Realignment Towards Cloud And Security Solutions Will Sustain Future Profitability

Key Takeaways

• Growth in recurring business and focus on cybersecurity is driving higher revenue and margin potential.
  
• Strategic shifts, including cloud solutions and automation, aim to protect profitability and improve operational efficiency amidst changing vendor dynamics.
  
• Declining infrastructure sales, competitive pressures, reclassification of revenues, wage inflation, and Microsoft changes threaten Data#3's margins and profitability.

Catalysts

Engages in the provision of information technology (IT) solutions and services in Australia, Fiji, and the Pacific Islands.

• Data#3 is seeing strong growth in recurring business, with Managed and Maintenance Services and Software Solutions experiencing gains of 28%, 38%, and 11% respectively, indicating a future boost in revenue driven by customer shifts toward Subscription-as-a-Service offerings.
  
• The company's focus on security solutions and onboarding more customers into its security operations center highlights an increasing priority on cybersecurity, likely leading to higher margin revenues as security becomes increasingly essential for customers.
  
• Data#3's strategy to mitigate the financial impact of Microsoft incentive changes by realigning towards Cloud Solution Provider, Copilot, security solutions, and Azure cloud migrations could maintain software profitability and protect net margins.
  
• The anticipated rebound in Infrastructure Solutions and pent-up demand for AI-enabled devices ahead of the Windows 10 support end in 2025 suggests a potential surge in future product gross sales and a positive influence on overall gross profit margins.
  
• Internal investments in automation and digital platforms for handling higher transaction volumes point to improved operational efficiency, which could lead to better cost management and enhanced net margins.

Data#3 Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Data#3's revenue will grow by 67.3% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 5.5% today to 1.7% in 3 years time.
• Analysts expect earnings to reach A$62.5 million (and earnings per share of A$0.4) by about April 2028, up from A$44.2 million today.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 25.7x on those 2028 earnings, up from 24.8x today. This future PE is lower than the current PE for the AU IT industry at 34.9x.
• Analysts expect the number of shares outstanding to grow by 0.12% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.72%, as per the Simply Wall St company report.

Data#3 Future Earnings Per Share Growth

Risks

• The Infrastructure Solutions business experienced a decline due to delayed customer decisions and the impact of the Queensland state election, which could lead to pressure on sales and margins in the future. (Revenue and margins)
  
• Competitive maintenance services deals at lower margins than other services impacted overall gross margins, potentially affecting profitability if competitive pressures continue. (Net margins)
  
• The reclassification of software licensing and maintenance support revenues led to a decline in statutory revenue, which could complicate financial performance assessment for investors. (Revenue)
  
• Wage inflation and increased spending on internal technology projects may pressure cost management and affect the company’s ability to maintain profitability. (Net margins and earnings)
  
• Changes in Microsoft's channel incentives could impact gross profit if mitigation strategies fail, despite efforts to reposition resources to align with more incentivized areas. (Earnings and margins)

Valuation

• The analysts have a consensus price target of A$8.275 for Data#3 based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of A$9.75, and the most bearish reporting a price target of just A$6.75.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be A$3.7 billion, earnings will come to A$62.5 million, and it would be trading on a PE ratio of 25.7x, assuming you use a discount rate of 7.7%.
• Given the current share price of A$7.07, the analyst price target of A$8.28 is 14.6% higher.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.