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

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.

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):

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, that can be a potent driver of share price growth - if those trends can be sustained for a decent period.

It certainly seems to be a profitable line of work - Softcat generates eye-catching returns on capital:

But what’s stopping others from seeing that and doing what Softcat does? Serious competition must be inevitable given these exceptional returns.

That said, Computacenter has managed to maintain stable profit margins for decades. Scale and learning curves are valid barriers to entry - and Computacenter and Softcat are number 1 and 2 IT VARs in the UK by revenue respectively. They generate and reinvest lots of profit every year - that must be hard to compete against, especially when coupled with industry know-how.

There are some differences between these two companies. Softcat is smaller by revenue but is growing faster, has higher margins, and its shares trade on a higher multiple. Computacenter has been around for longer, is growing more slowly, has lower margins, and is cheaper.

It’s notable that SCT is actually the bigger company by market cap when you consider CCC generates around five times as much revenue. Other listed VARs such as Redcentric and Adept Technology are far smaller.

When you compare the above chart on revenue to its equivalent for operating profit, we do see that SCT is significantly more profitable than CCC relative to the revenue it generates. The gap between the two companies reduces dramatically.

Softcat looks to have more than treble Computacenter’s profit margin - and while the latter’s has been steady for decades, the former’s seems to be increasing. This explains the difference in valuation. I am curious to know how Softcat can be so much more profitable than Computacenter.

Competition and potential margin pressure

The UK IT infrastructure and services market is highly fragmented and continually changing. Customer service is the only real differentiating factor. Competition is intense.

What’s more, new IT products may be easier for customers to set up and maintain themselves - commoditisation. “In the long run, everything is a toaster” after all.

Softcat’s gross profit margins have declined in the past as a result of the increase in revenue from public sector customers. It looks to me as though future growth might come at the cost of margin dilution as it courts lower margin (but larger) public customers.

The chart above shows CCC as red and SCT as black. Only 15 or so VARs reported higher margins than SCT, and most of these had much lower group revenue. There could be plenty of growth left in the tank before this becomes an issue for shareholders, though.

Can culture be a moat?

One way to retain above average profit margins is to have some kind of economic moat - a structural competitive advantage.

Softcat makes a lot of its unique workplace culture. On its website, everyone is wearing converse trainers and t-shirts. It looks great but show me a company that doesn’t boast about having a “fun and vibrant” office environment.

I don’t want to dismiss culture out of hand - in Softcat’s case, it really does seem to be something worth shouting about. In 2020, it was ranked 5th on Glassdoor’s 2020 best places to work in the UK.

Still though, can culture be a long term moat? Can you earn high margins forever because you have created a fun working environment? I’m not so sure. Others may disagree with me here - I note that Keith Ashworth Lord holds it in the Buffettology Fund, which typically goes for companies with moats.

Perhaps you can maintain a truly exceptional work culture for long enough to spark a period of sustained above-average growth. But cultures shift and evolve all the time. They are not as permanent as people sometimes think. Every day is a battle between good habits and bad.

A good culture is highly desirable - it is not, however, a structural competitive advantage that can guarantee long term above average margins.

Alphabet and why I want moats

Let’s circle back to Google. Investing in Alphabet is an option, so we need to know why we should invest in CCC or SCT instead.

Which company in the table below would you rather have held since inception?

Building up a c£1bn company over a couple of decades is clearly an impressive achievement. It just pales in comparison to what can be achieved by that top tier of companies. A disproportionate amount of total wealth and productivity is generated by a thin sliver of people and enterprises. Alphabet clearly belongs in this bracket.

It has been so successful because it is so hard to compete against. Alphabet is a series of tech titans, each with their own economic moats.

These economic moats - durable, structural competitive advantages - are profoundly important to long term investors. They entitle you to a greater slice of the value pie over a longer period of time, greatly enhancing compound returns.

Thinking about moats can get quite abstract. There are a few different conceptual frameworks. A classic categorisation might include:

• Intangible assets such as proprietary technology, intellectual property, trade secrets, or strong brands.
• Switching costs - stickiness through standardization, from a lack of substitutes, through integrations to other apps and data sources, or because you have a valuable workflow.
• Network effects, best described by Metcalf’s law. You have network effects if each additional user of your product accrues more value to every other user. A good example is Facebook.
• Cost advantages. For example, being a lowest-quartile miner as a result of owning and operating superior assets.
• Size advantages, aka economies of scale. The bigger you are the more operating leverage you have which lowers your costs. This can become difficult to compete against.

The above is part of the reason why video games makers are attractive - because, with their own IP and proprietary engines they are well placed to earn a large slice of total industry profit. If you get it right here, I think you can truly win big.

Case in point: Frontier Developments is hitting new all-time highs after releasing a very encouraging update here.

Schumpeter’s creative destruction

Joseph Schumpeter once wrote in his diary that he aspired to be the greatest economist, horseman, and lover in the world. I’d like to focus on the “economist” part of that unholy trinity (for now, at least).

“Creative destruction,” he said, is the driving force of capitalism. The thinking was cold and clear: most businesses fall to competitive innovation. Obsolescence is the norm, but the general prosperity produced by the “capitalist engine” far outweighs the broken companies it leaves behind.

