Information technology is to the brain what mechanical power is to our bodies – excellent prosthetics. Human beings aren’t very strong in the bigger scheme of things; chimpanzees are up to 5 times stronger than us on a power-to-weight basis. Neither are we very fast, Wayde Van Niekerk runs at a bit less than 10 m per second for 43 seconds while the laziest lab sheep or goat could run at 20m per second for more than 2 minutes! There are two classes of events we would be podium contenders for in an animal kingdom Olympics – any event that requires thinking and any endurance race. Believe it or not, we beat almost any terrestrial animal over long distance races, there are even marathons in Texas where horses run against people and people often win! And everybody knows we have the smarts – a clever monkey is no match for a 5 year old, but it is a clever MONKEY. We are even named after our greatest ability; we are Homo Sapiens (Homo the wise).
But we have cognitive limitations – we sometimes forget, we are terrible natural statisticians, we confuse a good story that makes sense with the truth, and we need regular down time (rest). To make a long story short, we need tools to help us cope with the complexity of the modern world. Some tools are luxuries and others necessities, I am of the opinion that information technology is fast becoming tech of the necessary kind as it is an essential extension of the human mind facing an uphill battle with the cognitive load of modern living.
The importance of IT in the modern world is creating tremendous economic demand for the goods and services that make IT possible and sustainably functional. There will be increasing demand for businesses who develop IT but also for those who help others profitably reap its benefits. ADI is well placed as both a producer of bespoke IT solutions AND a service provider effectively and efficiently implementing the solutions of others. In other words, they design and build IT and they maintain and integrate the IT of some of the world’s premier developers of IT IP (Microsoft, Oracle, SAP, etc). By designing their own IT IP, they create “sticky” demand for their goods and services as a functional company (customer) requiring real-time IT functionality is not going to change service providers on a whim (too costly and risky). And by ably providing and maintaining the IT offering of world-class companies, they ensure that their prospective clients have access to a one-stop offering from ADI. A client does not have to go somewhere else to get his IT fix, he or she engages with ADI and all is well.
AdaptIT provides information technology goods and services to the educational (22%), energy (20%), manufacturing (30%), and financial services (28%) sectors in South Africa, the rest of Africa, Australasia, Europe, and the America’s.
The majority of Revenue (73%) is made in SA with the rest of Africa (13%) a distant second. The Americas, north and south, contribute 7% while Australasia and Europe make up the balance with 5% and 2% respectively. At this point in time SA is still the big daddy as far as ADI’s business is concerned, but it seems that the company is successfully diversifying sector-wise and geographically.
It is difficult to determine the size of the SA pie that ADI is sharing with all other relevant competitors. I have heard (albeit from industry players) that the market is R150 billion-plus in size and it is apparently growing at an inflation-beating rate of around 8% per annum. In addition, many people with knowledge of the matter claim that the industry is very fragmented (lots of smaller players with a few employees) and is thus ripe for the type of strategy pursued by the ADI’s and EOH’s of this world. The essentials of this strategy is to grow by acquiring the smaller players in niche sectors of the bigger IT environment by enticing them with a combination of the potential to become part of a bigger listed, BEE- connected-enterprise, while hoping to maintain a high level of smaller company entrepreneurial flair by not micromanaging these acquired enterprises. And at acquisition prices that make economic sense of course, but we will get to that.
ADI – The numbers
I got a bit carried away this time with some detail. At least it should still read better than the local telephone directory – I hope!
The overall growth in Revenue for ADI from 2015 to 2016 was 38% (R830.3 million versus R578 million). Acquisitive growth accounted for 29% of the 38% growth while organic growth contributed 9%. In 2015 the split between acquisitive and organic growth was 24% and 18% respectively. The decrease in the 2016 organic growth performance is due to some pricing headwinds in the educational sector (the fees must fall movement capped ADI prices to tertiary educational clients) and the lower global oil prices of 2015/2016 created pricing pressure in the energy industry (this was managements explanation for the muted organic growth performance).
If possible, it is a very good idea to dig deeper into the revenue performance of a business by looking at the differential performance of the different sectors that they operate in. When we do that we see that the revenue growth for the educational sector was 9.5% in the 2016 financial year (R170.8 million versus R155.9 million). Presumably the rate of revenue growth would have been closer to the 2015 showing (26%) were it not for the passionate fees must fall movement and the concomitant pressure on the budgets of the tertiary institutions that ADI provide services to. I do not see this revenue performance improving substantially (in SA anyways) as students are committed in their opposition to future fee increases of any kind (at least with regards to 2017).
