value and opportunity

First of all a big “thank you” to all readers who either posted their suggestions as comments or sent me Emails. It definitely looks like that Australia is an interesting stock market and I will have a lot to do and too learn…..

DWS, an Australian IT consulting company is the first Australian company which I found interesting. Why ? There are some aspects which I like and which have worked for me in the past:

1. I am relatively familiar with the business (IT consulting). I own a similar stock from Norway (Bouvet)
2. It is founder/owner run. The CEO Danny Wallis owns 42%
3. Only 1 analyst covers the company, it is not in any index (“under the radar”)
4. It is relatively cheap (8x EV/EBIT) compared to European peers
5. The don’t use adjusted numbers, good cash conversion
6. The company has very little direct Mining/Resources exposure

Valuation multiples (at 1.09 AUD/share)

Market cap: 138 mn AUD
P/E 2015 10,7
P/E 2016 (est) 8,5
EV/EBIT 8,7
P/B 2,2
P/S 1,2
Div Yield 8,1%

The stock clearly looks cheap. Any half decent German or even Italian IT consultant would most likely trade at 50% or 100% the valuation.

IT consulting business:

I had written about the business already in my post about Bouvet. It is a decent business. Not as sexy as software but still very decent. A few additional obeservations from my side:

1. A certain size is important for an IT consultant. There is some overhead and you need to be able to ramp up projects quickly and spread the costs of training and pitching for new projects. However after a certain point in time, there are no big advantages anymore. So the biggest IT consultant does not have a competitive advantage simply due to its size.
2. Big data and SaaS are in my opinion not a big threat to most “real” IT consultants. This is more a problem for “box pushers”, companies who actually sell, install and maintain hardware. A pure IT consultant can actually profit ftom the current trend. SaaS and big data do not automatically connect themselves with the existing IT infrastructure.
3. Although consulting is a people’s business, I do think individuals have less “star power” compared for instance to law firms or investment banks. So in the long term, shareholders of IT consultants usually do better.

Why is the stock cheap ?

Looking at all the past financial reports of DWS, I think 2 main reasons are responsible for the cheap valuation:

1. Margin erosion since IPO

This is a table of how the margins and ROE developed from the IPO year (2006) to 2014.

	Op Margin	NI margin	ROE
2006	36,8%	26,5%	50,4%
2007	29,4%	20,5%	41,1%
2008	26,2%	18,1%	31,8%
2009	27,7%	19,4%	34,2%
2010	24,9%	17,7%	30,6%
2011	23,4%	16,6%	31,2%
2012	22,0%	15,5%	28,1%
2013	19,1%	13,7%	21,3%
2014	15,7%	11,0%	17,3%

We can clearly see that with the exeption of 2009, margins continously decreased along with ROEs. The big question is clearly: Does this continue or might they have reached a stable level ? If one reads the annual reports, the first talk about “problems in the Sidney office” in 2009. Then they start to adress the problem more generally in 2011 speaking of “tight labour markets” and 2012 when the first mention “off shore competition”.  Overall it seems that they were not able to pass on salary increases to clients over the last years and they seemed to have lost some clients especially in the Telco sector.

If we look at the same set of numbers from Bouvet, we can see that margins at DWS still look quite “rich”:

	Op Margin	NI margin	ROE
2007	10,7%	8,3%	39,3%
2008	12,3%	9,8%	42,3%
2009	9,7%	7,2%	34,3%
2010	9,1%	6,8%	40,1%
2011	9,8%	7,0%	50,0%
2012	7,6%	5,4%	40,2%
2013	8,5%	6,2%	46,2%
2014	7,0%	4,9%	36,3%
2015	8,1%	6,0%	45,8%

Bouvet’s margins have come down as well but the have never been close to what DWS used to achieve. I do believe that consulting is more competitive in Norway (it is only a 2 hour flight to bring in cheap Irish or Polish consultants) but clearly, margins at DWS could still go lower.

Bouvet’s ROE is better because they mostly grew organically, whereas DWS does carry Goodwill from previous acquisitions.

