Recurring Software And Services Shift Will Support AI Driven Earnings Expansion

Catalysts

About Datatec

Datatec is a global technology group that delivers networking, cybersecurity, cloud and managed services solutions through its Westcon and Logicalis divisions.

What are the underlying business or industry changes driving this perspective?

• The structural shift in Datatec’s mix toward over 70 percent software and services, most of it recurring, is deepening revenue visibility. This trend should support continued gross margin expansion and higher gross profit to EBITDA conversion ratios, lifting earnings growth.
• Rising demand for cybersecurity in an intensifying threat environment, with this category now driving more than half of Westcon’s total sales and growing at mid-teens rates, is likely to sustain high single to double digit gross profit growth and support resilient group margins.
• The multiyear move by enterprises toward managed services and OpEx consumption models, reflected in Logicalis International’s recurring revenue above 60 percent and managed services growth of around the high teens, should underpin steadier top line growth and structurally higher EBITDA margins.
• The emerging AI driven upgrade cycle in networking, distributed data centers and enterprise computing, visible in renewed hardware demand alongside software and services, positions Datatec to capture increased project volumes and higher gross invoiced income. This should support long term revenue and earnings expansion.
• Ongoing improvements in working capital efficiency and the transition away from inventory heavy hardware toward software are reducing net debt and strengthening cash generation. This can enhance free cash flow, support dividend growth and potentially fund earnings accretive bolt on acquisitions.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Datatec's revenue will grow by 3.8% annually over the next 3 years.
• Analysts assume that profit margins will increase from 2.3% today to 3.5% in 3 years time.
• Analysts expect earnings to reach $142.8 million (and earnings per share of $0.57) by about December 2028, up from $83.5 million today.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 14.8x on those 2028 earnings, up from 13.3x today. This future PE is greater than the current PE for the GB Electronic industry at 13.1x.
• Analysts expect the number of shares outstanding to decline by 1.71% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 22.53%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The AI led upgrade cycle in networking, distributed data centers and enterprise computing could remain robust for several years, sustaining high single to double digit growth in cybersecurity, cloud and managed services. This would likely drive gross profit and earnings well above current levels and support a higher share price through expanding valuation multiples and dividend capacity, lifting revenue and net margins.
• The structural shift to over 70 percent of gross invoiced income from software and services, most of it recurring, together with management’s focus on gross profit to EBITDA conversion in the low to mid 30s, could keep operating leverage high and produce compounding growth in EBITDA and earnings per share. This may cause the market to re rate the stock upward as earnings quality and predictability improve.
• Continued improvement in working capital efficiency, structurally lower inventory and reduced net debt, alongside strong operating cash generation in all divisions, could allow Datatec to increase dividends and pursue accretive bolt on acquisitions as M&A activity in the sector accelerates. This could provide additional upside to free cash flow and earnings.
• The growing mix of multiyear managed services and annuity contracts at Logicalis International and Latin America, with recurring revenues already above 60 percent and managed services growing in the mid to high teens, may underpin higher and more stable margins and support sustained growth in profit before tax and underlying earnings per share over the long term.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of ZAR88.03 for Datatec based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be $4.1 billion, earnings will come to $142.8 million, and it would be trading on a PE ratio of 14.8x, assuming you use a discount rate of 22.5%.
  
• Given the current share price of ZAR80.86, the analyst price target of ZAR88.03 is 8.1% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• 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.