vendors (Gartner Magic Quadrant reviews), including Crowdstrike, Zscaler, Menlo and Splunk.

Overall, based on the division’s focus and capability for delivering emerging technologies, subscription, cloud and re-occurring solutions, both Comstor and Westcon were nominated for more than 30 awards in CY21.

Management acknowledges the division’s concentration on Cisco and is actively looking to expand its non-Cisco business faster than its Cisco sales. This will be achieved by further developing relationships with Westcon’s strategic vendors such as Palo Alto, F5 Networks and Check Point as well as more ‘born-in-the-cloud’ vendors, such as Crowdstrike and Zscaler.

Re-occurring revenues reflect the increasing penetration of software & services and SaaS revenues (H122: 43% of Westcon revenues versus 40% in H121). Management expects the proportion of software-related revenues and subscriptions to continue to increase significantly in the coming years with the digital transition.

The IT trends that became apparent in FY21 (digitalisation trends driving networking, cybersecurity and cloud infrastructure), delivering strong growth globally, look set to continue through FY22 and into FY23.

Gartner forecasts the continued growth of cloud software, with cloud spending to be double that of on-premise IT spending by 2025. This trend is expected to drive 11% growth in the enterprise software segment in 2022 and 12% in 2023, as businesses focus on upgrading their software stack to deploy SaaS solutions more widely. Gartner forecasts that global IT services will be the second fastest-growing segment, with 7.9% growth in 2022 and 8.8% in 2023.

Worldwide IT spending is projected to total US$4.5tn in 2022, an increase of 5.1% from 2021. (Gartner, 18 January 2022), with companies finally in a position to move beyond the critical, short-term projects that have characterised the past two years, to focus on longer-term strategic investment. However, beneficially for Westcon, staff skills gaps and the battle for talent are likely to lead to companies having to rely on distributors and technology providers to deliver many of these projects. As a result, spending on the IT services segment is expected to grow 8% y-o-y in 2022, with spending on business and technology consulting expected to grow by 10% in 2022.

Westcon expects to see higher growth from its focus on networking, cybersecurity and cloud infrastructure. Market research shows that cybersecurity segments are expected to deliver strong growth over the medium-term: firewall, 15% CAGR to 2026 (Research and Markets); end-point defence, 25% CAGR to 2028 (Fortune Business Insights); and Secure Access Service Edge (SASE), 36% CAGR to 2028 (Research and Markets). Meanwhile, management estimates that unified communications as a service (UCaaS) is growing at 13-30% depending on the market and segment, with cloud managed networking growing by c 18%.

As a proxy for Westcon’s market growth, Cisco, Palo Alto and Check Point together account for over half of Westcon revenues. Check Point points towards c 6% revenue growth (below), with Cisco seeing double-digit revenue growth outside the Americas and Palo Alto continuing its phenomenal growth of around 30%. Taken together with the fact that Westcon is outgrowing the market and gaining market share, we estimate low double-digit growth for Westcon in FY23 and FY24.

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 15, we identify a number of companies which Westcon’s management team consider to be direct competitors in specific local or regional markets. 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, Nuvias owned by Rigby, Ingram owned by Platinum, Redington owned by Phoenix, Tarsus owned by Charterhous and Spark owned by KKR).

In H122, supply chain issues led to inventory build-up and significant backlog growth across Westcon. We expect to see similar dynamics in H222 and into FY23, implying a continued strong performance across both Comstor and Westcon operations. This will be driven by ongoing demand for software and services in networking, security and cloud infrastructure, held back, at least initially, by supply chain constraints limiting Westcon’s capacity to satisfy this demand.

We envisage that the semiconductor supply chain issues will persist throughout 2022, with inventory build-up and backlog growth only starting to unwind in late CY22 and early CY23. This picture should then support Westcon in the medium term, with the backlog reducing steadily in FY23 and FY24.

Although listed in Johannesburg, the Datatec group has negligible exposure to the South African market, with the equity story being a dollar-denominated global ICT play. Management is clearly positioning Datatec as an international investment story.

As a valuation snapshot, we have principally drawn Westcon’s peer group from North America and Europe. Westcon’s peers have average gross margins of 10.2%, with EBITDA margins of 4.2%, compared to our estimates for Westcon of 11.3% and 2.2% respectively. The peer group trades on average multiples of 0.4x FY1/FY2 sales and 9.5x FY1 and 8.9x FY2 EV/EBITDA. Applying these multiples to Westcon, factoring in Datatec’s 92% economic interest (8% is held by SYNNEX), indicates a valuation for Datatec’s interest of c US$1bn based on sales, or US$630m based on average EBITDA, our preferred multiple. The valuation has risen fractionally since our valuation note in August 2021, due to a rise in sector multiples.

To put this valuation in context, Datatec’s enterprise value (based on the H122 net cash figure) is US$685m, comparable to the valuation for Westcon International, even before considering the worth of Logicalis and Analysys Mason, collectively worth an incremental US$1bn+, as set out in Strategic review to unlock embedded value.

Westcon’s management has delivered a strongly improving operational performance at Westcon since 2018, despite the impact of the COVID-19 pandemic in FY21/22. Assuming that operating performance improvements continue, with EBITDA margins rising towards 3.0% 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.