18 January 2017
By Maynard Paton
Today I’m continuing my hunt for Watch List shares with a look at Softcat (SCT).
Here are the initial attractions that prompted this research:
* Illustrious financial progress: The group claims to have recorded 44 consecutive quarters of organic revenue and profit growth
* Owner-aligned boss: The chief executive has been in charge for 10 years and boasts a 7%/£44m stake
* Straightforward accounts: The books showcase net cash, little capex, sound cash generation and no acquisitions
As usual, I’m applying a question-and-answer template to help me pinpoint companies that match the criteria set out in How I Invest. I’m looking for as many Yes answers as possible.
Activity: IT infrastructure and services provider
Website: www.softcat.com
Share price: 300p
Shares in issue: 197,606,143
Market capitalisation: £593m
Does the business boast a respectable track record?
Yes.
SCT was established during 1993 by Peter Kelly, who spotted an opportunity to resell computer software through catalogues to small businesses. Within a few years, Software Catalogue (as it was then known) had become the UK’s largest supplier of Microsoft Open software licensing.
By 2005, the group had decided to become an all-round IT infrastructure provider. Softcat currently boasts in excess of 12,000 small- and medium-sized business customers and can supply them with a vast range of computer hardware and software, as well as a variety of IT installation, support and management services.
SCT joined the main market during 2015 and the firm’s website carries the admission document while Companies House stores all the earlier annual reports.
The archives show that revenue was £868k and operating profit was just £4k during the group’s first year in operation. By 2016, revenue had surged to £672m and lifted operating profit to £46m. The rate of expansion has been very commendable:
| 2011 to 2016 | 2006 to 2016 | 2001 to 2016 | 1996 to 2016 | |
| Revenue CAGR | 25.1% | 25.9% | 22.5% | 30.3% |
| Operating profit CAGR | 23.0% | 42.7% | 30.6% | n/a |
Even more commendable has been the absence of setbacks. Revenue has advanced every year since the company’s formation, while the last time annual profit decreased was 2005. The 2016 annual report claims SCT had, by last year, achieved 44 consecutive quarters of organic revenue and profit growth.
The last few years have shown splendid progress:
| Year to 31 July | 2012 | 2013 | 2014 | 2015 | 2016 |
| Revenue (£k) | 304,055 | 395,756 | 504,797 | 596,084 | 672,351 |
| Operating profit (£k) | 22,290 | 27,368 | 35,528 | 40,581 | 45,863 |
| Other items (£k) | - | - | - | (999) | (3,673) |
| Finance income (£k) | 135 | 82 | 102 | 195 | 213 |
| Pre-tax profit (£k) | 22,425 | 27,450 | 35,630 | 39,777 | 42,403 |
| Earnings per share (p) | - | - | - | - | 16.9p |
| Dividend per share (p) | - | - | - | - | 5.3 |
| Special dividend per share (p) | - | - | - | - | 14.2p |
The ‘other items’ recorded in the table above relate to the 2015 flotation. I’m impressed no other exceptional or one-off costs have been reported within the group’s 23-year history.
Has the business grown mostly without acquisition?
Yes.
The latest balance sheet carries no goodwill and I could not identify any external acquisitions following the company’s 1993 formation.
Has the business mostly self-funded its growth?
Yes.
The 2016 balance sheet displays share capital of £5m versus earnings retained by the business of £86m.
I note almost all of the £5m share capital was raised during the last few years through the exercise of share options (or similar), rather than by any type of formal equity investment or fund-raising.
Does the business possess an asset-strong balance sheet?
Yes.
SCT’s 2016 balance sheet carried cash of £62m and freehold property with a £3m book value. In comparison, bank debt was zero.
Furthemore, SCT is not burdened with any final-salary pension obligations.
Does the business convert profit into free cash?
