The rise and fall of global technology stocks at the turn of the millennium cast doubt on the long term sustainability of IT companies.
Whereas money once poured into dot-coms that purported to have a blueprint for the next Cisco, Microsoft or Google, it all reached a critical mass and investors suddenly became very cautious. These same investors actually created the dot-com bubble by rampantly speculating on the future of the Internet and believing new technology would fortify a paradigm shift in equity markets.
The inevitable realisation though, was that there was no shift and that this time wasn’t any different. In fact, as always, investments were best valued according to their real cash flows. Moreover, expecting exponential growth in a company’s earnings was still, at very best, speculative.
Figure 1 illustrates the rise and fall of the NASDAQ index, which had the greatest exposure to these dot-com businesses.
Figure 1 – The Dot-com Bubble (NASDAQ Composite Index)
The technology-heavy NASDAQ Composite Index peaked in March 2000
Australian companies suffered substantially less than their US counterparts when the dot-com bubble finally burst. Some say it was recompense for the stgastation of the late 80s, while others attribute it to the high concentration of embryonic IT companies in the US. Nonetheless, most computer and technology businesses became tarred with the same brush. If a company had anything technology based in its name, it was considered to be a highly volatile investment. This situation proved to be quite lucrative for value investors as many fearful traders sold quality companies into an increasingly depressed market. While many of these quality companies would continue to face some of the greatest challenges of their existence, they were still players in a very large market with unprecedented opportunities for growth.
In 1997, during the ramp up of the dot-com bubble, Data#3 Limited (ASX:DTL) listed on the Australian Stock Exchange (ASX). With the word data in its name and being in the business of providing IT solutions, the company was well poised for an exciting ride on the dot-com rollercoaster. But, there was a major differentiating factor between this company and its perceived associates. Data#3 had already been weathered by 20 years of operation in the same industry, challenged by markets and threatened by competitors. This wasn’t a company banking its future on the success of one highly abstract idea; it was a service-based business satisfying customers with real needs. What this meant, was although the company’s share price had been irrationally lifted to record highs, it was still a viable business with tangible earnings. This was the trademark difference between IT companies that were suddenly wound up and those that still operate today.
Data#3 began its life as an IT support organisation in 1977. The business originally traded as Powell, Clarke and Associates (PCA) and was the largest supplier of IBM based software to small hospitals in Australia. In 1984, it merged with Albrand Typewriters & Office Machines – a specialist IBM hardware reseller. Together, these businesses were able to complement each other’s skills to provide a full suite of technology solutions. This relationship eventually culminated in the company’s listing on the ASX in 1997, which provided much needed capital for expansion as a national service provider. Today, many years later, Data#3 is one of the top performing IT service providers in the country. It employs over 500 staff from offices in Brisbane, Sydney, Melbourne, Canberra, Adelaide, Gladstone, Rockhampton, Townsville and Noumea.
Figure 2 – Locations of Data#3 Offices
A common question regarding technology companies is – So how does a more traditional IT service provider like Data#3 really make its money? The short answer is – by connecting people and technology. Although this may sound quite vague, the scope of the company’s products and services really is that wide. If you have a problem that is best resolved with a technology based solution, chances are that Data#3 can provide the answer. Such solutions may involve: the stgelopment of software to streamline a business’s operations, implementation of hardware to facilitate global communications, or even the recruitment of people to collaborate on a technology based project.
Figure 3 – The Data#3 Solution Lifecycle
Fittingly, Data#3 has defined the following three areas of specialisation: software solutions, infrastructure solutions and people solutions. These loosely correspond with the earlier examples. software solutions involve the stgelopment of software and third-party licensing, infrastructure solutions connect people and technology through hardware and people solutions deal with recruitment and human resource management. Together, these specialisations allow Data#3 to provide end-to-end technology solutions for any sized organisation. Figure 3 further describes how the company delivers a solution from a strategic perspective.
Our valuation of Data#3 reads like a textbook example of a wonderful business. For the 2009 financial period, Data#3 has delivered a normalised return on equity (NROE) of over 61%. Also looking at the company’s NROE history (See Figure 4), we can see that NROE has been steadily increasing for the past five years. In simpler terms, the business has become more and more profitable as time has passed. This is one of the most recognisable signs of a truly good business.
Figure 4 – Normalised Return on Equity for Data#3
Figure 4 also shows that Data#3 has consistently been able to reinvest a significant portion of its earnings. Not only has the company had the opportunity to do so, but it has been able to reinvest at increasingly higher rates. Although this continued growth in NROE is not expected to continue indefinitely, it is a sign that margins have improved and profitability is getting better. Most companies generally find it harder to maintain previous NROE levels as they become burdened with more capital, so this is another sign that Data#3 has the traits of a truly wonderful business.
Figure 5 – Five-Year Performance for Data#3
To reiterate the company’s increasingly strong profitability, we can also look at movements in equity and profits over the past five years. Figure 5 shows that while equity has less than doubled, profits have actually nearly tripled. What is also a testament to the company’s performance is that it hasn’t had the need to employ debt to fund its growth. The company has quite literally grown itself through strong profits, significant reinvestment and sensible capital management.
Figure 6 – StockVal Valuation for Data#3
We value Data#3 Limited at $7.71 for 2010. While this is based on quite a conservative Adopted Performance Criteria (APC) and Required Return (RR), we believe it is warranted considering the fundamentals of the industry. Even though we think the industry is much more resilient than during the dot-com bubble, it is operating in some of the toughest economic conditions in the last 10 years.
Guy Carson uses StockVal. Exclusively for The Bull subscribers, StockVal is offering a free two-week test drive – click here.
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