Brian Rainier | Contributor | ITWeb

Sectors

Companies

About

Home
/
Contributors
/
Brian Rainier

Articles

Looking back

SA IT shares generally experienced a good 2005 and expectations for 2006 remain cautiously optimistic.

The only way is up

Buy, hold, or sell? Brainier Capital and Consulting analyses the financial strengths and weaknesses of the IT sector in their quarterly report.

Strong performance

The small cap IT index has surged by almost 20 percent since June, mainly on the back of good results from a number of IT stocks.Despite challenging market conditions and a strong rand, resulting in muted revenue growth, small cap IT (SCIT) stocks have demonstrated disciplined cost control and delivered respectable profit growth. The strong performance of South Africa`s SCIT index is in contrast to Nasdaq`s four percent loss, and also eclipsed the overall JSE IT index, which moved by a positive five percent. Highs and lowsThe individual price performances of the stocks that underlie the SCIT index`s performance are shown alongside, where we plot the movements since the end of May.Leading the stars were ERP.com, Prism and FrontRange.ERP.com showed solid earnings growth, ending the year with significant cash holdings and concluding a very clean BEE deal with Blitec.Prism faced a tough year with a double whammy of falling SIM prices and a strengthening rand, but managed to show reasonable profits and convinced the markets that its restructuring is sustainable and next year should show continued growth off a lowered base.FrontRange continued to excite the market with a return to operating profitability and the stated intention of pursuing an offshore listing, where similar (and recently listed) companies are trading at an order of magnitude higher rating.EOH, Mustek and Datacentrix all showed strong results and demonstrated confidence in growth. At the time of writing we were still expecting (strong) results from BTG and UCS, whose price gains have shown this anticipation. Whilst AST still has some way to go, the market seems to be supporting some belief in the turnaround and its share even showed a 20 percent price gain. The sad story of CS Holdings and the offer by Bytes Technology Group (BTG) of 15 cents per share saw CSH`s share dive by 40 percent, whilst Faritec`s latest results indicate it still has some way to go to win back the confidence of the market. Glotec has unfortunately closed its doors as a listed entity for the moment.Idion posted disappointing interims but saw off hostile bidder DataMirror, which may have led to a lowering of the underpin for its shares demonstrated over the past two years, leading to its share price decline. Valuation: More upside still availableThe rand/US dollar exchange rate continues to have a significant influence on most IT stocks - either in terms of lower end-user prices and squeezed fixed overheads or through customers themselves reducing spend or delaying projects.That said, we believe the rand has bottomed and see that many IT companies have restructured their cost base appropriately to be profitable at these levels, leaving room for strong rand growth on any currency weakness.Our forecasts still factor in an average currency appreciation for the calendar year of some 13 percent, but a depreciation of 10 percent by end-2005. Companies that have restructured cost bases appropriately say that while conditions remain tough they are reasonably positive about market demand in the next year. Many say South African government spending seems to be flowing once again.Having made changes to individual company forecasts to reflect the continued strong position of the rand, and factoring in the sustained stock price rally, we calculate that the SCIT index continues to trade at a relatively low forward price earnings (PE) ratio of 5.7 (5.8 in June). The forward PE represents the short-term value of the index, based on a one-year earnings view of the composite stocks.If we compare the SCIT index forward PE to the implied discounted cash flow (DCF) PE at 6.3, which represents a longer term valuation as it uses the projected cash flows of the companies to calculate the index price, this would imply the sector could still re-rate upwards by some eight percent to the longer term value. This upside has some additional conservatism built into it as we are using a discount rate of 25 percent in our DCF calculations, which could be argued is too high for our universe of listed stocks.Whilst both PE measures are still not demanding in a normal market sense, they continue to reflect risk and uncertainty in the sector. Although we believe earnings growth forecasts, coming off a largely re-based lower level, are reasonably achievable, market prospects and currency uncertainty continue to temper this confidence.In terms of the graph on the next page, we use a relative PE valuation for an indication of re-rating price potential today (pricing date 4 October 2004). We plot the potential price appreciation for each stock versus a subjectively applied measure of the perceived relative risk in the forecast earnings of that stock.RecommendationsIn general, where our model indicates a company is valued at below 10 percent of its current price, the stock is a SELL. Where relative valuation is in the -10 percent to +10 percent band, the stock is generally a HOLD. Where relative valuation is greater than 10 percent, the stock is generally a BUY.Referring to the graph presented above, we see three main investment bands, as of 4 October 2004 1. SpeculativeAST: Whilst the group has made progress in its turnaround, the challenge has swung to maintaining revenue growth on the reduced cost base in what AST sees as difficult and competitive market conditions, with a still weak balance sheet. We forecast practically zero revenue growth given recent declines and challenges still facing the group, but at an improved margin which is still some way below management`s anticipation.The proposed financial restructuring, the acquisition of Gijima and a rights offer all make valuation rather pro-forma at this point. However, our models point to potential unlocking of large value for the share in time. Risk remains very high and the effects of the financial restructuring and merger unclear and we continue to see investment as highly SPECULATIVE.Prism has successfully shrunk back to its core competencies and markets. It has restructured, refinanced and appears to have costs under control. It has high intellectual property capacity and global opportunities.The group has been adversely affected by both a strong rand and weak chip prices; but with these stabilising we forecast revenue growth for the 2005 year, with a margin consequently increasing close to historic levels. Whilst revenue and margin projections thereafter remain difficult, given Prism`s notoriously lumpy business and exposure to the US dollar, we have modelled reasonably strong rand growth with an improving margin.Prism`s business model and currency exposure has always led to highly volatile bottom line results. A more solid base appears to have been established and currency and SIM pricing expectations should help rather than hinder results. But there remains relatively high forecast risk, which, combined with the potentially high price appreciation, leads us to maintain a SPECULATIVE rating on the share.Faritec is proactively changing its business to improve competitiveness, profitability, annuity income and ultimate sustainability. Latest results indicate the company has come perilously close to losing its cash resources. However, management indicates that with the sale of some non-core assets, the investment cycle largely complete and the new units breaking even, cash flow should turn positive soon.A big year is expected - for demonstrating traction with the higher growth, higher margin, new businesses, which are expected to carry future profitability. We anticipate a return to positive headline earnings.Faritec remains in the process of business transformation. Its existing business underpins its current valuation, and to the extent that it can deliver its new investments, significant value can be recreated. However, given the early-stage nature of the investments, we characterise the share as appealing to longer-term private equity type investors, and maintain our SPECULATIVE rating. 