Description
Softchoice is a Canadian IT direct-marketer/value-added reseller ("VAR"), somewhat akin to a small-scale version of CDW before it was taken private by Madison Dearborn and Providence Equity Partners in 2007. In a simplified version of the technology supply chain, the direct-marketer/VAR falls on the node immediately prior to that of the end-customer. It is thus Softchoice's responsibility to help small and medium-sized businesses, large-scale enterprises, as well as government clients, purchase the right hardware and software combinations for their organizational needs. As a direct-marketer/VAR, Softchoice gets bulk-purchase discounts from a variety of hardware and software vendors.
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Simplified Technology Supply Chain
|Manufacturer/OEM| - |IT Distributor| - |Direct Marketer/VAR| - |End Customer|
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There are - arguably - undervalued stocks at several points along the technology supply chain today, from manufacturers/OEMs (see the recent VIC write-up on MSFT, as well as various value investors' comments on HPQ, DELL, etc.) to IT distributors (see the recent VIC write-up on IM). And while it's up for debate as to where Softchoice ranks among these competing names, I believe that the stock represents a compelling stand-alone absolute value.
Softchoice's business, like that of an IT distributor, delivers strong and consistent free cash flow, albeit at low overall profit margins. However, unlike a distributor, Softchoice is asset-light - it holds next to no inventory and has an accounts payables balance that completely offsets accounts receivables. The easiest way to conceptualize Softchoice is like a front-end for players such as Ingram Micro. Ingram holds all of the product (inventory makes up ~90% of book value), while Softchoice is really just responsible for selling it, and hence managing the relationship with the end-customer. As such, whereas Ingram only generates returns on capital in the high single digits and ROEs in the low double digits, Softchoice generates returns on capital in excess of 20% and returns on tangible capital in excess of 50%.
And yet for a business that delivers such stellar returns, as well as very consistent historical EBITA...
Historical EBITA
2002-2003: 17mm*
2004: 22mm
2005: 23mm
2006: 27mm
2007: 37mm
2008: 39mm
2009: 32mm
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...and that, in the first half of 2010, reported revenue up 19% year-over-year, and EBITA up 35%...
...the stock trades at:
- 6.4x EV/LTM Earnings, 7.1x Price/LTM Earnings;
- 8.2x EV/2009 Trough Earnings, 9.1x Price/2009 Trough Earnings;
- 8.4x EV/5YrAvg Earnings, 9.2x Price/5YrAvg Earnings.
I would highlight two additional data points: first, this is not a business that has been historically maligned by Mr. Market. In the five years prior to crash of 2008, Softchoice consistently traded between 11 and 15x LTM earnings, compared to 6.4x today. 6.4x is simply too low for a growing, free-cash-flow generating, high return-on-capital operation.
Second, in my calculation of 6.4x, I was actually being extra conservative by ignoring in the EV 15mm of the 45mm in cash that the company has on its books. I figure that this 15mm is necessary to finance seasonal working capital. Just doing a straight EV-to-LTM earnings calculation (fully-taxed and ex-interest income, of course) results in a multiple of only 5.8x.
* This is an average figure over two years because of large pre-orders in 2002 pulling forward business.
More Background
Softchoice was founded in 1989 and began its corporate life as a reseller of (primarily Microsoft) software products. By 1995 it had grown to become the largest Microsoft reseller in Canada, a distinction that it continues to hold today. In 1997, the company entered the US market, and now represents the fifth largest Microsoft "Large Account Reseller" (LAR) stateside. For those unfamiliar with how Microsoft sells its products, the lion's share of sales, apart from OEM installations, comes via two dozen or so geographically diversified LARs. Microsoft generally pays these LARs on a commission basis, accounting for number of licenses sold, renewed, etc. The LARs get preferential pricing and access to exclusive services and upgrades. The reason that software is sold via LARs rather than directly is because Microsoft, like Ingram Micro, doesn't have (or want) the internal sales force to deal with thousands of small-to-medium sized businesses w/a couple hundred licenses each. Yet the purchase, optimization, tracking, and renewal of these licenses is quite complex (for example, when a business makes new hires, a "true-up" payment must be made to Microsoft) and requires consultation with direct-marketers.
Softchoice's business took another turn in 2002, when management decided to enter the hardware re-sale space. In interactions with clients on the software side, the company noticed that the demand for hardware - really the demand for a one-stop-shop solution - was high. Since the 2002 market entry, here's how hardware revenue has trended:
Hardware Revenue
2002: 4mm
2003: 40mm
2004: 89mm
2005: 117mm
2006: 173mm
2007: 232mm
2008: 508mm
2009: 369mm
LTM: 408mm
So what a decade ago was a business almost exclusively dedicated to the resale of Microsoft product is now a diversified direct-marketer/VAR of a wide range of IT software and hardware. Microsoft still accounts for 30% of reported revenue and 57% of imputed revenue*, but "Other Software" from vendors such as Adobe, Symantec, and VMware accounts for 33% of revenue, and hardware accounts for 37%. Both of these segments continue to grow. The company today derives 60% of its sales from the US and 40% from Canada. Customers are split between small-to-medium sized businesses (44% of revenue), large-scale enterprises (36%), and government customers (20%).
* Softchoice reports Microsoft revenue on a direct and "imputed" basis. The need for an "imputed" revenue number is because, on certain sales of Microsoft products, Softchoice acts purely as an agent, making a commission in the mid-to-high single-digit percentage-of-sales. This commission is accounted for in Softchoice's overall sales figure, even though it is effectively a gross profit on sale. To show a more accurate trend of actual Microsoft product sales, the company calculates "imputed revenue", which includes the gross value of software sold in Softchoice's total sales, backing out the related commission.
