Is this time different for IT services?

This week Guy Carson reviews the IT services sector which is a sector typically overlooked by the Australian market.

When an investor thinks about the Australia equity market, they typically think of Banks and Resources. They may also think about supermarkets, Telstra and one of the more advanced REIT markets in the world. One sector they typically won’t think about is Information Technology. This is with good reason; Australia is not home to Apple or Google, and even the more exciting businesses which have begun in Australia such as Atlassian choose their future abroad. In fact, the largest IT company listed on the ASX is Computershare which arguably could be classified as a Financial. As a result it’s a sector that largely gets ignored by Australian investors. If one has no international exposure, they are unlikely to have much exposure to IT at all and this is likely to be costly. IT is the fastest growing sector globally and this is likely to be the case for years to come.
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To illustrate the likely road ahead for technology, it is helpful to consider the fable of the chessboard. The story goes that an ancient King played a game of chess against a wise man. When the King lost, he offered this wise man a reward of his own choosing. The wise man, who was also a wise mathematician, told the king that he would like just one grain of rice on the first square of the chess board, double that number of grains of rice on the second square, and so on: double the number of grains of rice on each of the next 62 squares on the chess board. This seemed to the ruler to be a modest request, so he called for his servants to bring the rice. The King was then surprised to find that the rice quickly covered the chess board, and then filled the palace. The amount of rice grains on the last square is 2 to the power of 63 or 18,446,744,070,000,000,000.

What does this have to do with technology? Well, Moore’s Law is that computer processing speed (transistors per square inch) will double every two years. This law has been remarkably accurate to date and at this point we are roughly half way through the chess board. The growth in technology has been exponential and this growth is set to continue. The ideas of virtual reality, self-driving cars and artificial intelligence are becoming more and more prevalent. So how does an investor in Australia benefit from this global phenomenon? Well there are two ways, firstly one can buy overseas shares directly or one can search through some of the lesser known Australian companies operating in the technology space. When one does search you can find companies that are leaders in niche products globally.

Whilst some areas of the Australian technology market such as the internet companies and some of the midcap software companies have seen significant rallies in recent years, one sector that investors are still a little wary of is IT services. Historically, this sector was built on a consultancy model that saw earnings dependent on the number of consultants and the utilisation of their time. However the rise of cloud technology has changed the dynamic significantly. Small and medium businesses have recently been moving away from on premise servers and are shifting to the cloud. This effectively means firms have outsourced their IT to a specialised building called a data centre. Providers such as NextDC have exploited this opportunity and are in the process of rolling out further capacity. There is a missing link, with the vast amount of cloud software available and the complexity of managing a remote IT network, a need for an external management party becomes essential. That is where the services sector is evolving, away from a consultant coming to your premises to the ongoing management of an external network. The advantage of the new model is a proportion of your revenue becomes recurring, meaning profits are less lumpy and less vulnerable to economic downturns.

Three companies that are benefitting are Data #3, Melbourne IT and Dicker Data. All of these companies are similar in they have historical businesses with large client bases and have utilised this advantage to roll out service offerings. Data #3 was an IT distribution that has expanded into services, the latter of which is now larger the first thanks to strong growth. Dicker Data is also a distribution business that has recently signed an agreement with Hitachi Data Systems to launch a new Enterprise Data division. Melbourne IT was a domain registry business that expanded into enterprise services.

Despite the change in business model, the market is still reluctant to pay too much for these businesses. All three trade on Price to Earnings multiples in the mid-teens despite strong earnings growth in recent years and paying out strong dividends.  If the recent trajectory growth continues (and with the continued adoption of cloud technology it’s not hard to see how it could), then a case can be made for higher multiples. If we consider that some of the software companies trade on multiples up to and in some cases north of 30x, then if a services company sees similar growth rates should they not trade on a similar multiple?  The answer is probably not and we don’t expect these companies to rerate that significantly. Service companies whilst having improved the quality of revenue in recent years are still more vulnerable and subject to downturns. Despite that we do see upside if the current growth rates are maintained. For example, if we look at the current share price of Data #3 and use a simple dividend discount model with a discount rate of 10%, we find the market is factoring in growth of around 5%. This is despite the fact that dividends have grown at an annualised rate of 25% over the last three years. If the company can continue to grow at a rate of above 5% over the coming years then there is significant upside available for patient investors.

Note: Data#3, Melbourne IT and Dicker Data are current portfolio positions.