January 8, 2020
American IT reseller CDW Corp has been a core portfolio holding of the Fairlight Global Small and Mid Cap Fund since inception. On first glance, CDW appears to share many low-quality attributes with its peers such as razor thin margins, reliance on large suppliers and a competitive environment characterised by intense discounting. In reality, CDW is closer to a high-quality consulting business which, thanks to growing scale advantages, enjoys consistent market share gains. Returns to shareholders have been excellent, with sales and operating earnings compounding at 8% and 9% p.a. respectively since 2005. Importantly, return on capital has increased steadily from 30% to 65% over the period as the company doesn’t require heavy investment in plant and equipment.
Having uncovered the quality of CDW and witnessed its compounding power over many years, the Fairlight team has been scouring the globe in search of similar businesses. After analysing several European IT resellers we identified Softcat, one of the leading players in the UK market, as the one sharing most of the traits that have made CDW successful.
Scale player in the SME niche
Similar to CDW, Softcat occupies a favourable niche in the IT reseller industry, targeting companies too small to be reached by the sales force of a large vendor or to have their own sophisticated IT teams. Softcat bridges this gap, operating as an extension of a vendor’s sales force and an extension of the customer’s IT team, making itself an indispensable part of the value chain. On the demand side, thanks to its scale, Softcat can offer customers a broader portfolio of products and deeper expertise than its smaller peers can. On the supply side, Softcat allows vendors to instantly reach thousands of accounts in a cost effective manner and a sales network of specialists that can accurately and reliably represent their products and brands.
Long runway for growth
Although Softcat only operates in the UK, the same dynamics that have driven strong organic growth for CDW in the US are present; IT spending tends to grow two to three 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 Softcat a long runway of market share gains ahead. While Softcat is the second largest reseller in the UK, it only has a 4% share of the overall IT market and 7% within the reseller channel. Softcat has been growing faster than the industry average over many years - recently it posted annual sales growth of 21% compared to 13% for the market. Operating profits grew 24%. This is impressive given Brexit-related uncertainty.
Superior incentives and culture
We attribute this stark outperformance to the company’s intelligently designed incentives which resembles those in place at CDW. Softcat’s account managers receive a relatively low base salary and then a percentage commission on gross profit earned on their sales, which is uncapped. Account managers are also given significant discretion on how they manage their teams and client relationships, fostering an entrepreneurial culture.
The low base salary ensures that only performing managers stay in the job, whilst using gross profit as the key measure for remuneration delivers good margin outcomes for the overall business. Successful managers tend to develop long term careers within Softcat and often are entrusted with the task of opening new offices as the company grows.
This entrepreneurial culture has helped Softcat to grow organically for 14 years by simply winning new customers and selling more to existing ones (Figure 1). We expect Softcat will continue to outperform peers over the long term.
Capital light and conservatively financed
Like CDW, Softcat benefits from the same capital light business model where growth requires only a small increase in working capital and additional staff. Since listing in 2014 Softcat has more than doubled its sales while paying shareholders 75% of the profits it generated over the period. The business has historically been debt free and it’s currently in a net cash position.
The Fairlight View
As one of the top IT resellers in the UK Softcat benefits from scale advantages in a fragmented and growing market. Thanks to its superior entrepreneurial culture we expect Softcat to continue to deliver strong organic growth through consistent market share gains. Subsequent to a sharp and short-lived share price fall, the Fairlight Global Small and Mid Cap Fund has recently initiated a position in the company.