Is there life left out there?
In the past year, market conditions have remained tough for practically all South Africa`s listed IT companies. With demand for all but necessary infrastructure upgrading remaining subdued, factors contributing to the continued postponement of a recovery – as well as potentially weaker earnings forecasts – have included the strong performance of the rand for foreign currency generators.Sentiment has also been negatively affected by the poor operating performance of the large capitalisation IT stocks, as well as some close corporate failures and/or expensive recapitalisations amongst the small cap companies, including, most notably, AST, MGX, Glotec and Prism. Profit warnings from previously solid performers such as Paracon and CS Holdings have further dented confidence.However, as we have been saying for some time now, some of the smaller, more flexible local niche players still have opportunities to grow their market share and take opportunities in consolidating even smaller players to supplement their own growth (eg Datacentrix, CSH, ERP and EOH). We are also beginning to see pleasing proof of promised turnarounds across the sector (eg BTG, Idion, FrontRange and Spescom).By defining the sector in terms of systems integrators (SIs) and software suppliers, and the strategic versus operational characteristics of the companies therein, we can present our modified Gartner Group Magic Quadrants:In Figure 1, we have included a section labelled Casualty to indicate those companies facing a challenge in terms of profitability, turnaround or cash constraint which might have an impact on their future ability to execute. In this section we see Faritec, which showed an operating loss at interims; AST, which is facing severe cash flow constraints, and MGX, which is still in the throes of severe restructuring.BTG appears to have moved from Casualty to demonstrating its renewed ability to implement. ERP and EOH are highly competent niche players whose only limitation in terms of implementation ability is their relatively small size with respect to the overall SI market. We see CSH slipping from the Challenger quadrant as we sense its ability to execute potentially being limited by anticipated cash flow constraints, given a recent trading update in which it indicated significant sales pipeline slippage.Datacentrix is a strong Challenger that has embarked on a strategy of diversifying its overall product and service offering in a desire to move into the Leader quadrant. Paracon is seen as a highly competent niche player that appears to have shrunk its aspirations to play more broadly in the SI space (which is perhaps wise at this point in time).In terms of the software providers, we present a slightly different picture, having seen many of them emerge from restructuring following heavy writedowns and losses, but with relatively uncertain markets, not entirely assured of being the strong cash generators they (should) have been in the past.Glotec`s recent results indicate serious Casualty and we await news of the operation and whether they will survive with all necessary organs in good functional order. We see Spescom and Prism having demonstrated signs of a turnaround and await confirmation of this in the next results.The balance of the software players appear to have successfully restructured, and should show strong growth potential if market demand for their products improves.In terms of our valuation assumptions, we forecast rand depreciation of 10 percent per annum from January 2003 for the US, Canadian and Australian dollars, as well as the British pound. We then interpolate the average yearly appreciation/depreciation for the relevant company year-end.By and large, we have not given the benefit of the doubt of a recovery in operating margins to a company in future forecasts and have generally pegged these at the latest demonstrated performance level – unless the company can clearly demonstrate to us why the margin should improve (and not just because higher levels were achieved historically).We use two valuation methodologies: a PE relative valuation and a discounted cash flow (DCF) method to determine potential price over or under valuation and we plot this against a measure of earnings risk to determine classes of investment recommendation.We have used a 30 percent discount rate for our DCF calculation to recognise the risk and liquidity constraints of this small cap sub-sector, which we currently see in the realms of a private equity/venture capital valuation methodology, which typically uses a similar minimum internal rate of return for this type of investment class.Having made some fairly significant changes to individual company forecasts to reflect both the continued strong position of the rand, as well as weak market prospects, we calculate that the sector continues to trade at a relatively low forward PE of 4.2.The difference between the sector-implied DCF forward PE, which is at 5.4, and the earnings-based forward PE indicates a potential sector price appreciation (to value) of some 21 percent. Both measures are generally not demanding in a normal market but continue to reflect the risk and uncertainty with respect to sector earnings. Whilst we believe the sector earnings growth forecasts, coming off