Description

Summary: Alviva Holdings (“AVV”) is an US$135MM market cap South African IT distributor. At R14.45/share, AVV trades at 4.2x LTM P/E, 3.7x LTM EV/EBIT and is a causality of the recent decline in South African small and mid- cap valuations. Over the near term, AVV’s shares will most likely be influenced by overall equity valuations in South Africa. Longer-term, AVV is a high quality, organically growing business trading at depressed valuations. Over the past 10 years, AVV has compounded book value + dividends by 19%/yr on a USD basis and generated an average ROE of 27%. While IT spend in developed markets has begun to flat-line, in Sub-Sahara Africa, penetration remains below developed markets and total spend still has a long-run way of growth. Most importantly, given AVV’s depressed valuations, AVV’s management has committed to returning the majority of AVV’s excess cashflow to shareholders via buybacks for the foreseeable future.

Overview: AVV’s core business is an IT distribution business, acting as a middle man between global IT companies and small and medium size businesses in South Africa. IT distributors sell large numbers of SKUs while earning a small mark-up on each, creating a difficult to replicate business and high barriers to entry. Generally, they are high quality businesses which generate high ROEs. The South Africa market is an oligopoly between AVV, Mustek Ltd (MST SJ) and private company Tarsus. In the appendix, we provide a link to an overview of the IT distributor business model and its role in the IT supply chain.

Over the past three years, AVV has grown core earnings (adj. net income) by 16%/yr and, factoring in its buy back, grown Headline Earnings Per Share by 20%/yr in a tough market. While AVV has undertaken several acquisitions over this period, as we will discuss below, they appear to have mostly not panned out. Thus, we believe the majority of the company’s earnings growth has been organic. Most recently, AVV continued to grow its bottom line in 2H19 (6/30/19) despite South Africa entering a recession in Calendar Q119, illustrating the business model’s resilience. Since then, the South Africa economy has rebounded somewhat (at least in terms of GDP) but remains fragile.

In FY19 (6/30/19), AVV generated R508MM of Levered Free Cashflow before changes in WC or ~25% of its current market cap. In FY20, AVV is guiding to R150MM of WC release, has R450MM of preferred debt which comes due (after which they are done paying down debt) and the remainder of free cashflow will be applied to share buy backs and a modest dividend. Through Q120 (9/30/19), the company has repurchased 3.6% of its shares outstanding.

Today, AVV trades at 4.2x LTM P/E, versus its five-year low, average and high P/Es of 4.2x, 7x and 10x. Direct South African peer MST SJ trades at 5.7x LTM P/E. International IT distribution companies trade at varying valuations from ~7x (SIS TB) to 30x (DDR AU) LTM P/E. Most recently in the US, Tech Data was purchased by Apollo for ~10x LTM EV/EBIT.

We believe AVV trades at a discount to historical trading levels and peers for three primary reasons:

1)      In 2017, EOH Holdings (“EOH”), a large South African IT company, was overcome with a bribery scandal related to how it won its public sector business. Since then, EOH has been a slow moving train wreck, as the company has been forced to restate its earnings, replace its board and management team, and sell off business lines to pay off debt.  EOH’s woes have painted a black eye on the entire South Africa IT industry, depressing valuations across the board. Bafana901 wrote up EOH on VIC earlier this year. In 2015, AVV had its own scandal, though on a much smaller scale. To counteract this, in 2016 AVV replaced its CEO and adopted a remuneration program which includes a Forfeitable Share Plan. In 2020, 40% of management’s compensation will be paid in three-year vesting shares. Additionally, we have seen some insider buying, with a large purchase by the CFO at the end of 2018.

2)      In 2016, Pierre Spies took over as CEO of AVV. While operationally Spies has been a strong performer - squeezing days inventory and outperforming direct peer MST - the market is suspect of his capital allocation. When Spies came into office, IT services companies were receiving elevated valuations in the South African market and he sought to use the steady cashflow AVV’s distribution business generated to transform AVV into an IT platform. While it is always questionable to judge another’s actions with hindsight, factually over the past three years, AVV spent 55% of it cashflow on M&A for its service segment which have produced no additional growth. In the CEO’s defense, the majority of the acquisitions were in more cyclical IT services businesses which industry wide have seen a drop-off as the South African economy slowed.  On its most recent earnings call, given the company’s current depressed valuation and mixed track record of M&A, going forward management committed to focusing on bedding down its past acquisitions and returning future cashflow to shareholders. In the appendix, we provide an overview of Spies’ historical capital allocation.

