Harsh verdict for AST
AST listed in 1998, and through aggressive acquisition became one of the largest systems integrators (SIs) in the country, with operations in South Africa, Namibia and Botswana, and some reach into the UK and Australia. The downturn showed the strategy to have been overly ambitious, however.The company cut back its workforce by ten percent to 3 600, and we expect to see significant trimming of its 27-branch, 60-location footprint in the next year. Through its acquisition of Iscor`s IT business in 1998, as well as other outsourcing contracts, it has established a capable technology infrastructure of some 14 mainframes, 100 Unix and over 3 000 Intel-based client platforms. Competitive disadvantageThe company`s offerings are structured into three divisions:* Solutions: concerned with the provision of business and IT consulting services and IT solutions – the last focused on large-scale projects;* Services: infrastructure provision and management, which has the characteristics of large long-term annuity contracts;* Business services: business process outsourcing, where AST focuses on human resource management and logistics support.While AST has the size and implementation capability to regain a position in the leadership quadrant of our Gartner-style chart (fig 1), the operational upheaval and impact of cash flow constraints make it a casualty at present.AST competes against the large, listed SIs, Didata and Comparex, as well as multi-nationals like EDS, CSC, IBM and T-Systems, and local unlisted parastatal Arivia.kom, all of which are under severe pressure to close deals in a tightening sector.It has some security in its existing customer base, but attracting new clients and business in its current stressed state will be more difficult than in the past.Additional medium-term challenges include the lack of an empowerment shareholder or partner and, given that it has a relatively strong market share, it will be less likely to gain further share and more likely to be exposed to the reduced growth characteristics of the general IT services market.Along with the other established SIs, AST will face increasing competitive pressure from smaller operators that do have the right empowerment credentials (like CS Holdings). Forecasts and assumptionsWe have taken a conservative view of the group`s future prospects, using the divisions` last reported depressed operating performance levels as a benchmark going forward. Tough market conditions and a stressed employee base provide good reason for this approach.Given AST`s size and market share, we believe the company will enter a period of growth more reflective of the growth predicted for the general market and increases in market share will become incrementally more difficult to achieve – other than for new business areas where growth will be off a relatively small base.In its latest (December 2002) interims, the group showed almost no revenue growth on the previous six months (-1.6 percent, in fact) and our overall revenue forecast to the end of the 2003 financial year is for zero growth. AST has seen continuing margin squeeze.Before interest, depreciation, tax and amortisation (EBIDTA), and excluding sales, general and administration (SG&A) and restructuring costs, its margins declined significantly – from 17.1 percent in 2002 to 11.1 percent at the most recent interims. We see these margins being maintained to the end of this financial year.We have modelled SG&A costs as twice the interim indirect costs disclosed of R65 million, plus a restructuring cost of R100 million, which allows another R25 million on the R75 million disclosed to date. This gives a total of R230 million for 2003. Going forward, we have modelled a cost of R160 million for 2004, given that further cost savings are said to have already been achieved, but that another R40 million in restructuring costs are expected. By 2005, we see the SG&A cost to sales ratio stabilising at five percent.Given our assumptions – that the group will maintain its current depressed operational margin performance, make annual savings at the SG&A level as indicated by management, pay high forecast interest cost and working capital requirements (given the current estimated 120 days, creditor assumptions are highly sensitive to cash flows and we have assumed a return to historic levels of 100 days) – we predict the group will continue to draw net operating cash for both 2003 and 2004.Plans are under way to re-capitalise the group and/or restructure debt, and the company believes operational cash flows will be better than our forecasts as a result of the rationalisation and business improvement processes being implemented.Vendor payments of about R45 million are still outstanding, R20 million of which can be settled by shares or in cash at AST`s election, due in September and during the next full year. The fully diluted number of shares in issue we used is based on the published amount for 2003 (which was calculated at a share price of 25 cents), and thereafter we have assumed a successful rights offer of R89 million at nine cents per share – implying massive dilution and hence an impact on the valuation of the per share price. Valuation counting downOur valuation is based on a “low road”, conservative outlook, allowing for little recovery of operational financial performance at this point. As such, it provides a low valuation of the