2. Undervalued (BUY) and at value (HOLD)FrontRange has refocused its strategy, which it is now aggressively implementing, based on three core software offerings, in CRM, IT services/helpdesk and the new market in contact centre-based products.The company has restructured its cost base and we expect continued improvement following the strong return to operating profitability in 2004, which we forecast will more than double within the next two years on the back of increased revenue and continued cost focus. We have forecast US dollar revenue growth rates of 10 percent based on recent performance, new product and version introductions and industry forecasts.FrontRange has demonstrated a turnaround and is well positioned to deliver strong results. FrontRange`s new CEO appears to have breathed life and energy into the organisation and, with the prospect of a US listing within the next two years, we expect continued support for the share if it delivers sequential growth. It`s a BUY recommendation.Idion has refocused to become exclusively a global software company, through its Vision Solutions subsidiary, by developing and supplying specialist high/managed availability software with a strong, but not exclusive, solution focus for the IBM hardware environment.The company is pinning strong growth on the release of its new software product, Orion, and is exercising strong cost control. On US dollar revenue growth forecasts of close to flat in 2004, and 10 percent thereafter, we forecast continued improvement in margins underpinning strong headline earnings per share growth.Idion has demonstrated a sustained return to operational profitability and, with its right-sized organisation and investment in new product, it should move to profitable growth in the medium term. Our valuations are conservative with plenty of upside possible in the medium term, and we would continue to BUY.Mustek is the dominant "assembler/ supplier" of PCs in the South African market and is also a successful distributor of PC components, peripherals and networking products. The company has consolidated its position in distribution, having divested from a number of unsuccessful product diversifications and investments, and is concentrating new efforts on geographical diversification, particularly in Africa, but more recently in Brazil.Rand appreciation and forex losses led to a disappointing financial year in 2004, but organic growth and new business promises a strong recovery. We see a reversal from revenue decline to growth at maintained margin levels.Mustek`s recovery in the final six months of the financial year, with relatively strong prospects, appears to have been appreciated by the market. However, our models indicate value can be extracted and we maintain our BUY recommendation.EOH appears to have successfully digested the Atos KPMG Consulting merger whilst continuing to post solid organic growth. Further benefits are expected from the merger in the medium term, adding both to EOH`s current ERP implementation and consulting capability. On the back of the recent acquisition of the Glotec BI business, we forecast continued strong revenue growth in 2005, reducing thereafter, with margins increasing as the merger is further settled, returning continued earnings growth.EOH maintains a strong track record of performance through a well-managed blend of acquisitive and organic growth. Its diversified products and services, on top of an ever-increasing customer base, combined with continued shrewd and well-integrated acquisitions on a relatively small market share, promise continued growth. We recommend a BUY.Datacentrix has positioned itself as a reliable systems integrator, providing network and PC-based infrastructure products and services to a large corporate and growing parastatal client base. The company is conservatively managed, has secured a 49 percent empowerment shareholder and is expanding its service offerings into ERP implementation and outsourcing.Recent results outperformed expectations as unit product sales grew faster than conservative forecasts, owing to new customers and successful geographic expansion. Margins also improved more than expected owing to "better operational buying and selling", as well as change in the product mix to the higher margin services and software.Given an expectation of rand depreciation and continued strong organic growth over the medium term, eps growth is projected to increase once again with medium earnings risk. With a strong track record, tight management control, empowerment positioning and successful services diversification efforts, Data- centrix should continue to provide above-sector average earnings growth in the medium term. New acquisitions and cross divisional new client synergies should support growth. Our models indicate a HOLD.BTG`s interim results announcement is due soon, which will give further insight into our forecast 32 percent growth in headline earnings for the full year. This has been supported to date by the group`s recent trading statement that it expects at least this performance improvement for interims. We maintain a HOLD at the current trading level. 3. Overvalued (SELL)ERP.com has established itself as a niche services company focusing on ERP implementations, security solutions, niche networking and document management solutions in South Africa. It has developed strong competitive positions and has strong implementation capability in selected areas, and also seems to be addressing African markets in a proactive manner.In spite of three years of exceptionally strong growth and some dampening effect of a strong rand on customer demand, we believe the company will continue to over-perform relative to the market, showing continued revenue growth over the next two to three years. Given the mix of products and services, we believe the company should be able to maintain margins close to current levels.ERP.com maintains its strong track record of performance where others have been struggling. It appears to be gathering more and bigger contracts as it proves its ability to deliver. The niche focus and strong cost control give some comfort to maintenance of operating margin. With a strong appreciation in the share price post results, we believe the share is overvalued and indicate a SELL at current levels.UCS is a software developer that dominates a major sector of the South African retail space. The company has established an application hosting/outsourcing model that ensures strong customer loyalty, attractive margins and a large annuity income stream. Similar models are being applied to its other software divisions.With the company bullish on the strongest pipelines seen in a while, we forecast revenue growth at modest organic growth levels.As a dominant niche player in a relatively large market, we see UCS as a quality company. The Affinity acquisition enhances its competitive position with significant services capability. We have been conservative in our forecasts for the Affinity business in the medium term. Further upside exists as synergies and UCS`s cost management style emerges. However, given the recent strong share price appreciation, our models indicate the share is currently overvalued and we recommend a SELL.We would avoid both CSH and Glotec, which are under serious construction at present.* Brian Rainier, a former rated analyst, is MD of Brainier Capital and Consulting, which provides detailed stock market research in a joint venture with Legae Securities. This analysis is subject to a disclaimer which can be found at www.brainier.co.za.