a largely re-based lower level, are reasonably achievable, market and currency uncertainty erodes this confidence, hence the skewing of our recommendations to high risk speculative calls.In relative value terms, we see some of the companies significantly undervalued relative to their peers (particularly in the case of the [international] software players) and, after adjusting to fair value, we see a potential sector PE re-rating from 4.2 to 4.4, which implies a price appreciation of four percent compared to the current level.In terms of Figures 3 and 4, the relative valuation can be used for an indication of re-rating potential today, whilst the DCF valuation indicates the value level towards which prices could move, given a return to positive sentiment within the sector. Alternatively, these valuations should provide good guidance for the longer-term investor.Our recommendations are based on a combination of the current relative valuation (implied PE price), the DCF value and the relative earnings risk. In general, where our model indicates that a company is overvalued relative to its peers today by more than 10 percent, and where there is no appreciation to the DCF valuation, the stock is a “sell”. Where the relative valuation is in the –10 percent to +10 percent band, and there is appreciation to the DCF valuation, the stock is generally a “hold”. Where the relative valuation is greater than 10 percent and there is appreciation to the DCF valuation, the stock is generally a “buy”. We consequently see three main investment bands: Speculative (buy)This category includes mainly software companies (Prism, FrontRange, Glotec, CS Holdings and Spescom) that have the potential for significant turnaround in earnings and which are also currently undervalued relative to their peers, many of which face similar challenges. They are speculative in that we believe the companies have yet to demonstrate sustainable turnarounds and an improving margin; this within market conditions which currently give very limited support to revenue growth. Undervalued (buy)The companies rated as buys are UCS, Datacentrix, Softline, Mustek, Paracon, ERP.com and EOH, all of which have moderate risk attached to their earnings projections. Overvalued (sell)Idion, BTG and Faritec are currently overvalued according to our models, particularly with respect to their peer group. AST is still in the throes of severe restructuring and a cash crunch. We see high risk and would AVOID.A note on termsA forward PE (price earnings) ratio is the ratio of the current share price to the 12-month forward (extrapolated) analyst earnings forecast. The DCF (discounted cash flow) valuation is the discounted value of the forecast free cash flows of the operation (typically two to three years out) with a terminal growth rate assumed at the end of period of six percent in perpetuity. Brainier Capital & Consulting disclaimerThis publication has been prepared by Brainier Capital & Consulting Pty (Ltd) ("Brainier") (P O Box 402 River Club 2149, 5 Roan Close River Club, Johannesburg, South Africa) for information purposes only. It is not an offer or solicitation for the purchase or sale of any financial instrument.All reasonable care has been taken to ensure that the information contained herein is not untrue or misleading, but no representation is made as to its accuracy or completeness, no reliance should be placed on it and no liability is accepted for any loss arising from reliance on it. Brainier, its affiliates and any of its or their officers may be interested in any transactions, securities or commodities referred to herein. Brainier, or its affiliates, may perform services, for, or solicit business from, any company referred to herein. Copyright and database rights protection exists in this publication. Any investments referred to herein may involve significant risk, are not necessarily available in all jurisdictions, may be illiquid and may not be suitable for all investors. The value of, or income from, any investments referred to herein may fluctuate and/or be affected by changes in exchange rates. Past performance is not indicative of future results.Investors are expected to make their own investment decisions without relying on this publication. Only investors with sufficient knowledge and experience in financial and business matters to evaluate the relevant merits and risks should consider an investment in any issuer or market discussed herein.
01 July 2003
In the past year, market conditions have remained tough for practically all South Africa`s listed IT companies. With demand for all but necessary infrastructure upgrading remaining subdued, factors contributing to the continued postponement of a recovery – as well as potentially weaker earnings forecasts – have included the strong performance of the rand for foreign currency generators.
Sentiment has also been negatively affected by the poor operating performance of the large capitalisation IT stocks, as well as some close corporate failures and/or expensive recapitalisations amongst the small cap companies, including, most notably, AST, MGX, Glotec and Prism. Profit warnings from previously solid performers such as Paracon and CS Holdings have further dented confidence.
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