Recently I came across Softchoice Corporation (SO on the TSX). Initially I put it on watch and focused on other opportunities. A couple of weeks ago a friend of mine said he bought some shares. When someone who is smarter than you thinks a stock is worthy of purchase, you should take a closer look.
From their website:
“As a leading North American provider of IT solutions and services, helping small, mid-market, enterprise and public sector organizations harness the power of innovation is our guiding principle. To do this we offer the best of all possible worlds. That includes the efficiency, reliability and cost-savings of a national IT supplier along with the personal touch and technical expertise of a local solutions provider. From in-person consultations to advanced solution design, delivery and implementation services, we’re redefining the level of service customers have come to expect from a trusted technology advisor like Softchoice.”
Softchoice is the largest Microsoft reseller in Canada, and has a large presence in the U.S. By not focusing on large complex problems that businesses face, Softchoice has been able to sell to thousands of companies and keep the sales cycle short. They are quite dependant on Microsoft products, as it represents a large portion of their revenue. Being a reseller has its advantages, like pricing advantages and access to licenses. It also can leave Softchoice vulnerable to any changes that Microsoft products makes and the agreement Microsoft has with its resellers.
In late 2008 to early 2008, Softchoice made three aqcuisitions. Total was around $100 million, which is huge for such a short amount of time.
In October 2007, NexInnovations was aqcuired. NexInnovations provides consulting, technology solution architecture, infrastructure deployment and support services to business and government organizations across Canada. NexInnovations was bought after the company entered bankruptcy. Total payment was for $12.7 million and has been recorded on the balance sheet as all customer relationships.
Software Plus was aqcuired in December 2007. The purchase had almost equal tangible assets and liabilities. Total price tag was $44.1 million, $20.4 million in customer relationships and $23.1 million in goodwill. Software Plus was the largest corporate reseller in the Midwest and the industry’s 9th largest Microsoft LAR (large account reseller).
Optimus Solutions was aqcuired in January 2008. Optimus Solutions provided comprehensive IT products and solutions focused on helping enterprise and mid-market clients plan, build and maintain their information technology infrastructure with headquarters in Norcross, Georgia, and nine offices elsewhere in the United States. Just like Software Plus, the aqcuisition had almost equal tangible assets and liabilities. Total cost was $40.9 million, $21.7 million in customer relationships and $18.5 million in goodwill.
Since the aqcuisitions took place, the economy changed dramatically. We all know Lehman went under and in a week, the rug was pulled out from under almost all businesses. The financing for the aqcuisistions was paid with some debt. The terms of the debt are not great (the term loan has interest in the mid-teens), and can’t be paid off for a couple of years. The debt is easily manageable by operations. All the aqcuisitions are in the same industry as Softchoice, so there was no diworsifications. Since the aqcuisitions the company’s market cap fell below book value and triggered a write-down of goodwill. This cannot be written back up later, even if the write-down was incorrect. Management has done a good job of integrating the acquired company’s into existing operations, all things considered. Margins have stayed in check and the cash conversion cycle has remained flat.
Internal competition in the industry comes from many players. This is a very fragmented industry with Softchoice’s share at less than 1%. They mention 3 public companies for comparison.
I will focus on NSIT, PCCC, MALL (all on the Nasdaq), and I threw in Hartco (HCI on TSX) were applicable as had already cruched their numbers. Data is provided by Morningstar.
Very similar Gross margins, Softchoice may have a slight advantage, but some years include foreign curreny swings. It is safe to say there is not moat here, or at least no sizeable one. This is likely a function of the similar relationships each has with Microsoft.
Again, very similar numbers.
|Capex% of Revenue||2005||2006||2007||2008||2009||TTM|
Get the point? Level playing field. No obvious advantage. Management execution, external influences and capital structure are critical. Finally, the cash conversion cycle (CCC).
Here there seems to be an advantage. SO seems to monitor its receivalbes better, and seems to be on better terms with suppliers. ROIC is in the high teens, even factoring in lease obligations.
As I mentioned before, relative valuation is not enough. You must find cheap relative and cheap on a absolute basis. Lets take a look at SO compared to its direct competitors.
|EV/Ebitda 3yr ave||5.39||5.97||6.16||4.49||5.84||23%|
|3yr ave NI||12.50||13.44||15.00||7.81||13.65||43%|
What the numbers show is that SO trades at a discount to more normalized earnings, but a premium to book and tangible book. It trades in line with TTM EV/EBITDA, meaning that the market has equal expectations of the future for all companies. That is important as the recession affected the companies in a similar way. When you buy SO, you are buying a company and the economy “story”. All of the companies are not trading at lofty valuations. Although I would expect the aqcuisitions to show some stronger growth for SO, but it is nice to see that I am not paying for that. On a side note, I used 15 times earnings for MALL as the actual numbers were large and would make SO seem even cheaper than it should. A couple other valuations are:
- EPV around $19
- The (Ben) Graham formula gives me $16.70 as fair value
- P/FCF and P/3yr ave FCF at around 7.
Lastly on valuation, I wanted to point out something I think worth mentioning. SO has a large amount of intangibles (around $40 million), mostly customer realtionships from the aqcuisitions. These are amortized over a 10 year life. I think the company is over amortizing. Depreciation and amortization are an accounting measure to show normal deterioration in assets. Since the aqcuisitions, SO has shown much higher D+A than capex. This means that the company is over stating the amount it has to amortize or it is not making enough capital expenditures. The average amortizatin before the aqcuisitions was $4-5 million, and capex was also $4-5 million. In the last 2 years D+A has run at $10 million and capex below $3 million. Since the slowdown has hit, every company that can is probably underspending in capital expenditures, SO included. A higher capex run rate is likely needed, but nothing close to 10 million. All this leads me to beleive that net income is understated and free cash flow is a better measure of value. Also, with such high intangibles, it could also mean the company overpaid for the aqcuired businesses.
The Ontatio Teachers Pension Plan (OTPP) owns 25% of SO and played a part on getting SO’s financing, at a good interest rate for OTPP. They may decide to sell at any time. Management currently owns just over 1% of Softchoice. SO is a business that needs very little capital investment to remain operational. Though margins are somewhat thin, there is a very short (sometimes negative) CCC. This business throws off money every quarter. Internal competition is rampant, and external competition is something to watch for. Microsoft is still the dominant name in many parts of the IT industry, but change is constant. Things like open source programs, falling hardware prices, and other companies entering the field are slowly eating away at Microsoft’s moat.
You have a sector that is likely to grow faster than GDP for a number of years. As long as Softchoice can maintain its position, it should benefit. Many analysts are calling for another “jobless recovery” and that companies are likely to invest in IT infrastructure before hiring. That may be true, but we aren’t paying for that when you buy SO at well under 10 times earnings and cash flow. SO under $10 is a buy.
Other info found on Sedi and Sedar