Still trading at value

The small cap IT sector is at or around value, with some risks. And what are the chances of CS Holdings turning the corner?All the companies we follow have now reported results. Using a calculated forward price earnings multiple of 5.5 and a discounted cash flow (DCF) valuation, with a 25 percent discount factor, the sector continues to trade at an eight percent discount to fundamental value.By the end of May, the small cap IT (SCIT) index had fallen three percent since the last pricing update at 7 May, compared with the Nasdaq`s gain of some two percent.The individual stock price performances that underlie the SCIT index performance, since our last pricing date, are shown below. Stocks for which we can attribute specific reasons for individual price performance include:* AST - the market is starting to anticipate weaker than originally expected results; * FrontRange - continued Nasdaq listing speculation, supported by the recent Nasdaq recovery; * CSH - uncertainty around the offer to minorities and Reunert`s and UCS`s withdrawals from bidding process; * EOH - positive reaction to a potential CSH bid; * Mustek and Datacentrix - continued rand strength might be having a negative impact on on net margins. RecommendationsHaving updated individual company forecasts to reflect both the continued strong position of the rand as well as relatively weak market prospects, we calculate that the sector continues to trade at a relatively low forward PE of 5.5 and implied DCF forward PE of 6.Our share recommendations are based on a combination of the current relative valuation based on PE ratios, DCF values and the relative earnings risk. In general, where our model indicates a company is at value or overvalued relative to its peers and DCF valuation today, the stock is a SELL. Where relative (under)valuation is in the zero to 10 percent band, the stock is generally a HOLD. Where the relative valuation is greater than 10 percent, the stock is generally a BUY. High-risk, high-return stocks are labelled SPECULATIVE. Based on stock prices on 28 May, we see three main investment bands: 1. SpeculativeThese continue to include AST, which has yet to demonstrate a return to profitability; as well as two potential software/specialised services company turnarounds, Prism and Faritec, which have yet to convince on sustainable earnings growth within their restructured entities. 2. Undervalued (BUY) and at value (HOLD)The companies we rate BUY are Idion, ERP and UCS, all of which have moderate to high risk attached to their earnings projections. We see EOH, Mustek and BTG at value and consider them a HOLD at current levels. 3. Overvalued (SELL)FrontRange, CSH, Glotec and Datacentrix all appear overvalued at present are consequently rated SELLs.* Brian Rainier, a former rated analyst, is MD of Brainier Capital and Consulting, which provides detailed stock market research in a joint venture with Legae Securities. This analysis is subject to a disclaimer which can be found at http://brainstorm.itweb.co.za or http://www.brainier.co.za CS Holdings - an analyst overview description and historyCS Holdings (CSH) was founded in 1990 as a division of PricewaterhouseCoopers. In 1996 a management buyout was concluded and the company subsequently listed on the JSE in 1998. The company grew through fairly aggressive acquisition to become a national, broadly based IT solutions provider and systems integrator, employing some 1 150 people. Through two major acquisitions, it secured strategic shareholdings from empowerment company Worldwide African Investment Holdings (WAIH) and international IT group Getronics NV.However, the recent downturn in the market for software integration services, caused to an extent by a strong rand, left CSH with an over-investment in resources and the company saw cash flow pressure and plunging profits. The company entered into a phase of restructuring, converting many employees to a contract basis and consolidating overhead and management services. With the share under pressure, Reunert acquired about 34 percent from previous shareholders Gensec and Getronics.Just when things looked like they might be stabilising, restatement of 2002 interims highlighted potential financial imprudence with respect to the accounting for a relatively hastily put together deal which was material to results and which was later reversed. CEO Annette van der Laan resigned in the wake of the negative publicity and an internally selected interim CEO was appointed.On 23 April Reunert announced an intention to offer minorities 35 cents a share, which was subsequently withdrawn on 17 May, the day that EOH announced its intention to mere an offer. Subsequently, on 20 May, UCS announced it was also considering an offer. Both UCS and EOH subsequently pulled out of the race.At the time of writing, CS Holdings intimated that a number of other unsolicited offers were being considered. StructureThe company is structured into three major operating divisions and addresses a number of vertical markets.CS Systems Integration focuses on delivering integrated IT solutions by providing strategic and IT consulting and broad based ERP implementation services (e.g. in the areas of SAP, JDE and Oracle). Niche markets include mining and manufacturing, where knowledge of process and manufacturing execution systems is a competitive advantage, and public sector consulting, relying on the core services of recently acquired Argyl Consulting, which is building on a strong empowerment profile.CS IT Solutions is concerned