By Jove! A pulse!
After several false dawns, the long-awaited recovery of IT spending and markets is on its way. But though there is most certainly a pulse, it remains weak.For the most part, recent financial results of JSE-listed IT companies tell the same story of flat revenues, deteriorating margins and prolonged restructuring exercises that have defined the industry since the beginning of 2000. But, among privately owned firms and venture capital investors, a spirit of renewed optimism is emerging.Brainstorm canvassed views from a range of industry players, including venture capital and private equity firms, software integrators and hardware suppliers, to gauge how the IT industry is doing at the grassroots level. The consensus is that the market is looking the healthiest it has in nearly four years, although most observers stop short of describing current conditions as the start of a full-blown recovery.There are several encouraging signs: hardware unit shipments are growing, venture capital deal flow seems to be improving and systems integrators are starting to win large projects again. Tempering the optimistic outlook is concern about the impact the strengthening rand will have on IT suppliers and their customers in the export-driven mining and manufacturing sectors.A recently released BMI-TechKnowledge analysis, South African Corporate IT User Trends, which surveyed more than half of the top 200 companies in the country, found that little growth was expected in business processes and solutions, with more companies sounding negative on outsourcing plans than reporting new plans to start or expand their outsourcing deals.While this spending reticence persists, however, significant areas are showing more optimistic signs - particularly IP telephony and mobile computing. The research house says companies that can offer solutions rather than just technology are likely to be able to take advantage of these trends.Rand is good for customersThe market for PC hardware and peripherals is starting to show some evidence of life again, says Guy Whitcroft, MD of Tarsus Technologies, one of the largest privately owned computer distributors in South Africa."The picture isn`t gloomy by any means. Next year is going to be a good one in dollar and unit shipment terms, but it`s hard to guess what the picture will look like in rands. I`m cautiously optimistic that things will be better next year than they have been for a while," Whitcroft adds.He does caution, however, that money is still tight in the channel and that rand-denominated sales will probably be hit by the dramatic strengthening of the currency over the past year."Rates, rent, insurance, telephones and so on are all rand-denominated and now chew up a higher percentage of dollar sales than before. To keep sales measured in rands constant, you need to sell more in dollars than you did last year. For people who`ve become accustomed to the rand depreciating at an average of 15 percent a year, it`s a difficult reality to manage," says Whitcroft.The rand`s strength might pressure margins, but customers could be spurred into accelerating their spending plans by the increased buying and bargaining power they wield.Says Rowan Williams, director of capital at private equity firm i capital fund managers: "Our fund has maintained quite a heavy weighting towards IT, and as a whole the portfolio is performing quite well at the moment. We see an uptick in demand [for IT products and services] in the year ahead - the market is definitely starting to loosen up."Mike Johns of Archway Venture Partners is less sanguine. "We`ve all been talking about an upturn for the last three years, based on little more than hope. The budgets of the companies in our portfolios do reflect an anticipated upswing, but then the same was true of the previous three years," he says.Look to big daddyIncreased government spending on IT is one factor helping to spur a mild recovery in the market, says Rudolf Pretorius, a partner at Treacle Venture Partners. "There`s a bit of infrastructure spending in the corporate market, but the real excitement is in government and parastatals. SITA seems to be getting its act together, which is creating new opportunities for IT companies," he adds.Financial services companies are also starting to spend on IT again as they prepare to become compliant with new regulations and industry standards such as Basel II and the new EMV credit card standard, says Williams.There`s still venture capital available for new and growing IT businesses from local private equity firms, although most of these investors are conservative and picky about the companies they provide with funding.Areas investors expect will yield high growth in the coming year include call centre outsourcing businesses that focus on the local and international markets, information security, enterprise resource planning software and services for the public sector, web services (particularly the Microsoft .Net environment), and infrastructure and software projects in the rest of Africa.A common complaint, however, is that there is still a dearth of well-managed, quality companies to invest in. "Our biggest frustration is that we`re under-invested - we`ve invested only