2. Frequent top management “resignations”

Let’s start with the most recent one: In 2014, founder Danny Wallis stepped down and former CFO Lachlan Armstrong took over. However, just a year later, Lachlan “resigned” and Wallis became CEO again. In December, the CFO and company secretary resigned as well. In the prior years, the strategy director resigned as well as the CFO from the IPO. My impression is that in the top management of DWS, with the exceptiuon of the founder no one “survives” very long. From the outside it is difficult to understand why, but I would prefer a less volatile leadership team.

The founder & CEO Danny Wallis

I didn’t found that much about him. He founded the company in 1992. He seems to have bought a nice house at a “discount price” in 2013. He had some bad press when he showed up in a reality show as a bidder and wearing T-shirts with adevertisement for one of his ventures. At Glassdoor, the reviews for DWS are not particularily good.

 

Potential upside & risk factor: acquisitions 2015

The first half year of 2015/2016 looks impressive: Sales are up 46% and EBITDA is even up 51%. Most of that increase however is due to 2 acquisitions: Phoenix, an IT/business consultant and Symplict, a “user experience” consultant. With (19.5+6.5) 26 mn AUD for Phoenix and up to 15 mn AUD for Symplicit, DWS spent 40 mn AUD in total on those 2 acquisitions. That’s twice the amount they have spent on acquisitions in the prior 9 years since they went public.

For the first time as public company they went into debt. The current level of net debt at 20 mn AUD seems managable but still makes the company more risky compared to the past and they do need to pay up to 10 mn AUD more for the 2 acquisitions. Intangibles are now slightly higher than equity. This is as such not a problem but could increase the risk of write downs in the future if things turn bad.

If the acquisitions are as succesful as the first 6 months indicate, DWS clearly should trade higher. If they turn out to be failures, then the risk is clearly higher than in the past.

Valuation – keep it simple

So now comes the big question: DWS looks cheap but clearly faces challenges. But how do we value this ?

I think the simplest way is to come up with 3 scenarios (negative, neutral, positive) and weigh them equally.

Negative case:

Here I would assume that DWS margins will further deteriorate and stabilize at a level of Bouvet’s current ratio of 6% NI margin and the market will price this at the current trailing P/E of 10,7, however sales remain constant. At the H1 run rate, I would expect DWS to achieve sales of 140 mn AUD. 6% NI would then be 8,4 mn AUD profit. at 11 times P/E this would mean a fair value of 92 mn AUD or 0,70 AUD per share

Neutral case:

The neutral case assumes stable margins, no growth but a multiple “adjustment” to a level of around 13x P/E which in my opinion would be resonable. In that case we could double the H1 2016 resulkt to an expected profit of 16 mn AUD times 13 = 208 mn AUD equity valuation, or 1,57 AUD per share.

Positive case:

In the positive case, I would assume the same margins but more growth and a P/E of 15. Assuming 5% growth p.a. for 3 years (and flat thereafter), I would then see a value of 2,10 AUD per share in that scenario.

Expected returns over different time horizonw

For simplicity reasons, I would assume a 3 year holding period and 8,33 cents of dividends p.a. in all 3 cases. This would then leave me with the following target value in 3/4/5 years:

3 year IRR 17,9%
4 year IRR 15,6%
5 year IRR 13,8%

The worst case in my scenarios woiuld be the negative 3 year case with a return of -3,58% p.a. , the best one the 3 year positive case with around 32% p.a.

That doesn’t look that bad and is clearly also a function of the relativel high dividend payout ratio.

Strategy with regard to Australian stocks

Other than in the past, this time I will not invest directly but try to look at more stocks before I make my first purchase. This has 2 major reasons:

First of all, I was usually too early in my previous “adventures” so time is not an issue here. Secondly, I think it also helps my goal of not trading so much.

Additionally, I still haven’t decided yet if I go for a basket approach or not. DWS for instande looks like a decent and cheap company, but at the moment I would not want to invest 5% of my portfolio into it.

Summary:

DWS looks like a decent business at a very good price. There is clearly the risk that margins deteriorate further, on the other hand, the stock would be a clear buy if they manage only to keep the status quo and the downside seems to be realtively small unless a catastrophy happens (or the M& transactions turn out to be failures).

As described above DWS will go onto my “Watchlist” as potential buy but I will wait until I have analyzed more Australian stocks.