And amid this endless innovative churn, investors seek value.

How much of this value accrues to the innovator depends on how quickly it attracts competition. That’s why economic moats are so attractive - you hold onto excess profit for longer.

Graham wrote this great breakdown of what makes Alphabet so spectacular. In it he relays an exercise to think about competition. I’m sure there are a few variants of this but the one I recall comes from Pat Dorsey’s The Little Book that Builds Wealth.

Discussing eBay, network effects, and economic moats in general, Dorsey recounts:

I once asked a candidate applying for an analyst job at Morningstar what he would do if I played venture capitalist, gave him huge amounts of financial backing, and told him to go beat eBay at its own game in the United States. He thought for a minute and then replied, “I’d return the money.”

Good answer.

To build a sustainable and profitable business, you need strong defensive moats around your company. Softcat operates in an industry which is subject to continuous and fast-paced technological change. Competition will always be an issue in this arena - no matter how good you are.

I don’t think either SCT or CCC have moats - but they do have some structural growth tailwinds and large, fragmented markets to expand into. Prospects look good in the medium term, I think, and some might even say the pair’s leading market positions, scale of operations and reinvestment, and sector know-how are enough to keep them at the top in the long term.

VAR industry prospects

Here’s a rundown of recent VAR comment on market conditions. Given the commentary below, I’ve decided to include forecast PE ratios (for now).

Softcat (LON:SCT)

• Market cap: £2,470m
• Revenue: £1,080m
• F’cast PE: 31.7
• StockRank: 77

17 March 2020

The second half has started well and to date we have not seen a material impact from the ongoing Covid-19 outbreak, although this does create uncertainty for the remainder of our financial year. Given the strength of our business model, lack of any bank debt and a strong cash position, we will continue to invest in our business and are confident in our ability to continue to build market share and drive profitable growth over the longer-term.

The group’s financial calendar actually shows the next trading update is on May 26th - so it will be interesting to see what the company says then.

Computacenter (LON:CCC)

• Market cap: £1,830m
• Revenue: £5,053m
• F’cast PE: 18.3
• StockRank: 95

15 May 2020

We stated in our trading statement on 23rd April 2020 that current trading was more robust than we had anticipated at the start of the crisis. Since that date business has accelerated further and we have managed to secure some substantial Technology Sourcing contracts due to our ability to scale our operations to meet the demand. These incremental volumes mean that we now believe that the first half of 2020 will be considerably ahead of the same period of last year.

While things are a little clearer, continuing uncertainty in the market is such that the Board believes that it is still unable to provide meaningful guidance at this time concerning the second half of the year due to the COVID-19 crisis.

Redcentric (LON:RCN)

• Market cap: £168m
• Revenue: £208m
• F’cast PE: 15.9
• StockRank: 71

3 April 2020

In the second half of March 2020 we saw a material increase in sales opportunities as a result of the COVID-19 pandemic. Demand has been particularly strong for increased bandwidth and, in particular, for our secure remote access product. As a result, the volume of new recurring revenue contracts signed in March was materially above that seen in previous years.

… Looking further forward, we anticipate a reduction in sales to new customers and a slowdown in major change projects from existing customers until such time as the COVID-19 crisis is averted. We also anticipate that some of our customers may come under pressure as a result of the COVID-19 pandemic and this may lead to delayed customer receipts and increased business failures.

Adept Technology (LON:ADT)

• Market cap: £54m
• Revenue: £57m
• F’cast PE: 6.9
• StockRank: 23

2 April 2020

The Group has seen another strong year with further geographic expansion into Yorkshire... We doubt that the world of work will return completely to 'as it was before', indeed we anticipate a 'new normal' where remote working is more prevalent - increasing the dependence on effective, unified communication, highly resilient networks and cloud technology...

we expect to be well placed to address the changed demands that arise.

Overall, these comments from various VAR players suggest to me that they are currently experiencing a surge in business (which may fade - or decline if the wider economic situation deteriorates). The body language of key players in this sector is much healthier than in other pockets of the market.

Conclusion

CCC and SCT look like good businesses. Adept Technology is also interesting at first glance, given the strikingly low valuation versus its peer group.

In investing though, you can wait for your pitches and I question whether you need exposure to this part of the market at all. It is cut-throat and there are no obvious moats. That said, the “winners” (such as Softcat and Computacenter) are very cash generative with excellent operating track records of profitable growth. They are the two clear winners in a large, fragmented industry. Softcat has great momentum, and Computacenter's recent updates have been strong.

Given this backdrop, I think both CCC and SCT can continue to grow profitably for years to come - but they will need to continually reinvest profits back into their operations in order to maintain any kind of competitive edge. Scale is a real advantage here - few competitors can offer the range of services to end users that SCT and CCC offer. Perhaps this is enough to ensure longer term profitability.

There is still a lot of growth to come in the medium term from businesses migrating to the cloud and the ever-growing need for enhanced cybersecurity. SCT continues to report broad-based, double-digit growth across all its operating divisions - fantastic operating momentum - and I’m not about to bet against that now. We should be hearing more from the company soon.

That said, I see long term industry profits accruing more to IP-creating software creators rather than to the value-added resellers that pass them on to end users. I would rather look at the actual cybersecurity vendors, for instance, and there are a few of these around.