Why Softcat Will Never Be Alphabet (and That’s Ok)

21st May '20 by Jack Brumby

12 comments 6058 reads

In 1996, two young men hunched over a big box computer in a messy dorm room somewhere in America. They were building a search engine called Backrub. Thankfully, they decided to rename it - I much prefer to “Google” things rather than “give them a Backrub”.

Since then Alphabet has soared to incredible heights, providing enormous value to the wider world.

Recently I’ve been looking at Softcat (LON:SCT), following on from VAR peer Computacenter (LON:CCC) 's recent bullish trading updates, but I’ve ended up thinking a little more deeply on the nature of competition and long term value creation.

I like both SCT and CCC. I think they are good at what they do. They are cash generative, liquid, and confident in their short and medium term prospects. Over the past five years, both companies have handily outperformed the market.

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Softcat has a history of double-digit growth and market share gains. That said, here’s why I won’t be investing right now (although I can understand why others might).

Strong growth in a fragmented UK VAR market

According to Channelweb, Softcat is the number two UK VAR (value-added reseller) by revenue, just behind Computacenter - and it is catching up fast.

The group handles a company’s IT infrastructure and frees them up to focus on their core operations. It has won market share over the years with a simple two-pronged strategy:

increase revenue from existing customers; and
win business from new customers.

Here's the top 100 UK VARs by revenue in 2019 (CCC is red, SCT is black. Listed peers Redcentric and Adept Technology are orange and yellow respectively):

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Competition is fierce and evolving all the time, but Softcat has a long history of taking market share and it says it continues to be presented with a “vast” opportunity.

Total revenue across the top 100 VAR firms added up to £17.2bn in 2019. Softcat generated just over 8% of this. I’m not sure this qualifies as a “vast” opportunity but perhaps it could still treble revenue or thereabouts before having to look abroad (as Computacenter has done).

Operating margins at Softcat are high single-digits and growing. Revenue is also growing consistently at double digits. When you get margin expansion and revenue growth at the same time,…

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timarr

21st May '20

HI Jack

Another very good article.

Keith Ashworth-Lord was quizzed on the Softcat (LON:SCT) moat on the recent PI call and responded by pointing out their high quality metrics. Which to my way of thinking is the wrong way around - a great company will have great ROCE, Op Margin, etc but you can have the same numbers without being a great company due to short term tailwinds.

However, the underlying trend is to move to web services. No start-up these days would even consider owning its own hardware or third-party software. I even know of banks who are trying to move into the cloud - which is a real challenge due to regulatory concerns and incredibly cautious compliance departments.

Both Softcat (LON:SCT) and Computacenter (LON:CCC) offer cloud solutions through Amazon Web Services so a lot of their future revenue will be dependent on their margins on that business and what they can sell around the edges. But the difference in growth rates is remarkable and, as you suggest, hard to explain.

A cybersecurity company review would be interesting. There just isn't much of any quality listed in the UK - Ncc (LON:NCC) and Avast (LON:AVST) are all that come to mind, although there are a fair few smaller operations providing simpler services. Qinetiq (LON:QQ.) , Bt (LON:BT.A) and Bae Systems (LON:BA.) all have substantial cybersecurity groups but none are pure plays. As usual, when it comes to tech, it pays to look West ...

Andy Sav

Looking at what Microsoft are doing with Power Apps: https://powerapps.microsoft.com/ (low code solutions that require minimum knowledge, based in the cloud); i'm wondering how this will impact companies like Softcat (LON:SCT) and £CCC. It could have a negative impact on their services. Intercede (LON:IGP) & Kape Technologies (LON:KAPE) are another two companies dealing with cybersecurity

WarrantStar

Jack, Thank you for this really good piece of writing!

My strategy used to be to buy & hold quality shares for a long time. I used to spend ages analyzing companies and the nature of their moats. But my approach has changed. I don't hold shares for so long now because I sell everything if the Fear & Greed index takes a tumble, so as to protect my capital. So now I don't spend any time at all looking at the nature of the moat. If the ROCE and operating margin are fairly high and improving, or at least being stable, then I take this to mean that the company has some kind of moat, which will probably last for longer than my holding period will be. However, if the ROCE and operating margin are not high enough or falling, then I will not buy, or I will sell. The falling metrics may mean that the moat is being eroded. But, again, I do not spend any time examining the reasons for this, I just conclude that the company is becoming less attractive to own. A useful side effect of this is that I can quickly screen for what I want, rather than spending ages on qualitative analysis.

Harry Hindsight

Agree. On furlough so can spend some time but when I get back to the bill paying day job then just need to churn maybe one a week and max holding of 12 stocks otherwise too many to keep track of - a chartist so spend hours studying 'rice traders' inventions.

Disagree. You do need to try and understand what they do, even and wide reading of everything out there. Thats the fun part. Not just spreadsheet analysis.

Newby so maybe just learning how to lose money. Plus 500 next.

greyster

22nd May '20

Jack

A very well constructed analysis, enjoyed reading it. My 12 year old daughter always asks about softcat because she likes the name. Probably not a basis for picking shares, but I have held it on and off but keep feeling the valuation gets ahead of itself.