with provision, maintenance and outsourcing of IT infrastructure (such as systems, servers, PCs and networks). The acquisition of Getronics SA in 2002 provided significant capacity (over 500 employees) and countrywide (16 service depots) capability in the managed services arena.CS Education Solutions is one of the largest providers of IT education and training solutions to the South African corporate market. Training ranges from generic desktop software training, through ERP training to highly specialised functional-based training such as that done under the auspices of the South African Production and Inventory Control Society (SAPICS). Recent developments in e-learning should provide CS with the ability to maintain a leadership position in this space. Competitive positionGiven increased profit and efficiency pressures, the group has had to accelerate efforts to unlock synergies across the operating divisions and their respective client bases and has had to consolidate strategic accounts sales and vertical market approaches. CSH`s empowerment profile is beginning to help it gain business in the public sector and it seems to be building a successful empowerment brand. But this could be under threat as many other SI players, in particular Comparex, similarly become empowered. The extent to which the company can maintain its empowerment shareholder (WAIH) in the potential buyout deals is also questionable.Given the broad service offering to a fairly wide target market, which includes all major business verticals in South Africa, combined with the relatively large size and implementation ability of the organisation, CSH has the potential to become a challenger in the SI space. However, we see the current tough market conditions, on-going restructuring and cash flow pressures, as well as the uncertainty caused by the competing share bids, restricting the company`s ability to attract new business. Consequently we see it potentially heading rapidly towards the casualty ward, alongside Glotec and AST. Divisional results and forecastsCSH announced December interim results in February. Revenue growth was lower but operating profit margin performance was broadly in line with our expectations for the full year, but well below previous management expectations and guidance. Significant restructuring costs of R8 million further spoilt the anticipated recovery story.Additional restructuring costs of R2 million were expected to the year-end, but a profit warning issued on 28 April indicated that earnings for the full 2004 financial year would be substantially worse than last year (more than 30 percent), implying a total additional charge of some R40 million for the full year for restructuring or provisions, according to our model.We have adjusted our revenue forecast for 2004 downwards once again, from R558 million to R512 million (compared with the company`s previous expectation of R638 million and revised expectations of R557 million), based on pipeline information supplied by the company three months ago, which represents some 19 percent growth on last year and continues to reflect acquisitive contributions.We have adjusted our margin forecasts, giving recognition to the operating performance achieved at interims. They are broadly in line with our previous forecasts, but at 5.9 percent (before restructuring costs and provisions totalling an estimated R40 million) still significantly below the company`s previous expectation of nine percent.We have further projected flat revenue growth through to 2006. This assumption is the riskiest in our model and assumes that CSH survives the current turmoil. Similarly, we have assumed that the company can continue to maintain operating margin performance at the aggregate 5.9 percent - and have further assumed that the bulk of restructuring costs and provisions are contained in the 2004 numbers.We have updated our working capital assumptions in line with the interim balance sheet, and adjusted interest costs accordingly, with a forecast that the company could consume cash of up to R54 million for the full year (depending on the scale and nature of provisions), highlighting the cash squeeze we believe the company faces. Our model indicates a forecast headline loss per share of seven cents a share in 2004, but a potential recovery to a profit of above seven cents in following years, given corrective action and support for the business as a going concern. ValuationWe have considered both a discounted cash flow analysis as well as a PE relative comparison. Regarding the DCF, we have taken cash flow forecasts out to 2006, and then utilised a terminal cash flow growth of six percent and a 25 percent discount factor to yield a DCF value of 25 cents a share.On a relative PE valuation, we have in-creased CSH`s discount relative to its selected peer group to 30 percent, given the overall increased risk, which places the company on a relatively generous 12 month forward PE of 4.1 and a price of 23 cents a share. RecommendationGiven the huge uncertainty surrounding the company, which weakens its position every day, a valuation that indicates a medium-term salvage value of 23 to 25 cents a share, and an appreciation for the shrewdness of the potential bidders, we would SELL down to that level.Regarding the effects on the one known potential bidder, EOH, our call on its current share price with respect to the proposed deal will be entirely dependant on understanding its offer, when it is published. We look forward to examining this in the next issue of Brainstorm.

