Data#3 (ASX:DTL) recently came on our radar after share price weakness that followed a fairy solid full-year result. Accordingly, we research the Company in The Dynamic Investor earlier this month and concluded that the weakness presented an entry opportunity.

The share price has so far failed to gain traction since our recent report. However, we consider that current levels may still present an entry opportunity and outline the key fundamental reasons supporting this view.

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 is the #1 partner to Microsoft, Cisco and HP in Australia and a top-5 partner to Dell Technologies in Australia. The Company reports across three segments: Software Solutions (67% of gross sales), Infrastructure Solutions (20%) and Services (14%).

Key Fundamental Drivers

Positive Outlook for Margin

Gross profit margin is expected to increase over time as the higher-margin Services contribution increases its proportion of group revenue. The Company has reported steady gross profit margin in recent years, despite strong growth in lower margin Software and competitive market conditions. Accordingly, DTL are focussed on gross profit growth (in $ terms) rather than gross margin %. The latter is expected to growth broadly in line with gross sales over the next three years (+8.5%/+8.9% gross profit/gross sales growth, respectively).

Strong Macro Tailwinds

DTL’s medium-term outlook remains robust, driven by structural tailwinds such as cloud migrations, cybersecurity and increasingly generative Artificial Intelligence (AI), with potential cyclical tailwinds emerging from a PC refresh cycle.

The revenue mix is reasonably defensive in nature, given that revenue is approximately equal split between enterprise/government customers. In addition, the key technology priorities of its customers are non-discretionary.

The Company is well positioned to leverage the adoption of Generative AI (GenAI) and the flow-on opportunities for both devices and services. DTL partners with major hyperscalers like Microsoft to manage and develop complex IT systems. This ’s business model, means it is well positioned to benefit from GenAi opportunities, including the recent Microsoft Office 365 Co-Pilot ‘Early Access’ program. Following the launch of ChatGPT in FY23 and Microsoft Copilot in FY24, AI-enabled PCs have been recently released, with device and server technology now designed to enhance AI performance.

Are Concerns About Revenue Growth Overdone?

The Company has generated gross sales growth of +14% over FY19-24 on a CAGR basis, underpinned by: i) Software licensing, multi-cloud solutions and services, ii) Strong customer spend in higher-growth education, health and resource sectors, iii) A high portion of recurring gross sales (~67%) and iv) The pull-forward of IT spend throughout COVID-19.

These tailwinds hove now subsided and has been replaced by a headwind in the form of a tight macroeconomic environment. This has resulted in IT leaders delaying making decisions as a result of having competing budgetary requirements. The rise of GenAI has seen rapid technological developments over the past 18 months – but at the same time, this has also led to incremental delays in decision making. This is mainly because IT departments/decision makers need to become more educated on GenAI. As the latter evolves, and GenAI investments gain momentum, gross sales growth is expected to trend back up.

There are also two short-term risks to revenue. These include: i) Further declines in Infrastructure sales from delays in spending decisions and ii) Potential Queensland government policy changes.

The expected decline in Infrastructure sales is likely being reflected in revised consensus estimates. In addition, any decline is likely to be offset by higher AI demand materialising earlier than expected.

Strong Balance Sheet & Efficient Cashflow

The balance sheet is in a net cash position with no debt. Cash as at 30 June 2024 was $276.4m, which was down from $404.8m as at 30 June 2023. However, the FY-end cash balance typically varies due to factors such as higher customer spend in the 4th quarter and timing of customer billing. Despite seasonal fluctuations at period end, DTL typically have a stable net working capital position. In addition, the working capital model is efficient in the sense that short or negative working capital cycles underpin a self-funding business model.

Fundamental View

The retracement in the share price post results release now sees DTL shares trading on a 1-year forward P/E multiple of ~24x, which is at the bottom end of the trading range over the last two years. While the shares are still trading at a premium to the long-term average, the current multiple is considered undemanding in the context of an EPS growth profile of ~10.5% over FY24-27 on a CAGR basis.

A key risk to our view is continued slowness in customer decision making and heightened competitive pressure.

Charting View

The recent sell-off in DTL has seen it come back to the uptrend line that started in 2022. However, because it fell sharply into this line, it may need to move sideways for a bit longer until it can start to pick up some upwards momentum again. Current levels are a buy where initial stops can be placed close by, just under $7.50.

 

Michael Gable is managing director of Fairmont Equities.

 

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