The revenue of the energy sector increased by 46.5% from R109.1 million in 2015 to R159.9 million in 2016. The comparable growth rate for 2014/2015 was 54.5%. As far as I am concerned 46.5% revenue growth is hardly pedestrian (!) but will surely not be maintained if no acquisitions are made to bolster organic growth in the sector. My reasoning is as follows (and applies to the other sectors ADI operates in as well):
Energy sector IT-spend in SA is not growing at 40%-plus, or at least not sustainably. If ADI is growing their energy-sector IT revenue at 40%-plus that implies one of four possibilities to my mind:
Firstly, they could be buying other companies providing services to the sector and thus gaining revenue (market share) in this way.
Secondly, they could be gaining market share (organically) at a tremendous rate due to the superiority of their offering vis a vis other service providers.
Thirdly, they could be expanding into other geographies (apart from SA) where there is the sort of room to grow revenues at 40% plus per annum.
Fourthly, they could be doing a little bit of all three possibilities mentioned. I don’t know what the true state of affairs is but I can tell you that chances are slim that their energy sector revenue will grow sustainably at anywhere near the 40%-plus rate unless they acquire other companies in the sector or grow internationally.
Turning to the revenue performance of the financial services sector we see that the acquisition of CQS was transformative and resulted in revenue growth of 135% (R232.2 million versus R94.7 million) for the 2016 financial year. The comparable 2015 performance was a statelier 46% increase. CQS is a leader in providing auditing software to the accounting profession where they have been active for decades and have a client base numbering in the thousands. Their results have been included in ADI’s for 6 months and although they make about 75% of their profits in the first half of any calendar year we can expect to see a significant contribution from them in the next 6 months as well.
The carried-away bit
(Note: I am of the opinion that there is a mistake in the ADI financials concerning CQS as they maintain that CQS contributed around R33 million PAT to ADI for the 6 months ended June 2016. This doesn’t appear accurate as the TOTAL Profit after tax for ADI in 2016 was R78.3 million (2015 – R52.6 million). Subtracting the PAT contribution from CQS thus leaves ADI with a 2016 PAT of R45.3 million which is 13.8% LESS than the 2015 PAT performance. This seems impossible considering that ADI’s organic revenue (without CQS included) growth was 9% and both its operating (15% to 17%) and net margins (9.1% to 9.75%) increased during the period.
How could your profit after tax DECREASE if your organic revenue increased and your profit margins improved? – It beats me but my best guess is that the CQS contribution to PAT has been overstated. Evidence for this conclusion is supported by the fact that ADI paid R217 million for CQS, which means that if CQS traditionally makes 75% of their PAT (R33 million?) in the first half of the calendar year, then a full years PAT will be around R40 million. This entails that ADI purchased them on a forward PE of around 5.4 times. This does not mesh easily with the guidance given by ADI on SENS (19 October 2015) that the financial performance of CQS was R10.7 million PAT for 2015. Unless CQS generated 3 times more profit in the 6 months ended June 2016 than for the ENTIRE YEAR ended February 2015, then Bob is probably your uncle AND your aunt.
Lets see if we can figure it out somehow. I see that the EBITDA of CQS for the year ended February 2015 was around R35 million, which suggests that the supposed R33 million PAT contribution from CQS as reported by ADI for the 6 months ended 30 June 2016 might in fact be a EBITDA number and not a PAT number. Or it could be that the 2015 PAT for CQS was materially lower than what it usually is. This could be as a result of a number of factors; either CQS had some serious debt, a big “I” in EB”I”TDA, a significant “T”, or a material “D and/or A” in 2015 which was subtracted from its R35 million EBITDA in that year to arrive at the R10.7 million PAT seen in CQS’ Feb 2015 results (EBITDA – I – T – D – A = EAT (PAT)). This would still not explain why the rest of the ADI business appears to have increased their profits when in fact there was a decrease if the reported CQS PAT number for 2016 is correct.
The bottom line is that ADI bought a company called CQS for R217 million. This company made R10.7 million profit after tax (PAT) for the year ended February 2015. This company either did exceptionally well in ADI’s hands, making 3 times more money in 6 months than what it made for the entire 2015 financial year as a stand-alone company or there is a mistake somewhere in the numbers reported by ADI.