Close to value - just

A three percent fall in small cap IT shares has put them at close to their fundamental value.

The charter takes shape

Brian Rainier gives a heads up on the progress on the ICT Empowerment Charter, and finds that, from an ownership point of view, listed companies have made significant progress over the last 18 months.

Tough rand inflicts pain

As company results come in, it`s becoming clear the strength of the rand is hurting the small cap IT sector, keeping it overvalued.Last month we commented that in spite of the recent pricing pullback on small cap IT company stocks, and after adjusting forecasts following some company results, we still saw the sector overvalued compared to its fundamental earnings capacity.We maintain this view, having seen most of the balance of companies report in the past month. We continued to see the negative effects of the strong rand on company earnings. Our composite small cap IT (SCIT) index mirrored the dip and recovery seen on Nasdaq as shown in the graph below.Mostly downThe individual stock price performances that underlie the SCIT index are show on page 54, along with our recommendations as at 13 February. By and large, the recommendations correctly projected individual price performance direction, with two notable exceptions (excluding the speculative stocks which tend to be highly volatile). We called Prism and FrontRange BUYS, but both came out with results below our expectations.Other than that, stocks for which we can attribute specific reasons for individual price performance over the past quarter - other than market sentiment driven by the large cap and NASDAQ declines - include:* AST: worse than expected interim results and prospects, continued uncertainty; * Idion: demonstration of turnaround, results in line with expectation; * CSH: weak interim results, recovery still some way off, accounting issues and a CEO resignation; * Faritec: weak interim results, recovery still some way off; * Datacentrix: profit warning, dollar affected revenues. Still lowIn the rest of this article we look at the balance of the recent individual company results (BTG, Spescom, Paracon and UCS are still to report). Having updated individual company forecasts to reflect the continued strong position of the rand and weak market prospects, and based on recent reported results, we calculate that the sector continues to trade at a relatively low forward price/earnings (PE) ratio of 5.9 and implied discounted cash-flow (DCF) forward PE of 4.8.In general, where our model indicates a company at value or overvalued relative to its peers and DCF valuation today, the stock is a SELL. Where relative (under)valuation is in the zero to ten percent band, the stock is generally a HOLD. Where the relative valuation is greater than ten percent, the stock is generally a BUY. High-risk, high-return stocks are labelled SPECULATIVE BUY.Based on stock prices on 2 April, we see three main investment bands.1. SpeculativeThese include the two struggling SIs, AST and CSH, both of which have to demonstrate a return to profitability; as well as two potential software/specialised services company turnarounds, Prism and Faritec, which have yet to convince on sustainable earnings growth within their restructured entities.2. Undervalued (BUY) and at value (HOLD)The companies we rate as a BUY are Idion, EOH, UCS and FrontRange, all of which have moderate to high risk attached to their earnings projections. We see Datacentrix, ERP and BTG at value and consider them a HOLD at current levels.3. Overvalued (SELL)Paracon, Glotec and Mustek all appear overvalued at present, particularly on a DCF basis, and they are rated SELLs. Results round-upWhere we observed optimism from companies towards the end of last year that market demand had stabilised and sales pipelines had begun to improve, the continued strength of the rand has put a dampener on rand earnings expectations, specifically in three areas:1. The foreign currency earners - e.g. Idion, FrontRange, Spescom and Prism; 2. The imported hardware suppliers - Mustek and Datacentrix; 3. Systems integrators whose customer base depends on foreign revenue (e.g. mining, manufacturing) - CSH, AST and to a lesser degree ERP and EOH. While gross margins have largely been maintained, revenues and net profits have declined, offset in some instances by (to an extent unrealised) forex gains (e.g. Spescom, FrontRange).Datacentrix - next year should be better. Expectations were set by interims and the continued performance of the rand, and while turnover was lower than expectations, the group managed to maintain margin and returned better than expected headline earnings, albeit below last year`s result. Operating cash flow was strong in spite of reducing creditor days to obtain better trade discounts. But after settling acquisitions, other financing activities and the proposed dividend, net cash flow was neutral.We forecast sustained strong top-line organic unit revenue growth, maintenance of margins and strong operational cash flows, which, with an expectation of rand depreciation over the medium term, suggests earnings growth is projected to increase once again, albeit with medium earnings risk.Given its strong track record, tight management control, empowerment positioning and successful services diversification efforts, combined with a strong niche focus, installed client base and strong operational performance, Datacentrix should continue to provide above-sector average earnings growth in the medium term. Trading at close to our current relative value, but at a premium to our DCF valuation, our model indicates a HOLD.Glotec - still an investment for the brave. In reported final results for the year to December 2003, revenue and operating profit for continuing operations were in line with expectations. Our estimates of losses from discontinued operations, taxation and profit from exceptional items were all significantly out. As most of these latter items are not relevant to future earnings, we have limited our analysis and forecasts to the remaining businesses, which include offerings in business intelligence, ERP software and niche solutions and ASP based systems for policy administration within the southern African insurance industry (although this latter business is currently on the block).Given the extent of the corporate restructuring as well as external challenging market conditions, we have forecast zero revenue growth for the divisions going forward, where we estimate last year`s comparable performance at a ten percent decline, but have maintained the same margins going forward, which sees a strong return to operational profitability.Assuming a successful rights issue and settlement of the long-term loan, an increasing tax rate, our model indicates the group will only return to headline profitability in 2004 and earnings expectations beyond that are subdued.Given the auditors` review opinion, contingent liabilities of about R4 million from ex-employees, comments by the company itself that considerable challenges remain, we continue to consider any investment at this point in time as highly speculative and would AVOID until the turnaround proves more sustainable.Idion - recovery strongly on track. Finals for December 2003 on 16 March showed performance at a revenue and operating profit level in US dollars in line with expectations and reflected the predicted recovery to profitability (albeit marginal).Licence growth was flat, but services and maintenance growth compensated and contributed to an improvement in the overall margin. Cash generation was almost double our expectation, mainly as a result of strong working capital reduction, which is not expected to the same degree in future. Most other items on the income statement were in line with expectations, except tax. New tax allowances in the US have led to a lowering of the rate, resulting in headline earnings being significantly better than our expectation.The company reports 256 new customer wins, good growth in the EMEA region as well as increasingly good prospects in the former Eastern bloc and China. Looking forward, primary demand for high availability (HA) solutions remains strong, although global demand for new IT systems, which tend to drag along HA solutions, remains muted. We have cut our dollar forecasts for both license growth and maintenance and services. We believe, however, that upside exists, particularly as Orion gains traction and next interims should give better guidance on this.Our rand/US$ forecasts anticipate a depreciating rand of the order of 15 percent in 2004 and 10 percent thereafter, which further increases the company`s rand performance, after 2004 (2004 still shows an average appreciation of about nine percent) and we forecast the earnings before interest, tax, depreciation and amortisation (EBITDA) margin improving returning the group to respectable profitability.Similar to the challenges faced by FrontRange, Idion`s major challenge will also be cost control. The key to profitability over the next two to three years will be highly dependent on maintaining or improving on the costs of sale, while maintaining revenue growth.Although global market conditions remain muted, Idion`s own strategy should provide profit and we see earnings risk decreasing. Liquidity issues aside, compounded by the Datamirror holding of 43 percent, we maintain our BUY recommendation.

