Data#3 well placed for tech services reboot

Is Data#3 the market’s best-value technology services stock? An easing share price this year has the business software solutions company near value territory and looking like a bargain compared to its pricier peers. At the right price, it could provide excellent leverage to a recovering technology investment cycle in the next few years.

Data#3 is trading at an 11% premium to its estimated $1.12 intrinsic valuation, as calculated by Skaffold. It does not provide a sufficient margin of safety to buy just yet, but should have a front-row seat on portfolio watchlists. Another bout of share price weakness will create an opportunity.

Data#3 stacks up well against its IT peers on several measures. Its 45% return on equity (ROE) is the highest of a group that includes SMS Management & Technology, Oakton, DWS, Technology One and UXC.

Data#3’s latest half-year result, while sluggish, also compared favourably against several peers. It showed a 5% decline in first-half net profit for 2012-13; SMS Management reported a 15% fall, Oakton a 33% fall, and DWS was down 13%.

Moreover, Data#3’s A2 rating is an excellent score for a small-cap company in such a cyclical industry, and topped only by Technology One, which is A1 rated.

Relative value favours Data#3 at current prices. SMS Management and Oakton each trade at a 37% premium to their estimated intrinsic value. UXC is at 45%, Technology One at 39%, and DWS at a 33% premium. Data#3’s estimated 11% premium looks good by comparison.

There was significant value in Data#3 in FY11. Back then the intrinsic value per share estimate was $1.45 and Data #3 shares were trading around 80 cents at the start of that financial year. Sure enough, the share price eventually tracked the intrinsic value and by year’s end was slightly above it. Those who tracked these changes were well rewarded.

A history of trading below intrinsic value is possibly because the market has never given it sufficient recognition, or because it is under-researched by analysts.

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Return on equity has averaged 45% over the last five reporting periods, a performance most ASX-listed companies would kill for, and while ROE is forecast to ease to about 40% over the next three years, the absolute number remain impressive.

Software firms can produce terrific returns on equity. Being people businesses, they require less investment in plant and equipment and other fixed costs. Data #3’s non-current assets were valued at just $13 million in 2011-12. About two-thirds was for plant and equipment and the rest for goodwill.

The ability to produce strong sales – in Data#3’s case, $809 million in FY12 – on low fixed investment is a hallmark of companies that can build competitive advantages. Unlike mining companies, for example, software companies are not lumbered with big investments in plant and equipment that can sit idle and rapidly depreciate when market conditions soften. It is far easier to cut back on people than plant.

Data#3’s other attraction is little debt. It has had hardly any over the past decade and in FY12 debt was just $2.5 million. The number of issued shares (153.9 million) has not changed for four years, and the capital structure is clean and tight. Again, this supports a high and rising ROE over time.

Taken together, Data#3 is producing excellent returns on shareholder equity, is virtually debt free, and offers more compelling value – though not quite enough yet – than its peers. So why does the market have modest interest, with Data#3 shares falling recently from a 52-week high of $1.42 to $1.25 (they are currently trading slightly higher at $1.30)?

Three reasons stand out. First, the market for software service companies is tough as governments and the private sector cancel, defer or shrink technology projects.

The second reason for market indifference towards Data#3 is its outlook. It says the 2013 technology market will “at best be similar to the 2012 market” as chief information officers in big companies delay project commitments. Consequently, Data#3 did not provide earnings guidance in its latest result – a decision that may have spooked investors.

The third reason was Data#3’s interim result. Although better than most of its peers, Data#3 reported a 6.8% drop in revenue to $406 million for the first half of FY13, and a 5.1% drop in net profit to $6.8 million, which was consistent with previous company guidance. Challenging, competitive market conditions and the timing of some licence agreements weighed on the result.

Operating expenses increased by 19% to $8 million over the same time last year. This short-term pain should lead to long-term gain, with Data#3 investing in infrastructure, systems and property to provide a stronger foundation for growth. So the result, in some ways, was better than it appeared.

The challenge for investors, however, is timing. Do you buy Data#3 now and persevere through another year or two of flat earnings as the technology investment cycle limps along? Or do you wait for more signs of improving technology investment and risk paying higher prices?

A better strategy is to ignore market noise, focus on value, and watch and wait for an opportunity to emerge. Buying Data#3 when it offers good value – possibly closer to $1 – could prove rewarding.

Roger Montgomery is the chief investment officer at Montgomery Investment Management. If you would like the opportunity to discuss your portfolio and investment options with Roger or his team simply email office@montinvest.com.