R63 million out of a R240 million fund," says Pretorius."We don`t necessarily look for the latest hot technology trends to invest in, but are looking for companies with management we believe can manoeuvre in these difficult times, backed up by a strong technology component. We just can`t compare ourselves to Europe and the US where there are more professional managers available," says Johns. "There are, however, some companies out there that meet our criteria and some good opportunities for deal-flow coming up."Out of the ashesA number of new companies have been formed through management buyouts of subsidiaries and divisions of crumbling empires such as AST, Global Technology and MGX - a trend private equity players find encouraging.Unburdened by the debt and bureaucracy they faced as part of larger parent groups, these new businesses are moving quickly to forge credible ties with black empowerment partners and to bring new capital in to fund growth."The market is still tough for young companies, but we`re starting to see some encouraging signs, like people breaking away from larger IT groups to set up their own businesses," says Pretorius. "We`re dealing a lot with entrepreneurs who have become frustrated with the corporate world, and that`s good because they bring a wealth of experience into their new ventures."One such company is Software Futures, which seems to be recuperating well after its split from the beleaguered MGX group. The company reports that it has secured several major deals, one of which is the largest yet in its almost 10-year existence since it was bought out of its parent group by a consortium made up of management, Cape-based structured finance house Brown Brother Holdings and Kopano ke Matla Investment Company, an investment arm of Cosatu.A combination of a cash injection from its new owners and improved black economic empowerment credentials all contributed towards an improvement in Software Futures` performance."September was a turning point in our business, as the positive effects of the sale of Software Futures to Kopano Ke Matla were reflected in major sales upturns in several business units. These divisions previously struggled under the burden of institutional risk and negative market conditions," says Arthur Brown, the recently appointed MD of Software Futures.One insider was less diplomatic: "We just weren`t doing any business while the trouble was going on," he confided.Valuations lag expectationsAs yet, the activity in the market is not reflected in the valuations of IT companies, although most investors hope that this will start changing next year. "It`s more of a buyer`s market than a seller`s market," says Johns."The market is starting to move in the right direction and next year we`ll start to see valuations improve. For now, we`d rather work with our businesses and build their operational capacity. Things like IPOs are still a long way out," says Williams. "Alt-X [the JSE`s alternative exchange for small capitalisation companies] isn`t really an option at this stage - there is no appetite for that sort of risk."Pretorius agrees: "We don`t think that Alt-X is going to get much institutional support in the short-term. Too many people have memories of losing money on small companies without the right corporate governance in place during the last boom." Shakeout survivors primed for growthMost of the survivors of a four-year long shakeout of the JSE Securities Exchange technology sector look in good shape to take advantage of an expected upturn in IT spending in 2004. (For separate comment on the small cap IT sector, see Looking good, but the rand factor weighs, page 71).However, there is still plenty of scope for further consolidation of the market, particularly through black economic empowerment-related transactions.At the risk of sounding predictable, the group that looks best positioned for the future is Comparex Africa, which has proven resilient enough to survive trials that would have buried lesser companies.Comparex was forced to start restructuring and take costs out of its businesses a good two years ahead of most of its peers after it was created through a messy merger between Persetel and Q Data. More recently, Comparex managed to shake itself free of its loss-making, low-margin European businesses.With the recent conclusion of a merger with black empowerment Microsoft reseller Business Connexion, Comparex is on an enviable footing for the future.Looking very strongUnder terms of the deal, which had no empowerment discount, Business Connexion will be folded into Comparex in exchange for an 11.8 percent stake. Business Connexion will pay R117 million to bring its stake in Comparex up to 25 percent, funded by a loan from Comparex that is repayable with interest.Irnest Kaplan of Kaplan Equity Analysts, who assisted Brainstorm with some balance sheet analysis, rates Comparex as very strong, given its cash balance of some R2.2 billion and rather less long-term debt (R240 million).But now that the empowerment deal is done, Comparex will be distributing most of the cash pile it has jealously guarded for several years to its shareholders, although it will retain R600 million for working capital and in case it loses a