I used your screen that you built and used on software businesses a couple of weeks ago. I applied it to mu US subscription and it came up with lots of interesting companies including Qualys, which I believe Smithson recently purchased for their investment trust.

Keep up the good work it is appreciated and used by me. (PS I always do my own research).

Best wishes

Greyster

andrea34

An interesting read, Jack... but I would not have said that either AdEPT Technology (LON:ADT) or Alphabet are fair companies to compare against as their product/services are quite different in my mind.

Jack Brumby

Thanks Tim,

Really enjoyed the lockdown post you wrote a couple of weeks ago.

I did catch that interview with KAL - they didn't dwell too long on SCT did they, but I remember walking away with the same impression. High ROCE alone is not confirmation of a moat (but is desirable and suggests there might be one if you start digging).

I'll add those cyber names to the list - also thanks Andy Sav for IGP and KAPE.

Any particular part of the market either of you have been looking at recently?

iwright7

Jack,

Richard Bennard wrote a piece in February where I think he correctly identified the Softcat (LON:SCT) Moat:

Softcat’s biggest asset is its account managers, who help customers decide what to buy and advise them on implementation. Its strategy requires it to recruit and keep hold of good salespeople. The company, which has offices all over the UK and a handful overseas, will only open a new office when it has an employee to promote from within to run it. It only recruits salespeople at entry level, so they know their prospects will not be diminished by high-level appointments from outside the firm. In 2019, Softcat reduced its working week by 2 hours.

Macro

My own take on this is through both Computercenter and Softcat as takeover targets post Brexit transition.

Imagine the UK outside of Single Market and with no future arrangement for Services. The UK's own internal market is sub-scale compared with both USA and EU - so margins lower for those UK market participants that have a UK-only domestic footprint.

With GBP now weakening against USD and EUR could both Comptercenter and Softcat become takeover targets for larger USA and EU based companies who want to tap the UK market via a wholly owned UK subsidiary? Then export USA and EU sourced service solutions to their UK subsidiary to gain additional returns. Increasing Value at Scale.

zenzini

Great article Jack. In my humble opinion, a high ROCE but no moat company will probably not make a good long term investment due to reversion to the mean.

24th May '20

Hi Jack

Everything’s of interest :)

Although I don't invest in companies for dividends, it's interesting to see who’s still paying them. In my portfolio since the crash in mid-March the following have paid or declared increased or unchanged divvies: Unilever (LON:ULVR), Treatt (LON:TET), Spirent Communications (LON:SPT), Schroders (LON:SDRC), Rathbone Brothers (LON:RAT), Moneysupermarket.com (LON:MONY), Prudential (LON:PRU), Tp Icap (LON:TCAP), Aj Bell (LON:AJB), Cerillion (LON:CER), Avast (LON:AVST), Domino's Pizza (LON:DOM), Jarvis Securities (LON:JIM), Legal & General (LON:LGEN), M&g (LON:MNG), Pearson (LON:PSON), Reckitt Benckiser (LON:RB.), Relx (LON:REL) and Sage (LON:SGE).

A few companies there supplying consumer essentials and the rest of them have businesses that are primarily internet / mobile based. The latter have attractive economics if they have hard to replicate business models - asset light with low capex, good operating margins and most of them have net cash or very low levels of debt. A lot of financial companies there too – insurance, fund managers and stock brokers were among the first to digitise and have business models unaffected directly by lockdown.

Anything that supports home working, telehealth or home based socialising is of interest but that’s so obvious there’s not much of any value around. But I'm also looking hard at businesses that fulfil the remote operations criteria in sectors that are currently furloughed - for instance: travel agencies (On The Beach (LON:OTB)), estate agencies (Rightmove (LON:RMV), Purplebricks (LON:PURP) ), education (Pearson (LON:PSON)) and car dealerships (Auto Trader (LON:AUTO)). The economics of their real world competitors look seriously damaged as and when normal service is resumed.

The disparity between the valuations of some online companies and their furloughed equivalents now look stretched - Boohoo (LON:BOO) is on a PER of 54 and Next (LON:NXT) is 11. Both of those look wrong. I don’t have a huge amount of confidence in a lot of asset values right now – if companies move to home working at the same time as swathes of the High Street go bust then commercial property values will drop – and, if there’s a switch to residential, a lot of housebuilders will see write downs in their land banks.

However, there’s a price for everything – J Sainsbury (LON:SBRY) on a PE of 9, a P/TBV of 0.6 and P/S of 0.14 looks anomalous when they’re still trading and debt is dirt cheap. Or Aviva (LON:AV.) at 4.4, 0.75 and 0.13. Notwithstanding the headwinds for both businesses there’s a hell of a margin of safety in there.

All crises throw up opportunities, but people tend to anchor to favourite stocks and historical prices. This isn’t just a reset, it’s a major reboot – but from here whatever survives will probably do OK. At the very least we should see a partial rebound in the second half, things could hardly get worse. Could they?

27th May '20

Thanks, I'll google around for that article. Always interested to get Richard's take on a company.

Why Softcat will never be Alphabet (and that’s ok)

Strong growth in a fragmented UK VAR market

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Jack Brumby

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