If there is NO mistake, then the rest of ADI’s business did NOT have a good 2016 as the profits of the rest of the business, apart from CQS, decreased from R52.6 million to R42.3 million. If there IS a mistake, then ADI paid a hefty multiple, at least historically, for CQS at around 20 times its 2015 PAT (R217 million/R10.7million = +- 20 PE). As far as I am concerned, paying up for CQS is a lesser evil than seeing the core ADI business going backwards to the tune of minus 14%, and as such I hope the PAT number attributed to CQS is a mistake.)
Moving on from that extended interlude to our revenue performance discussion we see that the manufacturing sector grew its topline at a rate of 12.4% during the 2016 financial period (R242.2 million versus R215.4 million). In the 2015 period the growth rate was 45.8%. The problem with analyzing ADI is that I just don’t have access to the type of fine-grained information that I would like to have. The problem is not too much information, but too little. Is a 12.4% revenue growth performance sustainable? It surely is much more realistic than to suppose 40%-plus growth rates but there is a significant range of uncertainty here.
If the overall IT market in SA is growing at around 8% per annum and ADI is growing at 30% plus it means that the company is stealing market share from others. Even at the 2016 organic growth rate (without any contribution from companies that it acquired in 2015/2016) the company is still eating at least part of someone else’s pie.
The non-negotiable when stealing market share is that you do so profitably. There is an almost unlimited market for pricing popular goods at unacceptable levels. In other words, in theory ADI can act gluttonously by attempting to eat the whole SA IT pie if it is willing to provide the services it does for a price that is low enough. But how long will its charity be sustainable? I like the fact that ADI is growing at double-digit rates revenue wise, but I want to see that they do so profitably, and hence value accretively. To determine this we need to investigate ADI’s profitability.
AdaptIT made R136.5 million operating profit in 2016 (R86.5 million in 2015), which is 43.9% higher than in 2015 at a return on average assets (ROA) of 17.8% (21.7% in 2015) and a return on average equity (ROE) of 19.8% (20.8% in 2015). You will see that the growth in revenue from 2015 to 2016 (38%) is lower than the growth in operating profit for the same period (43.9%). This means that ADI was able to manage costs in such a way that they grew slower than the growth in revenue and this shows up as an increase in margins (either gross margins or operating margins or a combination).
Looking more closely we see that the gross profit margin (GP margin) for 2016 was 56.3% while it was 47.7% in 2015. I cannot comment too much on this without more info. What happened to the operating profit margins? The operating profit margin (OP margin) for ADI as a whole increased from 15% in 2015 to 17% in 2016. Digging deeper we see that the OP margin for the energy sector increased from 22% in 2015 to 24% in 2016. The OP margin for the education sector remained unchanged at 17%. The OP margin for the financial services sector also remained unchanged at 15%. The OP margin for the manufacturing sector increased from 13% in 2015 to 16% in 2016.
The 5-year profitability of ADI shows that its ROA’s have been pretty stable. In 2016, its ROA (return on average assets) was 17.8%. In 2015, it was 21.7%, in 2014 20.9%, in 2013 18%, and in 2012 it was 17.6%. The 2016 performance was thus slightly below the 5 year average ROA of 19.2% and is largely a result of the CQS acquisition. I expect to see the ROA rise back to the 20% level over time as the next 6-month profit contribution from CQS is added to the asset base (the total assets of CQS has been added but not all the profits due to it been in the results for 6 months only.). In addition, there should be at least some revenue and cost benefit from its been part of the ADI stable going forward (shared back office and the like).
For valuation purposes I like to take a look at the ROE numbers of a business as this gives one a sense of what the business generates for its equity owners as opposed to all capital providers like an ROA or ROIC. If the accounting value of the business per share (Its accounting assets per share – accounting liabilities per share = book value per share (equity)) approximates the market value (stock market price) it means that the business will sell at a price to book P/B of 1. If this is the case then the ROE of a business is a good indication of what sort of rate of return the investor will make on his or her equity all else held equal. For example, if Standard bank trades at a P/B of 1 and has an expected 1 year ROE of 10%, then you should make around 10% (in that year) when holding its shares.