long-running dispute with the taxman.Still, Kaplan says, it is turning around operationally, and is showing positive cash flow from operations.Only a handful of JSE-listed systems integrators - like CS Holdings and Datacentrix - can now compete with Comparex`s empowerment credentials, and they do not have nearly the reach or capacity of their larger competitor. The Comparex/Business Connexion merger creates a R3 billion-a-year ICT giant that employs more than 4 000 people.According to Benjamin Mophatlane, CEO of Business Connexion, and Peter Watt, CEO of Comparex, the deal differs from many previous empowerment deals in that it is not just an equity transaction. "Business Connexion is a functioning business, meaning we can address the operational side of empowerment too, including the customer interface."Many of the tailwinds driving Comparex/Business Connexion will drive others in the sector too. Watt says some "serious decisions" will have to be made in 2005, noting that current systems are taking a lot of strain nearly five years after the last big money was spent on IT."We are confident there will be another wave of spending, and that mobile and the Microsoft environment will be central to that," says Watt.Figures from BMI-Techknowledge back this up. In PC Computing Forecast and Analysis 2002 to 2007, published earlier this year, it noted that mobile computing growth was tracking at over 40 percent, compared to around five percent annual unit shipment growth predicted for PCs for 2004.Upping the anteThe Comparex deal effectively ups the ante for the likes of Dimension Data and AST, who have been long on talk about black empowerment but short on delivering the deals their customers and shareholders are demanding. Expect to see more transactions along the lines of the Business Connexion and Comparex merger in the year to come.While critics may argue that such deals merely result in entrepreneurial black-owned companies being swallowed by larger white-owned groups, the reality is that the small black businesses need the transactions as badly as the JSE-listed companies do. Besides, any trend that sees traditionally white and emerging black IT companies start to merge in the mainstream rather than continue to develop in separate ghettoes can only be good for the industry.It`s also encouraging to see that a few of the small fry of the nineties listings boom have grown into significant players in the local IT landscape and credible competitors to the likes of Dimension Data and Comparex.Examples include the likes of ERP.com, UCS Group, Datacentrix and Paracon, all of which have grown into businesses worth more than R100 million a year through a mixture of organic and acquisitive growth and all of them with solid track records and sound financial management.UCS, according to Kaplan, has a very strong balance sheet with almost no debt and good ratios. Operationally it performs well, and shows positive cash flow. Datacentrix, Paracon and ERP.com are likewise sitting on very strong balance sheets, having avoided debt, accumulated cash and shown strong operational growth and cash flow.Still healthy but weaker due to higher debt or disappointing operational performance, according to Kaplan`s analysis, are companies such as CS Holdings, Faritec and EOH.Among the larger listed groups, hardware distributor Mustek and diversified electronics and ICT group Altron both continue to turn in solid performances in a turbulent market.Although PC sales were slow in its last financial year, Mustek managed to lift operating profit from R202 million to R213 million on sales that increased a mere two percent to R2.2 billion. Cash generated from operations was also impressive, with cash on hand increasing from R229 million to more than R430 million. During the year, subsidiary Rectron, which was shunned by investors as an independently listed company, grew sales to around R1.2 billion.The outlook for the hardware market is uncertain, however. Like many of its peers in the PC, components and peripherals distribution game, Mustek has to shift ever more boxes to keep rand revenues constant as a result of falling PC prices and a stronger rand.In addition, the pricing differential between international brands and local brands such as Mustek continues to narrow and controversy continues to rage about government departments specifying that respondents to their tenders need to be international tier-one brands.Government connectionMustek`s recent conclusion of an empowerment deal that entitles Safika Holdings acquire up to 25 percent plus one share of the group over five years should help the group defend and extend its business in the government sphere, however.Altron, which counts listed companies Bytes Technology Group (BTG) and Altech among its subsidiaries, managed to push headline earnings per share up by more than 10 percent in its latest set of interim results. That increase in earnings came despite restructuring that pushed revenues down to R5 billion from R6.2 billion in the comparable period of the previous year.At the time of reporting its interim results, Altron was in the enviable position of having cash and cash equivalents of R1.6 billion.Of the two listed IT subsidiaries in the Altron