"Different type of moat" -- Softcat (SCT)/Keith Ashworth-Lord

[MaynardPaton]

This 54min webinar is worth listening to:

piworld Thursday webinar: Keith Ashworth-Lord, CIO, Sanford Deland...

I have a lot of time for Keith. I used to read Analyst back in the day and leant a lot from what he wrote.

Keith took questions from listeners, and a good question at 35m40s was raised about Softcat – “does it have an obvious moat?”.

Keith referred to SCT’s return on equity, cash generation, organic growth, margin development and going from 9th to 2nd within its industry. He therefore claimed the business must have “something special” and enjoy a “different type of moat” to the traditional patents/brands etc enjoyed by the likes of Rotork, Games Workshop, etc.

Keith did not mention SCT’s margin, which for the last two years was 8.5%:

So not exactly Buffett-type ‘franchise’ profitability.

A skim of the 2019 annual report reveals staff are all-important:

So: can staff ‘culture’ ever create a sustainable moat? Keith seems to think so, at least at SCT.

Mind you, there are many ‘people’ businesses with high ROEs etc where perhaps the moat is not very sustainable.

I had a good feeling about SCT back in January 2017 where the shares were 300p: Maynard Paton | Softcat: 44 Consecutive Quarters Of Organic Profit Growth

"There is a lot to like about SCT, not least its splendid track record, the owner-friendly boss, the reassuring cash hoard and the wonderful return on equity numbers.

True, there is no obvious ‘intellectual property’ here to keep rivals at bay.

Reselling products from the likes of Microsoft and Cisco will never earn anyone much money, but I guess bundling them all together within an associated IT service can be more lucrative.

Mind you, what is clear from SCT’s annual reports is the group’s belief that top-notch employee happiness leads to first-class customer service, which in turn can lead to superior financial progress.

Empowered workers are not exactly a textbook ‘moat’, but SCT’s financial history is very tough to criticise. So perhaps a vibrant employee culture really can be difficult to replicate and therefore can create a sustainable competitive advantage."

Obviously in hindsight I should not have quibbled about the then 15-16x P/E and instead backed SCT’s “vibrant culture”.

Perhaps there is more to moats than the conventional advantages of ‘network effects’, patents and so on.

Your thoughts are welcome.

Maynard

[Ben123]

Hi

Solely on Softcat, and some of this is abit off the thrust of this post, there are a couple of aspects to Softcat which I am not particularly keen on;

• Softcat tend to issue share options which vest at £nil cost to the option holder. Ideally options should allow the option holder to participate in value creared over term of the option, rather than from the beginning of time…

• roce is high however this is a consequence of high asset turnover and low margin. My preference is for low asset turnover and high margin businesses as evidence of (traditional) moats.

Getting back on track (with staff engagement and moats) it is a way of competing with competition but maybe this is at the expense of shareholders and to the benefit of employees (with the aforementioned generous share options which of course don’t go through the P&L) ? I say this because eps have doubled over the previous 4 years however the 2.5% or so dividend gobbles up virtually all available operating cash. (revenue growth isn’t great however debtors seem to tie up high incremental cash amounts each year imo) Consequently NAV per share has not changed in any material way over the period, either.

So why would an investor pay a pe of 32 when all you are receiving is a smallish dividend and not much cash is being reinvested and compounded within the business (other than in working capital) ? (I appreciate I have in all likelihood missed some factor or maybe I am unaware of some growth plans because I do agreeK A-L is a great investor!!)

Ben

[MaynardPaton]

Hi Ben

Many thanks for the reply.

@Ben123

Solely on Softcat, and some of this is abit off the thrust of this post, there are a couple of aspects to Softcat which I am not particularly keen on;

• Softcat tend to issue share options which vest at £nil cost to the option holder. Ideally options should allow the option holder to participate in value creared over term of the option, rather than from the beginning of time…
• roce is high however this is a consequence of high asset turnover and low margin. My preference is for low asset turnover and high margin businesses as evidence of (traditional) moats.

Yes, nil-cost options are not great but I have become somewhat pragmatic about such remuneration over time. Buffett I am sure has said something along the lines of ‘if it ain’t broke, don’t fix it’ when it comes to remuneration, meaning that if nil-cost options keep the staff performing for shareholders, then so be it. The alternative to nil-cost options may be lots more standard options that result in a similar net gain for the employees and similar dilution.

My preference is for high margin businesses, too.

@Ben123

Getting back on track (with staff engagement and moats) it is a way of competing with competition but maybe this is at the expense of shareholders and to the benefit of employees (with the aforementioned generous share options which of course don’t go through the P&L) ? I say this because eps have doubled over the previous 4 years however the 2.5% or so dividend gobbles up virtually all available operating cash. (revenue growth isn’t great however debtors seem to tie up high incremental cash amounts each year imo) Consequently NAV per share has not changed in any material way over the period, either.

On revenue growth, bear in mind the revenue calculation was changed (reduced) during 2018 for IFRS 15, so comparisons pre-2018 with 2019 are not like-for-like.

Good point on the debtor position. But that is offset by the creditor position, so the net effect is neutral. My sums for the last 5 years show aggregate cash change in debtors of negative £188m versus aggregate cash change in creditors of positive £185m. Add on a £7m 5-year outflow for inventories, and the overall working-capital cash outflow is just £9m – quite small for a business that has doubled reported operating profit to £84m during the same time. These cash flow numbers feel alright to me, though I have not looked at the balance sheet entries and what exactly the debtors and creditors represent.

