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What we don't like

At its current share price, the stock implies a price-to-book ratio (PBR) of 1.7x, which is above its long-term average of 1x. Also, a PBR of 1.7x implies a return on equity (ROE) of 15%, which is also above its long-term average of 10%.

This share price performance has been driven by an earnings recovery off a depressed 2010 base. The company was affected by the global economic downturn and thus its earnings base was at a cyclical low. However, the share still looks expensive on a price-to-earnings ratio (PE) of 14x versus its long-term average of 10x. However, for cyclical companies like Datatec it is more instructive to consider its multiples based on the Graham and Dodd PE (G&D PE) or the Shiller PE (see below). These two PE metrics differ from the conventional PE in that they take into account the 10-year average earnings and not just the latest reported earnings. The G&D PE uses nominal earnings, whereas the Shiller PE uses real earnings. These two metrics attempt to smooth out the business cycle’s impact on earnings by using a 10-year moving average of earnings. Hence, the key difference between these measures and a conventional PE ratio is what they say about earnings relative to their long term “trend" – and in the case of Datatec the current cyclical high earnings base understates the PE ratio (15x currently) when compared to its through-the-cycle earnings base, which yields a PE closer to 26x.

Valuation aside, the other two concerns we have with Datatec are;

  1. The company only tends to generate positive free cash flow when revenue growth slows or declines (see graph above). Thus the more the company grows, the less cash flow it generates as it is obliged to invest in more working capital.
  2. The company is still heavily exposed to Cisco. Products sold on behalf of Cisco still comprise half of group revenue. The risk is that Cisco can exert pricing pressure on Datatec, which would materially affect operating margins negatively.

 

What we like

Datatec has an experienced management team who have been relatively conservative with respect to acquisitions. They have increased the geographic diversification of the revenue stream and attempted to refocus the portfolio of businesses on profitable niches where they perceive the group to have a sustainable advantage.

 

Risk to the valuation

The key risk to our valuation is that there is structural change in the industry, which enables margins to remain at historically high levels and allows the business to continue generating consistent cash flows.

 

sim.sense’s bottom line

On a price-to-book multiple and PE basis, the share is expensive and implies a return on equity significantly above its historic average. The business model also brings into question the company’s ability to generate consistent free cash flow due the need to invest significant cash in working capital when the company is growing.

 

Expensive compared to earnings history 

Cash flow an issue in growth periods  

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