stable, it is Altech that performed most impressively during the interim period. Revenue and operating profit for the continuing operations increased by 8.5 percent and 6.5 percent to almost R2 billion and R160 million respectively. Altech`s cash and cash equivalents increased to an amount in excess of R1.2 billion.BTG`s operating profit declined by 2.4 percent to R77 million as a result of a disappointing performance from its UK operations, which was also the major reason for a 25 percent drop in the group`s revenues. However, BTG management has promised a turnaround by the next financial year, and its balance sheet remains fairly healthy, with R190 million in cash and R249 million of long-term debt.The market`s big losers in the short term appear to be those with a strong offshore orientation, like Dimension Data and Datatec. Despite strong balance sheets with plenty cash to cover debt, both have both been clobbered by foreign exchange losses due to the strengthening of the rand this year, and have performed poorly from an operational point of view. (Didata`s latest results are covered in a separate news analysis, p.18.)Transparently sensibleAlthough Datatec is a well-managed distribution group and has done as good a job as could be expected of managing its margins in a depressed market for the networking hardware it sells, the weakness of the rand has partially masked unexciting revenue and profit growth in real (dollar) terms over the past two financial years. Unlike Didata on two counts, Datatec did report a profit, but could not generate positive cash flow from operations either.The decision to adopt US dollar-based financial reporting, announced with Datatec`s last set of interim results, will make its figures more transparent for both local and international investors. The move makes enormous sense since Datatec derives more than 90 percent of its revenues offshore, with a large portion of its sales coming from the US.Jeremy Ord, Didata`s executive chairman, reports good-looking order books. "There are signs in all regions that demand has stabilised, as has pricing pressure from vendors. Touch wood. Let`s hope it stays that way. Recent customer wins suggest traction in demand for solutions."In turnaround modeA host of companies are still in the midst of their turnaround strategies. A question mark still hangs over CS Holdings, one of the larger listed second-tier systems integrators.In its last financial year, the group`s operating profit sagged to its first ever loss of R25 million even as revenues climbed from R403 million to R430 million. The group`s cash on hand fell from R31 million to R26 million while current liabilities increased to R159 million from R121 million.CS Holdings ascribed these woes to growing pains from the integration of acquired businesses into its fold, and promises a return to profitability in the new financial year.On a more positive note, CS Holdings has managed to build a good empowerment profile by selling a 25.8 percent stake to Worldwide African Investment Holdings and has also forged business partnerships with powerful market players such as Telkom.Only time will tell whether last year`s poor performance was a once-off event, or whether it points to more fundamental problems with CS Holdings` strategy of rapid growth by acquisition. Critics of this aggressive strategy probably feel somewhat vindicated, but investors and customers, so far, have shown faith in the group.CS Holdings also brought electronics group Reunert on board as a new shareholder after the latter bought a 31.7 percent stake in the group from Dutch company Getronics and Electra Share Ventures.Problem childAn even more troubled child of the late nineties boom is debt-laden IT services group AST. Management has shown laudable commitment to doing whatever it takes to turn the troubled group around, but one still wonders whether AST will be able to shake off its debt burden or whether it will follow the likes of MGX into oblivion.Directors at AST have managed to find cost savings of more than R200 million a year and have moved quickly to unload non-core and unprofitable business units. But at the end of the last financial year AST still had liabilities of more than R728 million.Since then, restructuring, recapitalisation and cash raised from selling off businesses has helped AST cut its debt by a further R90 million, and it has managed to reschedule some payments. The group has also managed to win large new deals or extend existing services contracts with customers such as Iscor, Kumba and Columbus Steel.Nonetheless, like MGX before it, AST could eventually find itself in a position where it needs to sell its crown jewels for a pittance simply to keep going. There`s also concern that the group will find itself strapped for resources after mass retrenchments in the last financial year.A proposed takeover of the group by parastatal arivia.kom could well be the best outcome for AST`s shareholders, depending on how much arivia is willing to pay for it.But it would be sad to sit on the verge of a new growth period only to watch a final victim of the boom-bust cycle succumb to a bailout by nationalisation.With additional reporting by Patrick Lawlor and Ivo Vegter.