Yes.
| Year to 31 July | 2012 | 2013 | 2014 | 2015 | 2016 |
| Operating profit (£k) | 22,290 | 27,368 | 35,528 | 40,581 | 45,863 |
| Depreciation and amortisation (£k) | 475 | 1,167 | 1,778 | 2,147 | 2,123 |
| Net capital expenditure (£k) | (4,494) | (3,097) | (2,152) | (2,501) | (1,715) |
| Working-capital change (£k) | (9,529) | (6,056) | 8,772 | 12,968 | (7,095) |
| Net cash (£k) | 10,104 | 8,676 | 37,720 | 74,642 | 62,361 |
Certainly SCT does not spend vast amounts on capex compared to operating profit, and any difference with the associated depreciation charge is relatively small.
Meanwhile, working-capital movements since 2012 add up to an aggregate £1m outflow of cash. Such cash-flow management is very impressive given operating profit has doubled to £46m in the same time.
The excess cash generation has allowed net cash to surge from £6m to £63m between 2011 and 2016 — and that is after the business paid dividends of £75m during the same time!
Does the business enjoy a competitive advantage?
I am not sure.
Within its flotation prospectus, SCT listed its main operating strength as:
“Differentiated culture fostering motivated and empowered employees to deliver outstanding customer service
The Directors believe that Softcat’s open, supportive and vibrant culture differentiates Softcat from its competitors and fosters an employee base that is empowered and motivated to deliver the highest levels of customer service.
High performing employees and teams receive company-wide recognition. In addition to payment of commissions and bonuses, there are annual trips abroad and recognition lunches. Other benefits include participation in regular social, sporting and charitable activities, workplace perks, such as free breakfast and wellness treatments, and celebration of birthdays with a half-day holiday.
In addition, there are no offices for individuals; all employees, including members of the senior management team and other senior employees, share the same open workspace.”
I can’t recall free breakfasts and open-plan offices ever featuring in Michael Porter’s landmark Competitive Strategy book, but clearly the working culture at SCT has helped deliver that illustrious financial history.
Certainly SCT does not appear to enjoy a conventional operating advantage. Suppliers include powerful IT groups such as Microsoft, Hewlett-Packard, Dell and Cisco, and SCT’s operating margin of 7% suggests there is not an immense profit to be had from reselling their software and hardware.
I can only trust SCT’s “vibrant culture” can be sustained and continues to set it apart from more traditionally run rivals.
Does the business produce a respectable return on equity?
Yes.
Return on average equity for 2016 was £33m/£92m = 36%. A wonderful figure, especially when the asset base carried substantial cash balances that currently earn little interest.
The 36% return for 2016 is actually the lowest SCT has recorded during the last ten years — the average during that period is 45%, with the annual figure hitting 60% during 2011.
Does the business employ capable executives?
Yes.
The aforementioned Peter Kelly, who started the business during 1993, retired from the company in 2015. He handed over executive charge to SCT’s current chief exec, Martin Hellawell, during 2013.
Mr Hellawell was appointed managing director in 2006 and I have the impression he has led SCT’s day-to-day operations ever since. As such, he should take credit for how well the company has performed.
Mr Hellawell turns 52 later this year, so ought to have time on his side to build the business further before he contemplates any thoughts of retirement.
SCT’s other boardroom executive is the finance director, who joined the group in 2015.
Does the business employ good-value-for-money executives?
I think so.
Mr Hellawell received a £228k basic salary and £330k annual bonus during 2016. I would say such sums appear quite reasonable when the year saw operating profit improve by 13% to £46m.
Details on Mr Hellawell’s pre-flotation pay arrangements are limited, but the 2016 annual report suggests he could collect a £278k salary, a £309k bonus and a £258k LTIP award for a “target performance” during 2017.
I would not describe such arrangements as outrageous should the business once again produce a 13% profit advance.
For what it is worth, Mr Hellawell does not receive any company-paid pension contributions.
Does the business employ owner-orientated executives?
I think so.