3)      Over the past year, the entire South African small and mid-cap sectors have sold-off sharply as investors have grown fatigued with Cyril Ramaphosa’s reform efforts. In December 2017 at an ANC conference, Ramaphosa was elected the ANC’s candidate for president on a platform of reforming corruption in South Africa. While initially this was greeted with a period of euphoria by financial markets, Ramaphosa has been forced to spend the first two years of his presidency building a coalition to implement his sought-after reforms. During this period, the South Africa economy has continued to deteriorate, culminating mostly recent in Moody’s putting the country on negative watch (Moody’s is the country’s last Investment Grade rating). While Ramaphosa is well intentioned and making progress (the next milestone will likely be the government’s restructuring of Eskom), his success is clearly not guaranteed and the South African economy is the primary risk one bears in an investment in AVV today. In the Appendix, we provide a more detailed account of Cyril’s presidency.

Historical Cash Flows: Below is a snapshot of AVV’s historical cashflows. 

In FY19, AVV’s inventories expanded as South Africa entered a recession in Calendar Q119 (3/31/19), leading AVV to miss its sales forecasts. AVV has guided to days inventory returning to 18 days in FY20 which should release R150MM of cash.

Conclusion: We tried to keep this pitch simple. If one excludes FY19’s working capital build, AVV is a high quality, capital light, organically growing business trading at a ~25% LTM levered free cashflow. While harder to quantify, there is likely a cyclically depressed aspect to AVV’s LTM as well. If Ramaphosa succeeds, stepping out 2 to 3 years, it would not be hard to imagine scenarios where AVV’s earnings double and its valuation triples.

It is important to note that the entire South African market is on sale at the moment, not just AVV. AVV stood out to us specifically because of the high quality of the company’s business, confidence in its ability to continue to grow earnings if the South African economy continues to merely muddle along, and management’s commitment to returning all excess cashflow to shareholders. Please feel free to leave comments on others investment opportunities.

Appendix: Risks and Other Items to Understand

1)      Black Economic Empowerment (“BEE”) Ratings: The South African government requires that businesses meet certain BEE criteria to be eligible for government work. One of these criteria is black ownership. AVV is empowered at the subsidiary level, where it sold 51% of one of its subsidiaries, DTC, to a black trust. Previously, AVV wanted to do an equity raise at the holding level and exercise their call to buy out the minority owner at its subsidiary to clean up the structure. Management has put this on hold as they don’t believe they can do it on a value neutral basis given the current depressed share price.

2)      Forfeitable Share Plan (FSP) – Over the past three years, AVV has purchased 5% of their stock as part of the LT comp / FSP plan. They are holding these as treasury shares to potentially be paid out in the future and the shares should not be deducted from the sharecount.

3)      AVV’s Business Model – In the above, we glossed over AVV’s business model and why it is high quality. This link provides an overview on how IT distributors work and their role in the supply chain -  http://www.gtdc.org/research/Understanding-the-Technology-Distribution-Business.pdf

4)      Buy Back – The South African Companies Act is ambiguous towards the amount of shares a company can buy back in a given year (AGM to AGM). Previously, AVV believed that they were capped at 5% of their market cap per year, which they maximized. While they could have returned the remaining free cashflow to shareholders via dividends, this limit partly explains why Spies went on an acquisition spree. The company sought and received a different legal opinion and now believes they can go above the 5% per year threshold. We have recently seen a couple companies in South Africa go above 5% as valuations have fallen across the board.

5)      Other Segments – AVV operates two other business lines in addition to its distribution business. It’s IT Projects & Services segment is primarily Datacentrics in addition to the majority of their recent acquisitions. This segment has more cyclical exposure and has moved side-ways recently. Financial Services is a finance receivables business.

6)      Capital Allocation – Below, we break down AVV’s historical capital allocation since Spies took over. While AVV has spent R1.2B on M&A since 2016, half of this was spent on buying out the remaining 42% of Datacentrics which it didn’t own in FY17. The deal, while cyclically poorly timed, made sense in our minds given AVV’s ability to fully integrate the business. The remaining R600MM (~25% of AVV’s cashflow) was spent on a hodgepodge of smaller businesses, including Synerg Group,  a Sage Reseller; Merylnn, an AI software platform; Obsure, an IT security solution; Sintrex, an IT infrastructure monitoring solution - and VH Fibre Optics, a fiber-to-home passive network. The majority of these have acquisitions have been lumped into AVV’s IT Projects and Services segment which has seen flat earnings over the past three years

For illustration purposes above, we simplistically assumed levered free cashflow is flat YoY in FY20.