@Ben123

So why would an investor pay a pe of 32 when all you are receiving is a smallish dividend and not much cash is being reinvested and compounded within the business (other than in working capital) ? (I appreciate I have in all likelihood missed some factor or maybe I am unaware of some growth plans because I do agreeK A-L is a great investor!!)

I suspect KAL is looking at the incremental return. The best businesses to own are those that can grow profit without needing to reinvest vast sums back into the business. Again, rough sums, but 5-year SCT earnings of £228m have funded cash dividends of £193m, so suggesting £35m was reinvested into the business during that period. Yearly earnings over the same time have moved from £31m to £68m… so reinvest £35m to enjoy extra earnings of (£68m-£31m) £37m gives an c100% incremental return. If SCT can repeat that over the next 5 years, then maybe the 32x rating is justified? That said, a ‘buy’ case was much easier to make when the rating was 15-16 a few years ago!

And I am still not sure whether SCT has a real moat!

Maynard

[Ben123]

I think the moat is that they are in a sweet spot between the customers who only want a single point of contact to purchase their software and the suppliers who would like them to push their products and they have a huge network.

I see what you are saying about it being a capital light business, which is a great point.

I would be interested to know what happens to Softcats client base when everyone is on the cloud. Would it evaporate because clients just renew directly with the end supplier?

[MaynardPaton]

@Ben123

I would be interested to know what happens to Softcats client base when everyone is on the cloud. Would it evaporate because clients just renew directly with the end supplier?

Not sure. KAL might know Any SCT holders here that can answer? You would have thought most new business would be going on the cloud these days anyway, and SCT must have been delivering such services to have grown as much as it has. Going from in-house to cloud is not an overnight job for IT departments though.

Maynard

[johngscrivens]

I became a Softcat shareholder partly because of KAL’s endorsement of the company as he is one of the three fund managers that I follow closely. To be honest, I do not believe that Softcat has a deep moat although, as you mention, the company offers a very comprehensive range of products/services and its accreditation with numerous software companies must represent a competitive advantage. I would argue that an attraction of the company is that it does not need to do much different to continue its success. Its relatively small market share (6% according toShares Magazine in August 2019) and the steadily increasing size of its markets create a long growth runway for Softcat. I guess the need for IT and software upgrades/updates is a pretty fundamental requirement for most organisations so I would suggest that this growth should be reliable as well as long lasting. I agree that one uncertainty is the impact after Softcat’s clients have moved to the cloud but I would have thought that the process of moving could actually create more business for Softcat owing to the company’s expertise in this area.

[MaynardPaton]

@johngscrivens

I became a Softcat shareholder partly because of KAL’s endorsement of the company as he is one of the three fund managers that I follow closely.

Hi John,

Thanks for joining the forum. I have followed KAL’s work since c1998 when he joined Analyst, a insightful publication for the more discerning LTBH investor (and now defunct). Always worth looking at the shares he holds, although some have not been textbook Buffett-type companies – they were more value based and a few did not work out.

Anyway, I would welcome any thoughts you have on KAL’s holdings or those of the other two managers. And is it easier simply to buy the funds, rather than try picking their best ideas? I compare KAL’s performance to mine and maybe I should leave investing to him and do something else. But I would miss the fun of trying to unearth the next big winner!

Maynard

[MIA1]

@MaynardPaton

Mind you, what is clear from SCT’s annual reports is the group’s belief that top-notch employee happiness leads to first-class customer service, which in turn can lead to superior financial progress.

Customer satisfaction is a big theme running through Softcat’s annual reports. The company quantifies this through their annual client survey and it is important enough to be monitored as a non-financial KPI.

IT infrastructure is complex and critically important to the businesses that use Softcat - I think that makes trust/reputation a big part of Softcat’s moat and is the reason why they place such high importance on customer satisfaction.

Market dynamics could also add to this moat effect - Softcat operates in a fast growing and highly fragmented market. Prospective clients have to choose from a large number of different companies offering a wide variety of complex solutions in critical areas like cybersecurity. In that market environment Softcat’s strong track record of successfully delivering for lots of other similar clients has to be a competitive advantage.

[MaynardPaton]

@MIA1

IT infrastructure is complex and critically important to the businesses that use Softcat - I think that makes trust/reputation a big part of Softcat’s moat and is the reason why they place such high importance on customer satisfaction.

Agreed, SCT confirms customer trust is vital:

Organic growth now at 15 consecutive years. I think it was 11 or 12 when looked at the business for my blog. Clearly this business has “something special” as Keith A-L says – and I dare say the vibrant employee culture is very hard to replicate. A moat, then.

Maynard

[MIA1]

One company that could be displaying similar traits to Softcat is Alpha FX [AFX].

On page one of this year’s annual report:

…as a company, we continue to put our people first, knowing that in turn they will do the same by our clients and that our shareholders will benefit from the growth that results.

That sounds rather similar to the comment you made in your blog about Softcat.

The theme of ‘superior service’ resulting from the company’s ‘people and culture’, is heavily used throughout AFX’s annual reports. Here’s just one (of very many) snippets on this theme from this year’s report:

When it comes to providing a leading service, we passionately believe there are two things that matter more than anything else – people and culture.

and on client retention, AFX also references loyalty and trust:

We then aim to retain these clients, whilst increasing our wallet share, by constantly evolving our service and earning loyalty and trust.

Alpha FX just might be another company with a similar type of moat to Softcat - “something special” that, as you say, is very hard to replicate.

There is also an interesting article on ShareScope by Richard Beddard on the people-first culture at AFX.