The Companies House archive indicates Mr Hellawell became an SCT shareholder during 2007, although it is not clear whether Mr Hellawell bought his shares or was given them for free.
Either way, and with the help of share options in the meantime, Mr Hellawell currently boasts a 7%/£44m shareholding. I should add that Mr Hellawell sold 37% of his holding at the flotation.
(Company founder Peter Kelly off-loaded 37% of his stake, too, and now hangs on to a 33%/£195m shareholding.)
Signs that Mr Hellawell is running SCT with outside shareholders in mind include keeping the option count at less than 1% of the share count, and declaring a special 14p per share dividend within the firm’s maiden annual results as a quoted company.
Does the business enjoy reasonable growth prospects?
Maybe.
For what it is worth, the flotation document cites research that claims SCT’s target customer market has increased its spending on external IT services by 8% per annum during recent years.
The document also states SCT may be able to secure more public-sector work as and when new contracts come up for tender.
More recently, a Q1 trading update in November said:
“The Board is pleased with performance during the period. Positive momentum has been maintained during the first 3 months of the current financial year and gross profit performance has been strong. The Company has continued to make significant investments in both sales and technical resource. As a result, operating profit has performed in line with the Company’s expectations.
The Softcat management team remains focussed on delivering profitable growth and cash conversion whilst building scale and developing the offering.
The Company has invested heavily in future growth and much of this investment is phased into the first half of the current financial year with the returns on these investments becoming evident in the second half of the year – seasonally the stronger six months for the Company – and beyond. As a result, operating profit is expected to be weighted towards the second half.
Martin Hellawell, Chief Executive Officer, commented:
“While it’s still early days for us in FY17 we are off to a good start. We are pleased with the levels of growth we have seen in the first quarter and the investments we are making will further enhance our position in the market.”
I do become wary when companies say profit is expected to be weighted towards the second half. Quite often that is City code for a first-half profit that is not as high as expected.
In the past, SCT’s profit has been split about 40:60 into H1:H2.
I presume SCT’s heavy first-half investment covers extra personnel, and this is an area to keep an eye on. I note revenue per employee for 2016 was £770k — SCT’s lowest figure since 2010. That’s not a great achievement for a business that trumpets its workforce as its prime asset.
(I also see the average employee cost to SCT has been stuck at about £40k for the past seven years. I guess hiring more, lower-paid, recruits over time has helped keep a lid on costs. )
Does the share price stand a good chance of becoming a bargain?
Maybe.
At 300p, the share price is equivalent to 15-16 times the adjusted 19p per share earnings reported for 2016. However, alter the £593m market cap for the £62m cash position and the multiple reduces to 14-15.
I must admit, that rating does not look extravagant for a business that has delivered consistent double-digit earnings growth during the last few years.
Current broker forecasts suggest earnings could remain at about 19p per share for 2017 and improve towards 21p per share for 2018.
Is it worth watching Softcat?
I think so.
There is a lot to like about SCT, not least its splendid track record, the owner-friendly boss, the reassuring cash hoard and the wonderful return on equity numbers.
True, there is no obvious ‘intellectual property’ here to keep rivals at bay.
Reselling products from the likes of Microsoft and Cisco will never earn anyone much money, but I guess bundling them all together within an associated IT service can be more lucrative.
Mind you, what is clear from SCT’s annual reports is the group’s belief that top-notch employee happiness leads to first-class customer service, which in turn can lead to superior financial progress.
Empowered workers are not exactly a textbook ‘moat’, but SCT’s financial history is very tough to criticise. So perhaps a vibrant employee culture really can be difficult to replicate and therefore can create a sustainable competitive advantage.
Anyway, there’s enough going for SCT right now to give it a spot on my watch list. It will be fascinating to discover whether free breakfasts and open-plan offices really can help protect and grow the business further.
Maynard Paton
Disclosure: Maynard does not own shares in Softcat.
