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Softcat's growth set to purr

Buy the quality tech services company
March 30, 2017

Technology reseller Softcat (SCT) was founded in 1993 as a mail-order software service business. Domestic expansion, a change in business structure and an impressive capacity to partner with global tech giants has seen it become one of the UK's biggest IT infrastructure providers. Following nearly 11 years of revenue and profit growth, Softcat listed in late 2015 and has continued on its impressive organic growth trajectory since then. That historic growth profile and current favourable trends in the tech marketplace underpin our bullish investment case.

IC TIP: Buy at 349p
Tip style
Growth
Risk rating
Medium
Timescale
Long Term
Bull points
  • Strong long-term growth profile
  • Favourable market conditions
  • Good cash flows
  • Potential for special dividends
Bear points
  • Low barriers to entry
  • High working capital requirements

This year has started well for Softcat and, although recent half-year numbers were flattered by the absence of IPO costs, the underlying performance was none the less impressive. Double-digit revenue growth was reported in all three of the group's operating divisions, which sent the top line up nearly 30 per cent to £379m.

 

 

The software business - half of overall revenue - performed particularly well, with sales up 40 per cent. Meanwhile, a rise in demand for new PCs helped spark a recovery in Softcat's hardware division - one third of revenue - where sales rose 14 per cent to £126m. However these lower-margin sales contributed to a fall in gross margins from 18.3 per cent to 16.2 per cent. But this isn't something that worries chief executive Martin Hellawell. "Margins will go up and down," he said. "We'll just sell where there is demand." Indeed, given that price rises on items such as computer hardware are largely passed at cost to clients, we think the view that gross profits - up 14 per cent in the first half - are more indicative of sales performance is well justified. On that basis, encouragement can be taken from the fact that underlying operating profits - up almost a tenth to £21.4m - represented 34.9 per cent of gross profits, which was only a marginal slip from 36.4 per cent in the six months to the end of January 2016.

Softcat's cash profile is impressive, but does need to be seen in the context of large working capital requirements, which reflects its role as a reseller. And at the half-year stage working capital included £152m of receivables (money owing to Softcat already booked through the income statement), £5.6m of inventories and £138m of payables (costs already booked by Softcat but not yet paid out). Even so, the cash position coupled with strong cash generation, which is helped by the business's meagre capital expenditure requirements (less than £2m last financial year), means there are good grounds to expect the company to provide far more income to shareholders than the official target of 40 to 50 per cent of earnings.

While the forecast in our table implies an uninspiring basic dividend yield of 2.3 per cent this year, the fact that management targets a net cash balance of £30m, while net cash for the year-end is forecast at £53m, means extra capital returns look likely. In 2016, £28m of excess cash was paid back via a 14.2p special dividend. A similar payout this year indicates a yield of nearly 6.0 per cent. With the dividend so well covered by earnings, future income also looks secure.

And Softcat's operating market is attractive. The technology industry is expanding enormously, driven by demand for the internet of things (IoT), faster communications, cyber security, data storage and increasinged complexity. Softcat is the third-largest tech reseller in the UK and yet it only has 6 per cent of the market. The scope for organic growth is therefore exciting, and management wouldn't rule out an acquisition if it was "genuinely compelling".

True, without its own intellectual property or brand, barriers to entry are relatively low and Softcat is heavily reliant on the quality of the service it can provide for customers. However, the group's track record suggests its focus on graduate recruitment and staff training does put it ahead of much of its competition. Indeed, the 10,000-strong client base keeps coming back for more and in the first six months of the 2017 financial year gross profit per customer rose by 4.6 per cent to £61,000.

SOFTCAT (SCT)

ORD PRICE:391.50pMARKET VALUE:£774m
TOUCH:391.50-392.00p12-MONTH HIGH:391.50p263p
FORWARD DIVIDEND YIELD:1.7%FORWARD PE RATIO:20
NET ASSET VALUE:35.3pNET CASH:£46.6m

Year to 31 JanTurnover (£m)Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)*
201450536.0nana
2015*59640.015.80.0
201667242.019.15.3
2017**79950.020.59.2
2018**87153.021.79.4
% change+9+6+6+2

Normal market size: 1,000

Matched bargain trading

Beta: 0.43

**Berenberg forecasts, adjusted pre-tax profits and EPS, excludes 14.2p special dividend in 2016

*Softcat listed in November 2015