The ROE performance of ADI for the last 5 years has been excellent although the decreasing trend over time is something to keep a very close eye on. ADI generated a return on average equity of 19.8% in 2016, 20.8% in 2015, 27.47% in 2014, 29.5% in 2013, and 30.6% in 2012. The 5-year average ROE is 25.6%. It is not unusual to see the ROE of a business decrease over time. Economic theory suggests that competition for profits puts pressure on the margins of very profitable businesses such as ADI as potential competitors enter the market (eyeing the gold so to speak). My concern is that many companies in their rush to grow do so unprofitably by pricing their goods badly, by choking on too much debt, or by paying too much for acquisitions.
The CQS acquisition was done at a PE of 20 odd times. Inverting the P/E to give us an E/P (earnings yield or return on price) shows that is was bought at around a 5% earnings yield. Effectively this means that IF CQS does not make MORE money than what it already does (from its 4000 clients and 20 years in the market) then ADI, and us as its equity owners, will only make 5% on the CQS part of ADI going forward. This is far below ADI’s current ROE of 19.8% and will require that CQS make not 2 times more but 4 times more profits after tax than what it did for the year ended February 2015 (R10.7 million) to ensure that ADI’s ROE does not drop further from 19.8%.
Why is a drop in ROE not good? A drop in the returns of a business, whether a return on assets (ROA), a return on invested capital (ROIC), a return on equity (ROE), or however you want to define your return measure is crucial to the fundamental value of a business. If it drops, the value of a business drops all else held equal. The fundamental value of a company depends on three factors, the ROE (or other return measure), the growth in earnings, and the cost of capital.
V = E (1- (g/ROE)/(k-g))
– Where V = Fundamental (intrinsic) value of the company
– Where E is the profits after tax generated by the company in a given year
– g is the growth in profits after tax (PAT)
- And k is the cost of capital (see my previous articles for a more thorough explanation of the cost of capital concept)
Assume that the ROE remains at the 20% level for the foreseeable future. The organic growth rate was 18% in 2015 but dropped to 9% in 2016. Supposedly the SA IT market is growing at 8% annually. ADI grew earnings (PAT) at a compounded annual growth rate of approximately 34% during the last 5 years. I don’t know if it will manage this type of growth and even if it does I suspect the 20% ROE assumption may suffer as a result of expensive acquisitions and equity(share) issuance. Lets suppose that ADI can double their PAT over the next 4 years (about 18% per annum). After that we will assume it grows at the SA IT market rate of 8% until the ANC does not govern anymore. Plugging these values into our formula we get:
E = 78.3(1.18)^4 = R151.8 million PAT (“doubling” PAT in 4 years)
ROE = 0.2 (20%)
k = 15% (0.15 – what I require to risk my money in shares)
g = 8% (0.08 – SA IT sector growth into perpetuity)
V = 78.3(1.18)/(1.15) + (78.3)(1.18)^2/(1.15)^2…(78.3)(1.18)^4/(1.15)^4 + 151.8(1.08)(1- (0.08/0.2))/(0.15-0.08))/(1.15)^4
= R1140 million
At R13.05 per share, ADI has a market cap of R 1.827 billion. This is 60% more than the fundamental value we worked out given the assumptions that we used. Does that mean the company is grossly overvalued? Not necessarily. It could be that our assumptions were too conservative. Once one knows that the 3 fundamental variables affecting a companies valuation are its ROE, its cost of capital (k), and its growth rate (g), one can imitate the Chinese and reengineer almost anything, including what the market “expects” these values to be given the current market price. Its simple maths, you have an equation with 4 unknowns, if you have any three of these then you are able to find the 4th without any further ado.
Lets do one basic reengineering calculation for ADI:
V = E (1- (g/ROE))/(k-g)
What is the sort of E (PAT) that the market expects from ADI assuming our other assumptions are correct?
E = V/(1-(g/ROE))/(k-g) = 1827/(1-(0.08/0.2)/(0.15-0.08) = +- R213 million
Basically this means that the market is expecting ADI to make R213 million profit after tax (E) at present if our other assumptions are correct. As of June 2016 they are making R78.3 million. Seeing that they are not in fact making that much (R78.3 million actual versus R213 million expected) does not imply that they are overvalued, once again, our assumptions may be too conservative, but it does show that the market thinks ADI will grow their earnings to AT LEAST R213 million in the near term (they need to make more in future to compensate for time value of money), and probably much closer to the R300 million mark if you ask me.
Is this doable? I think so, but know that the current share price of R13.05 is already expecting a lot from this company.