Some of these acquisitions make sense; some are head scratchers. The jury is largely still out. 

7)      Ramaphosa’s Presidency – The following is our opinion only, so please do leave a comment in the forum if you have further thoughts.

South Africa has a parliamentary system of government, where the president is elected by the governing majority in parliament. For the past 25 years, the African National Congress (“ANC”) has held a majority in parliament and elected the president of South Africa. From 2009 to 2018, South Africa’s president was Jacob Zuma, whose term was marked by a period of cronyism and associated deteriorating economic conditions.

At the December 2017 ANC Leadership Conference, Cyril Ramaphosa defeated Zuma’s chosen successor, Nkosazana Dlamini-Zuma (Zuma’s ex-wife) to become the ANC’s choice for president of South Africa. Ramaphosa was Nelson Mandela’s right-hand man while negotiating the end of Apartheid before leaving the political system to join the business community. Ramaphosa ran on an anti-corruption campaign focused on restoring business confidence and investment in the country.

Financial markets initially greeted Ramaphosa’s victory with elation, captured in the headline “Ramaphoria.” This euphoria deteriorated as the complexities of the larger political situation became apparent and the subsequent period has been coined “Ramaphobia” or “Ramagaddean.” In our opinion, there were several reasons this took place:

a)   Ramaphosa’s December 2017 victory at the ANC Leadership Conference was by a narrow margin, which initially limited his immediate ability to clean up the government. In exchange for the winning block of votes, he was forced to take on a questionable Deputy (Vice) President, David Mabuza. Additionally, long-time Zuma ally, Ace Magashule, defeated Ramaphosa’s preferred candidate for ANC Party Secretary.

b)  South Africa holds general elections every five years, with the following election scheduled for May 2019. Rampahosa’s primary competition in the election was the socialist group the Economic Freedom Fighters “EFF”. For the first year and half of his candidacy, Ramaphosa governed with an eye on winning a large mandate in the May 2019 election, which practically meant he swung his policies to the left to neutralize the EFF. This specifically manifested itself in the ANC trying to own and control the EFF’s primary message which was land redistribution. That really spooked the market.

c)   The damage to South Africa’s institutions was much more extensive than previously realized and the process of re-building them has taken longer than anticipated. While Ramaphosa was able to replace the heads of South Africa’s key posts including, Finance, State Owned Enterprise, South Africa Revenue Service (equivalent of IRS) and Law Enformcent it has taken time to re-build these department. Eskom, the countries, state owned utility has turned out to be particular problematic as its has was grossly underinvested in under Zuma leading to a series of rolling black-outs at the start of 2019.

In May 2019, the ANC won ~57% of the general vote - above expectations. Ramaphosa, believing he had won a convincing mandate for his platform, responded by cleaning the majority of the cronies (old Zuma allies) out of cabinet. The Zuma faction of the ANC responded by calling for the central bank to be nationalized and had the state public prosecutor, a Zuma hold-over write-up Ramaphosa on false charges of money laundering creating continued uncertainty.

After four months of moving sideways, today Ramaphosa finally seems to finally have to control the ANC. Additionally, potentially because of Ramaphosa’s doing, the second largest political party in SA, the Democratic Alliance, recently fired its head and replaced him with an individual more supportive of Ramaphosa efforts.

In August 2019, Ramaphosa’s finance minister, Tito Mboweni, came out with a radical blueprint for turning around South Africa’s economy, most importantly calling for the privatization of many of South Africa’s state-owned assets. The first test of this new blueprint and Ramaphosa’s power is currently taking place as the government has threatened to close South Africa’s state-owned airline, South Africa Airways, unless the unions play ball. The big test will be the upcoming restructuring of Eskom, which the government hopes to split into three units (generation, distribution, and transmission) and which Mboweni has called to be privatized.

Catalyst

The primary catalysts for the name are related to South Africa overall. Over the next several months we expect the government to announce their plans to restructure Eskom.  In February 2020 Moody's is set to review South Africa's Soverign Credit Rating Credit Review