Could Data#3 shares be a value trap?

In mid-December, Data#3 (ASX:DTL) issued an ASX release stating the impact from changes announced by Microsoft to its partner incentive program. The changes, which came into effect on 1 January 2025, reduce the incentives earned by DTL on its Microsoft Enterprise Agreements (EAs).

The announcement led to a significant de-rating in DTL shares, as consensus earnings expectations have re-based lower and as the market realises the risk associated with having a higher earnings exposure to one large vendor that has such significant bargaining power. Does recent weakness present an entry opportunity?

About Data#3

Data#3 provides IT products and services to almost exclusively Australian-domiciled clients. Data#3 partners with leading global tech firms (eg. Microsoft) to procure, deploy and manage complex IT systems to its clients. The Company has a diverse client base across the Government, education, healthcare and resources sectors.

The Company is the #1 partner to Microsoft, Cisco and Hewlett Packard in Australia and a top-5 partner to Dell Technologies in Australia.

Key Fundamental Drivers

Microsoft Changes to Impact Gross Profit

As part of the latest changes announced by Microsoft, Microsoft will increase its focus on Small, Medium and Corporate (SMC) initiatives. Microsoft will also increase incentives for its Co-pilot, Security, Azure Migrations and Cloud Solutions Provider (CSP) programs.

The changes, which came into effect on 1 January 2025. DTL noted a 3% impact to Gross Profit (GP) in FY24 had the full effect of the changes in Microsoft Enterprise Channel Incentives had applied throughout all of FY24. The 3% impact is considered relatively minor given that Microsoft has been de-prioritising EA license funding for years. While incentives for EA’s are no longer available from 2025, these had already been in decline.

Impact Can be Mitigated – But by How Much?

DTL has implemented a range of strategic initiatives to mitigate the earning impact over the medium term. These include:

i. Continue to focus on SMC, with the Company previously targeting smaller customers. However, while DTL has secured SMC contract wins in managed services, there is uncertainty as to whether this strategy proves successful, given the historical focus on larger customers.

ii. Bolstering its CSP business, which is well progressed due to strong Co-pilot, Security, and Azure Migration offerings. DTL may also be able to cut or pass on the cost of resources servicing the Microsoft Enterprise business.

iii. At the AGM held in late October, the Company noted a strong FY25 sales pipeline, with high sales activity across the public infrastructure, education and health verticals. In particular, there is potential for more budget release and IT projects re-starting into calendar year 2025 (after being delayed this year). Further, while Federal government spend could slow in the lead up to the election this year, it provides a potential re-acceleration catalyst into FY26.

iv. Macro tailwinds remain. DTL’s medium-term outlook remains robust, driven by structural tailwinds such as cloud migrations, cybersecurity and increasingly generative Artificial Intelligence (AI). The Company is well positioned to leverage the adoption of Generative AI (GenAI) and the flow-on opportunities for both devices and services.

An area of market concern is that the Company has not quantified the expected impact on GP for FY25. Nor has it quantified by how much it can reduce the impact. On our analysis, if the Company can mitigate half the impact, there would be a moderate to decline in Profit Before Tax. The latter would decline by ~3% in FY25 and ~6% in each year for FY26 and FY27.

Fundamental View

DTL shares are currently trading on a 1-year forward P/E multiple of ~22x. The current multiple is near levels when DTL shares previously suffered a major de-rating (in March/April 2020 and mid-2022). It is also well below the average multiple of ~25x over the last five years.

While there is potential for the Company to mitigate the impact to gross profit from several strategies, it is worth noting there has also been a significant step-down in the EPS growth profile. The latter was +11% over FY24-27 on a CAGR basis prior to the announcement, to +8% currently. The commensurate declined in the share price since the announcement suggests that the market is no longer attributing a premium to DTL’s multiple.

Accordingly, we consider that a re-rating in the shares is likely to occur once the Company can resume its GP growth profile and restore EPS growth to low-double digit % via the mitigation strategies. Alternatively, it can use its net cash balance sheet position to undertake capital management and/or EPS-accretive acquisitions.

Charting View

The chart of DTL for the past 12 months has been dominated by large selling and the shares are in a downtrend. However, it has bounced off major support near $6. This means that, for the short-term at least, we should see further upside from here. The next major resistance level is near $7.30.

Data#3 (ASX:DTL) weekly chart
Data#3 (ASX:DTL) weekly chart

 

Michael Gable is managing director of Fairmont Equities.

 

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