group – even if we assume that a successful re-capitalisation or debt restructuring is achieved. We have considered both a discounted cash flow (DCF) analysis as well as a comparison based on price-earnings (P:E) ratio.The DCF valuation reflects a longer-term view than the P:E-relative method, and we have taken cash flow forecasts out to 2005, utilising a terminal cash flow growth of six percent to yield a sensitivity table (fig 2), for which we have selected a discount rate of 30 percent. We chose this rate to recognise the risk and liquidity constraints of the small cap sub-sector, as is common with private equity or venture capital valuations for this type of investment class.This yields a DCF value of five cents for the AST Group.In a more “normal” environment – or if we were analysing a larger cap stock – a more appropriate discount factor of the order of 20 percent could be applied. In this case, the resulting DCF value would be 17 cents, which represents the current price of the stock much more closely and perhaps indicates that the market is prepared to look through to a recovery of the company.In terms of a P:E-relative valuation, we compare each stock and re-rate it where relevant on a relative basis compared to the current average forward P:E rating of its peers. In so doing, we establish its implied forward P:E, from which we can calculate an implied price. The price difference between current and implied price then indicates current over/under valuation.Establishing a company`s ranking relative to its peers is based on determining its score against criteria we determine to be the characteristics of winning companies, and comparing this with its peers` scores.These characteristics include the following:* A strong competitive position (on, say, Porter`s Five Forces model);* Strong leadership;* Strong management;* Strong vision;* Ability to implement the vision, and a track record of achieving targets;* A cohesive and strong corporate culture;* A large and growing market;* Proprietary processes or product;* High margin products or services;* Recurring revenue; and* Replicability of sales and/or implementation. Very far down, too...With reference to the table on the next page, we believe it is appropriate to compare AST to similarly sized SI companies in South Africa. We have excluded Didata and Comparex from the calculation of the average P:Es below, but include them for comparison.We believe that given the challenges faced by the restructuring, the cash flow pressures, the competitive environment and the downturn in spending in AST`s markets, AST should trade at a discount of 20 percent to the average of its peers in the current market.Including the highly dilutive effects of the rights offer and the low forward earnings forecasts, the valuation returns an implied current price for AST of one cent.While a forward P:E valuation typically works well as a relative valuation technique for stocks, and is one of the most common methods, it tends to break down when a company`s forecast headline earnings are abnormally low, as is the case here. A more rigorous approach in this case would be to consider for example a two-year P:E and then discount that back to today – but this is then fraught with the difficulties of forecasting a turnaround situation years into the future, which is more in the realms of a “what-if” analysis. This is equally a criticism of the DCF valuation in this case. Recommendation: avoidGenerally feared by the market for some time now, AST has shown itself not impervious to the slowing down in market demand. Concerns surrounding dubious and/or aggressive acquisitions and investments, revenue recognition and longer-term project profitability appear to have some substance, being demonstrated in the deteriorating debt position.Given the current and medium term poor performance and high-risk outlook, current valuation is harsh. Higher value potentially lies in the share if or when the company turns around, which opinion, as well as a number of acquisition discussions, may be supporting the current relatively high share price.With significant restructuring and profitability turnaround challenges ahead, and our relative valuation pointing to an overvaluation even at these levels, we would avoid the share until demonstration of operational turnaround and sustainability and the nature and effects of a re-capitalisation are known.Brian Rainier, a former rated analyst, is MD of Brainier Capital & Consulting, which provides detailed stock market research in a joint venture with Legae Securities. This analysis is subject to the disclaimer which can be found at http://brainstorm.itweb.co.za/
31 July 2003
AST listed in 1998, and through aggressive acquisition became one of the largest systems integrators (SIs) in the country, with operations in South Africa, Namibia and Botswana, and some reach into the UK and Australia. The downturn showed the strategy to have been overly ambitious, however.
The company cut back its workforce by ten percent to 3 600, and we expect to see significant trimming of its 27-branch, 60-location footprint in the next year. Through its acquisition of Iscor`s IT business in 1998, as well as other outsourcing contracts, it has established a capable technology infrastructure of some 14 mainframes, 100 Unix and over 3 000 Intel-based client platforms.
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