Still overvalued

Despite the fact that prices have come back recently, the small cap IT sector still looks overvalued in relation to its fundamental earnings capacity.

Looking good. But be wary...

Things are still rosy in the small cap IT sector. But one needs to watch out for uncertainty in the equity and currency markets.In our last quarterly review, in Brainstorm November 2003, we noted there had been strong price appreciation of 15 percent in the composite small cap IT (SCIT) index over the previous quarterly, yet we recommended that investors either BUY or HOLD onto their stock, commenting that not having one SELL across the universe of stocks was a pretty brave call.However, the change in the rand`s direction, added to the Nasdaq`s strong ten percent run-up through December and January, saw a largely sentiment-driven SCIT index continue to appreciate strongly by some 14 percent - although not as sharply as the overall JSE IT index (J090) which moved by a staggering 40 percent. ValuationWith the cumulative performance of last year, the question now is: has the sector recovered to full value or is there still upside?In light of the valuation discussion below, we believe it appropriate to reiterate our forecast approach and assumptions:Our assumptions on the rand / $ exchange rate at calendar year-end are:* 2004: 7.45 (i.e. 15 percent depreciation on 2003 at 6.48); * 2005: 8.20 (10 percent depreciation); * 2006: 9.02 (10 percent depreciation). The resultant year-on-year average rand appreciation/depreciation is thus calculated as: * 2003: 28 percent appreciation (we had previously estimated 24 percent); * 2004: 10 percent appreciation; * 2005: 12 percent depreciation; * 2006: 9.2 percent depreciation; Thus implying, for example, that a company with a 2003 or 2004 December year-end and 100 percent $ dependence has to overcome a 28 percent or 10 percent currency hurdle respectively before showing any rand growth.By and large we have not given the benefit of the doubt of a recovery in operating margins to a company in future forecasts and have generally pegged these at the latest demonstrated performance level, unless the company can clearly demonstrate to us why the margin should improve (and not just because higher levels were achieved historically).We have also used a 30 percent discount rate for our discount cash flow (DCF) calculation to recognise the risk and liquidity constraints of this small cap sub-sector, which we currently see in the realms of a private equity / venture capital valuation methodology, which typically uses a similar minimum internal rate of return (IRR) for this type of investment class. Low PEHaving once again made some fairly significant changes to individual company forecasts to reflect the continued strong position of the rand, and factoring in the recent stock price rally, we calculate that the sector continues to trade at a relatively low forward price-earnings ratio (PE) of 5.4 (4.9 in October), although some individual stock PEs have jumped significantly (particularly the software companies).We commented in our previous update that we felt we were about to observe an inflection point in terms of sentiment, where forward PEs were about to start trading above the implied DCF valuations. Indeed, this can now be seen to have occurred, where the sector forward PE of 5.4 is now trading some 15 percent above the implied DCF PE of 4.7 - typically observed in our SCIT universe in bull markets.This brings us to the question of the discount rate in the DCF calculation and whether we fundamentally believe that risk has reduced significantly enough to reduce the chosen 30 percent rate. By way of example, if we use a rate of 25 percent instead of 30 percent across the universe, then the implied DCF PE goes up to 6.1, which implies that the sector could still re-rate upwards by some 13 percent to value. We are not yet fully convinced that fundamental market growth for the sector is yet sufficiently supportive to justify a lower rate, and thus base our recommendations on the 30 percent DCF discount rate.Thus, while both PE measures are still not demanding in a normal market sense, they continue to reflect the risk and uncertainty with respect to the sector. While we believe the sector earnings growth forecasts, coming off a largely re-based lower level are reasonably achievable, market and currency uncertainty continues to erode this confidence.The relative valuation can be used for an indication of re-rating potential today, whilst the DCF valuation indicates the value level towards which price could move, given a return to less positive sentiment within the sector (see graphs). Alternatively, these valuations should provide good guidance for the longer-term investor. Recommendation summaryOur recommendations detailed above are based on a combination of the current relative valuation (implied PE price), the DCF value and the relative earnings risk. Given the comments regarding overvaluation in terms of our DCF valuation, we have tightened up on our recommendation bands (see IT sector ranking table).In general, where our model indicates that a company is at value or overvalued relative to its peers and DCF valuation today, the stock is a SELL. Where relative (under) valuation is in the 0 percent to +10 percent band, the stock is generally a HOLD. Where the relative valuation is greater than 10 percent, the stock is generally a BUY.We see three main investment bands, as of 2 February 2004: SpeculativeThese include the two struggling SIs, AST and CSH, both of which have to demonstrate a return to profitability; as well as Idion and Faritec, which have yet to convince on sustainable earnings growth (and deliver on restructured focus in the case of Faritec). Undervalued (BUY) and at value (HOLD)The companies that we rate as a BUY are EOH, UCS and Mustek, all of which have moderate risk attached to their earnings projections, noting that UCS and Mustek are expensive on a DCF valuation. Having enjoyed price runs in the past quarter, ERP and Prism are at value and we consider them a HOLD at current levels. Overvalued (SELL)At or overvalued on a PE relative basis, as well as the DCF valuation, are FrontRange, BTG, Datacentrix and Paracon. Individual company expectationsOn a slightly different tack, looking ahead to the balance of the year, what are the few big things we expect as a minimum and/or would like to see from each of our selected companies?* AST - a return to profitability; * BTG - earnings growth >20 percent, a BEE deal and improved liquidity in the share; * CS Holdings - a return to profitability; * Datacentrix - continued turnover growth, a strategy to minimise exchange fluctuations; * EOH - a successful bedding down of the Atos-KPMG deal, no hiccup in earnings growth; * ERP - continued earnings growth at greater than 30 percent; * Faritec - the new initiatives all showing the promise of profits in the following (FY05) year; * FrontRange - sustained recovery in earnings; * Idion - sustained recovery in earnings, sorting out the DataMirror share overhang; * Mustek - continued earnings growth; * Paracon - a recovery in earnings growth; * Prism - sustained recovery in earnings; * Spescom - sustained recovery in earnings; * UCS - bedding down of the Affinity acquisition, no hiccup in earnings growth, a significant international software sale.

