July 12, 2022
Fairlight’s investment strategy focuses on owning wealth creating businesses – those that consistently generate returns well above their cost of capital for the long term. Historical records provide a good starting point when assessing the quality of our businesses, however given that competitive and industry dynamics do evolve, significant work goes into monitoring the sustainability of our portfolio companies’ competitive advantages. As part of this ongoing analytical process, a recent research trip provided the opportunity to review our assessments of quality and probe the investment theses for most of the Fund’s holdings domiciled in Europe and the UK. An example of such effort involved meeting with the management of IT value-added resellers Softcat and Bechtle, speaking with their competitors and also with industry participants.
Scale players in growing markets
Whilst there are some differences between the two companies, most of what was discussed in our previous profiles of Softcat (see December 2020 and April 2021) is also valid for Bechtle, a German domiciled value-added reseller of IT hardware, software and services. Scale advantages are important in this industry which leads to a dynamic where larger players tend to consistently gain share. On the demand side, larger resellers can offer customers a broader portfolio of IT products and deeper expertise than smaller peers. On the supply side, larger resellers allow IT vendors instant access to an extensive sales network of trusted specialists. Bechtle is the largest player in Germany with a 3.3% market share.
Although Bechtle operates mainly in Germany, the same dynamics that have driven double-digit organic growth for Softcat in the UK are also present: IT spending tends to grow about two percentage points faster than the broader economy as businesses require increasingly more complex technology to remain competitive, and the highly fragmented nature of the market gives Bechtle, the local leader, a long runway for market share gains. Since 2006, Bechtle has been growing business volumes at 9% per year, eclipsing German GDP growth (Figure 1). Importantly, growth has been highly profitable (EPS CAGR has been 14%) with excess capital returned to shareholders via dividends.
Demand for IT infrastructure remains strong
One market concern for Bechtle is that after a Covid-induced surge in demand for hardware and software there will be a natural slowdown. Our conversations with multiple executives suggest that while there is an element of this, particularly in the area of devices, investment in corporate cloud infrastructure remains buoyant and there is significant pent-up demand across product categories that require face to face or on-premise implementation. Widespread hardware shortages and supply chain issues have also meant that not all demand has been fulfilled yet. Bechtle’s order book, for example, at the end of March was 80% higher than at the previous corresponding period. Moreover, software is predominantly sold on subscription contracts linked to usage which provides a solid annual revenue base on which to improve upon every year as more features are introduced. Finally, we also received the consistent feedback that government bodies are significantly lagging corporates, and even smaller businesses, in their digitalisation journey. Both Softcat and Bechtle have significant government businesses.
IT spending resilient during recessions
Investors are also understandably worried about the prospects for the global economy. We are well aware that higher energy prices and rising interest rates have substantially increased the probabilities of a recession in the near future, but we do note that, historically, IT investment has proven to be resilient during periods of weak economic activity. Softcat grew both revenues and earnings through the global financial crisis while Bechtle experienced a 4% decline in revenues in 2009 and a 28% decline in operating profits, which was primarily due to management’s decision to not fire staff and instead invest for future growth. This decision was vindicated the following year, when revenues and profits rebounded quickly (Figure 2). If a severe recession occurred, we expect the margin for both Softcat and Bechtle to prove resilient given much of their expenses are variable in nature (due to the high percentage of staff remuneration linked to performance). Inflationary pressure on wages is also less severe than in other parts of the IT industry given their focus on hiring mostly graduates. Lastly, we also take comfort from the fact that both businesses have net cash balance sheets.
Digital transformation a structural trend
The long-term industry outlook, remains positive. The pandemic has accelerated the pace of change and highlighted the importance of investing more in IT infrastructure. Strong IT systems allow corporates and governments to remain operational under the most dire circumstances, while also delivering their products and services in a more digital world. These systems also lead to better staff retention as more choose to work in a hybrid work environment. Our conversations with multiple executives from several industries corroborated the idea that digital transformation is a long-term structural trend. Both Softcat and Bechtle continue to hire new graduates and the latter has just announced it will almost double its warehousing capacity in Germany. As discussed in August 2021, we are supportive when our companies invest through periods of uncertainty without trying to optimise short-term earnings via myopic cost measures. This usually leads to strong organic growth over the following years.
The Fairlight View
Whilst Fairlight’s investment philosophy is long-term in nature, this should not be mistaken for a blind ‘buy and hold’ strategy. Investments are subject to ongoing scrutiny and if thesis drift is detected, sold. Our findings from this recent trip to Europe and the UK suggest that Softcat and Bechtle remain well placed to weather any short-term headwinds and deliver strong returns to shareholders over the coming years.