Historical Revenue Trends By Segment (All Figures in Millions)
Microsoft Revenue (Imputed)
2002: 567
2003: 445
2004: 549
2005: 579
2006: 661
2007: 772
2008: 1,124
2009: 920
LTM: 992
+ Other Software Revenue
2002: 163
2003: 190
2004: 231
2005: 213
2006: 229
2007: 258
2008: 326
2009: 326
LTM: 335
+ Hardware Revenue
2002: 4
2003: 40
2004: 89
2005: 117
2006: 173
2007: 232
2008: 508
2009: 369
LTM: 408
= Total Revenue (Including Imputed Revenue)
2002: 734
2003: 676
2004: 869
2005: 909
2006: 1062
2007: 1261
2008: 1958
2009: 1616
LTM: 1735
Risks
The most vivid risk to the Softchoice thesis is the company's dependence on Microsoft. This risk can manifest itself in two ways. First, there is the nightmare scenario in which Microsoft pulls all of its business from Softchoice. I find this to be highly unlikely, given the companies' 20-year relationship and end-customers' need for a direct-marketer. The second risk is pricing pressure. Commissions from Microsoft have fallen from the 8-9% level (of gross product sales) a couple of years ago to 6.1% in the most recent quarter. This is partially due to the recession - end-customers are not hiring, which affects "true-up"-related commissions paid from Microsoft to Softchoice for incremental licenses added. A further driver is the fact that we are at the end of a licensing cycle (Microsoft's software is generally sold on three-year agreements), and margins in year three are lower than year one. Some 175bps of the change, though, is just Microsoft squeezing its customers. Clearly the situation bears close monitoring.
Yet even acknowledging this risk, Microsoft's absolute profit contribution has stayed pretty steady over the last decade as sales increases have offset decreased margins. More importantly, given the way that the stock is priced, Softchoice could lose all of its Microsoft business overnight and still be trading at less than 12x cash earnings. The Microsoft business generates gross margins in the 6% range, compared to 9% for the company as a whole, suggesting that perhaps the implied multiple would be even lower in such a disaster scenario. But the idea of the company losing all of this business is pretty absurd to begin with. The way I look at Microsoft going forward is that it will generate a steady but not spectacular stream of income for Softchoice.
A second risk is the potential for management bone-headedness in the future. From the company's IPO in 2002 through 2007, Softchoice's managerial actions had actually been pretty reasonable. Marginal returns on capital were attractive, growth was healthy, options issuances were not egregious, and there was no evidence of empire building. Furthermore, the company was paying a nice dividend of 6mm per year. Then, in late 2007 and early 2008, management decided to make a couple of larger-scale bolt-on acquisitions in both hardware and software, spending nearly 100mm and levering up the balance sheet in the process. While prices paid weren't unreasonable, the timing couldn't have been any worse, and the company was forced to issue very high-cost debt (16%) and a small slug of equity in a February 2009 refinancing. There's no doubt that Softchoice deserves some penalty for this behavior, but since the occurrence the long-time CFO has been replaced, and the company has rebounded to a strong net-cash position. Upon analysis, I truly believe this was a one-time bone-headed move coinciding with the most severe economic downturn in a generation...but there's always the risk that management proves me wrong.
A third risk is cloud computing and its effects on direct marketers/VARs. The company addresses this in the 2006 annual report:
"A number of software publishers, such as Salesforce.com, Webex.com and Microsoft (with respect to Live Meeting), are marketing software that can be accessed from a remote site and customers are charged based on a usage fee, rather than a one-time perpetual license cost. The risk to the Softchoice business model is that these publishers could use their direct access to the customers to disintermediate Softchoice and abandon the distribution channel. While this is a risk in our business, we believe that the publishers' decision to deploy their software electronically and charge a usage fee is different from their decision about how to sell most effectively to their customers and their use of the channel. Customers also generally still prefer to deal with a reseller who is independent and can help them determine the best software solution and licensing strategy to meet their needs."
In other words, even if software moves progressively to the cloud, and the delivery mechanism changes (the delivery mechanism has changed before - from CD-based installation to electronic distribution, from one-time to subscription-based licensing, etc.), end-customers will still need help in designing systems, and acquiring and managing licenses to suit their needs. Since this quote in 2006, Softchoice's non-Microsoft software sales have increased by 46% and Microsoft software sales by 50%.
Finally, there is the risk of the general economy going bad again. Although reasonably resilient, Softchoice does suffer from some economic sensitivity, as witnessed by the declines in hardware and Microsoft software sales in 2009.
Reasons From Mispricing & Conclusion
After factoring in the various risks, I still believe that Softchoice's current price of 6.4x fully-taxed cash earnings (5.8x unadjusted) is unreasonably low. There are a couple of explanations for this. First, we're dealing with a Canadian small-cap; I've found greater levels of inefficiency in this space in general (witness the complete lack of US hedge funds in the name). Second, of what scant sell-side coverage there is, analysts do not back out the massive non-cash, non-economic amortization charges generated by the mis-timed acquisitions in late 2007/early 2008. If you don't back those charges out, then Softchoice looks like it is trading at ~10x earnings - still cheap, but not spectacularly so. Yet there is no good reason not to back them out. Prior to the acquisitions, non-cash amortization was less than 2mm compared to nearly 8mm today. The company doesn't consistently make acquisitions nor does it have much in the way of purchases of intangibles. These are pure non-economic charges that serve to hide true earnings power. Finally, the company's financials may cause confusion for some investors, with terms such as imputed revenue.
Catalysts
- Continued earnings growth and recovery from 2008 stigma.
- Reinstatement of dividend.
- Improvement in Microsoft margins driven by new product cycle.
Catalyst