Looking good, but the rand factor weighs

If 2003 was the year of share price recovery for the small cap IT sector, then 2004 will be the year the sector has to prove the recovery has substance.

The rand hedge software phoenix

This month our small cap expert guest writer focuses on FrontRange and Idion, and observes that while a strong rand may not be the greatest of news for South African investors in these two companies, both have engineered enough of a turnaround to warrant some investor attention.Idion and FrontRange both listed in the late nineties boom times (FrontRange as Ixchange) and used expensive stock to acquire operations in the US. Idion went to the board in August 1998 and took full advantage of the IT boom to raise capital to fund a number of acquisitions, initially in the local software market, and ultimately in the US with its purchase of Vision Solutions, which owns globally competitive proprietary clustering and high/managed availability (HA) software and services and support aimed primarily at the IBM iSeries (AS/400) product family.FrontRange listed on the JSE in 1997 as Ixchange and, like Idion, took advantage of the IT boom to explore a roller coaster strategy of acquisitions, followed during the IT meltdown by a reverse process of disposals, to position the group as a focused global player in the mid to small company customer relationship management (CRM) market.After enduring a tough few years, the outlook is now more promising, although both remain risky investments. Idion remains a hold for now, but FrontRange looks a buy.Let`s take a closer look at both companies. IDION TECHNOLOGY HOLDINGSLast year saw Idion successfully fight off a hostile bid for control of the company by major global competitor DataMirror, which acquired some 38 percent of Idion`s shares. Management and other friendly investors have essentially locked up the balance of shares, leading to a fairly unproductive stalemate in terms of share liquidity.Significant reorganisation at Vision Solutions and the sale of non-core operations has seen the company focus all its attention on Vision Solutions, with recent results indicating a strong return to headline profits and positive cash flow.Looking at its competitive position, Vision Solutions addresses a number of markets within the high-availability (HA) space and in September officially released its latest flagship product, Orion, which had been in development for some time.Vision Solutions regards Orion as the first multi-platform-based software solution that enables users to predictably manage the functional availability of servers, data and applications across an enterprise, regardless of platform.Orion supports the OS/400, Windows and Linux platforms and DB2/400, UDB, Oracle, Sybase and SQL Server databases. Vision has invested significantly in Orion`s Java/XML component based architecture, enabling a completely modular and highly scalable solution set.Vision refers to comments by Dan Kusnetzky, author of the IDC Worldwide Clustering and Availability Software Forecast 2002-2006, saying, “we believe vendors that have strong cross-platform offerings, like Vision Solutions` Orion, are likely to be the leaders throughout the period”.Idion faces direct competition across its product range from global competitors – DataMirror and Lakeview in the IBM space, Quest in the Oracle/HP/UX space and from numerous storage-centric competitors, including major players Veritas and Legato.But Vision Solutions should maintain its strong position in the heterogeneous IBM space as well as increasing its ability to address multi-vendor and platform environments.But it will remain a small niche player, albeit a well-positioned one, with revenues still well below the $50 million mark, but starting to attract attention from industry researchers – leading to higher customer sales but also putting it onto the radar screen of bigger players looking for acquisitions.The major inhibitor to growth continues to be the continued soft rate of global spending on infrastructure (typically the sale of HA software is driven by the implementation of multiple new hardware installations).Positive growth factors include the higher visibility HA is enjoying post September 11, new functionality offered by Orion, as well as increased support from IBM. It is estimated that sales of the IBM iSeries platform continue to be in the order of 30 000 to 40 000 per annum.The company is highly focused on cutting costs and achieving profitable margins. Since acquiring Vision Solutions, 26 of the 28 senior managers and over 50 percent of staff have been retrenched or replaced, leaving 170 employees. The development and maturing of the reseller channel is also having a positive effect on margin improvement. The forecastGiven the proprietary nature and minimum of third party product for the bulk of its offering, Vision Solutions enjoys significantly high gross margins on its licence (99 percent) as well as service/maintenance sales (about 64 percent). The company appears to have restructured its cost base appropriately, while still supporting sales and research and development, to return reasonable double-digit earnings before interest, tax, depreciation and amortisation (EBITDA).Despite the long-term potential of Orion, I have maintained a US dollar revenue growth forecast of nine percent for licences and 20 percent for sales and marketing. R&D should stay around 20 percent of sales, and sales, general and admin (SG&A) costs should fall from 50 percent to 45 percent as revenue increases in the 2005 financial year. The EBITA margin should be 17 percent by 2005. The big challengeAs with FrontRange, Idion`s major challenge will be cost control, with the key to profitability over the next three years being its ability to maintain or improve on the above costs of sale, while maintaining revenue growth.Improved operating profit, more stringent control over channel debtors, favourable prepaid maintenance revenues and the deferred tax asset all point to strong headline earnings and, more importantly, positive net cash flow forecasts from the 2003 financial year onwards.Using a terminal cash flow growth of six percent, and a 30 percent discount rate, Idion has a discounted cash flow value of 179 cents out to 2005.There is still high risk in Idion`s profitability prospects, but this is also the case for DataMirror and FrontRange. However, recognising the typical discount for being listed in South Africa, Idion should be placed at the average of the selected peer group rating, or an implied current price of 209 cents – just above its current 200 cents.Idion has demonstrated a sustained return to operational profitability – and that with its right-sized organisation and investment in new product, which should stand it in good stead in the medium term.These forecasts and valuations are conservative, with plenty of upside potential in the medium term, making the stock a hold, albeit in the speculative region of the risk spectrum. FRONTRANGE LIMITEDFrontRange operates in nine countries including South Africa, the US, Singapore, France, Germany and Italy, employing some 450 people, down from 540 a year ago. The user base is in excess of one million people or over 120 000 companies worldwide.The listed entity recently increased its stake to 100 percent of the US-based subsidiary, which focuses on two separate markets within the broader CRM space, namely business contact management and sales and marketing automation software (GoldMine); and customer service and support software (HEAT).Both GoldMine and HEAT are acknowledged as serious industry players in their markets by global IT research organisations such as Aberdeen Group and Gartner (which rated HEAT as a “Challenger” in the IT service desk vendor Magic Quadrant in 2002) and both have won significant customer and industry awards for functionality and ease of use.Aberdeen observes in an executive white paper that the company has created a solid strategy that is finding support from the market and “if the company can continue to drive its message out to the broader market, it will be able to secure a leadership position in the growing CRM middle market”.However, FrontRange has recently abandoned its vertical CRM strategy, because of the costs of further segmenting its customer base, and the costs of implementing vertical applications.The company has consequently refocused its CRM strategy on its core product offering and in further refining and developing a distribution channel that has seen some attrition over the past year as many smaller IT businesses have closed shop.HEAT, representing some 65 percent of revenue, continues to be well supported and the product strategy remains, with continued feature enhancement and development.R&D efforts are further being focused on developing and integrating Goldmine and HEAT on the latest technology platforms of the XML, SOAP and web services standards. The Microsoft factorCompetition remains from Microsoft, as well as major software vendors like SAP and PeopleSoft as they add integrated CRM functionality to their product suites.FrontRange indicates that while Microsoft could become a serious competitor in the long term, in the medium term it competes with only about 25 percent of FrontRange`s current product offering; and faces similar challenges in bringing new product to market.Barriers to entry in the CRM market space have increased dramatically and FrontRange`s competitive position is consequently enhanced as Microsoft increasingly demonstrates its intentions to carve out a niche, capital for new entrants remains scarce and competitors continue to show depressed revenue growth and performance.But much depends on which way the market for CRM solutions moves in two main respects:1. Integration into packages versus best of breed. This is difficult to call, but with the ease of integration through web services architecture, it may become less of an issue and functionality may become the differentiator instead;2. The dominance of a standard (such as Excel in spreadsheets or Word in word processing). Here it is likely that a certain functional subset will be standardised (within Outlook for example), but that workflow and integration associated complexities will probably leave room in a market for more complex products.FrontRange continues to demonstrate relatively stronger performance than its closest competitors in the CRM space over the past year: overall revenues dropped by some four percent in US dollars, compared with 20 percent to 30 percent for Siebel, Pivotal and Onyx, with licence sales showing even higher declines.Forecasts for global spend on software and services are still soft to cautiously optimistic for the balance of this year.With prospects for licence and accompanying services revenue growth still looking slim, and a move to channel rather than direct sales, licence growth forecasts in US dollars falls from three percent to minus 10 percent for next year, and minus five percent in 2005, before stabilising at zero. Putting plans in placeServices should show zero growth and maintenance should grow at 10 percent, returning flat to low US dollar revenue growth for 2004 and beyond, in line with management`s expectation.The company is putting programmes in place to reduce its product cost of sales (such as no longer bundling certain database components) and increase the product margin through a more efficient channel strategy, so product gross margin should rise from 78 percent currently to 80 percent by 2005.Management is targeting a reduction in sales and marketing costs to 45 percent of sales in 2004, with an ultimate target of 35 percent, but based on a conservative 45 percent to 2006, and unchanged costs of general and administration and research and development, the EBITA margin for 2006 should be close to 10 percent.Improved operating profit through more stringent control over costs and savings from implementation of the channel strategy should ensure strong headline earnings and positive net cash flow forecasts.On a similar discount cash flow model to Idion (six percent terminal cash flow growth and a discount rate of 30 percent), FrontRange has a DCF value of 162 cents.While there is still high risk in FrontRange returning to strong profitability, its global and local competitors in the CRM space face similar market challenges and FrontRange should trade on par with them. Using the same logic as with Idion, FrontRange has an implied current price of 325 cents, well above its current price of 170 cents.Trading at a significant discount to its US peers, FrontRange is bound to start attracting more offshore corporate and investment banking interest and a medium-term investment must be underpinned by a US-based exit. This makes the stock a buy.Brian Rainier, a former rated analyst, is MD of Brainier Capital & Consulting, which provides detailed stock market research in a joint venture with Legae Securities. This analysis is subject to a disclaimer which can be found at www.brainstorm.itweb.co.za.

Sizing up the BEE challenge

Local IT firms have had nearly six months to peruse government`s black economic empowerment framework. Sadly, few meet its exacting standards.