Description

Overview: ADI is a US$43MM market cap South African software roll-up. ADI is a combination of higher quality software as a service (SAAS) businesses and lower quality software services or project based businesses.  At R4.6/share, ADI trades at 4.6x LTM EV/EBIT and 6x LTM P/E which is attractive given its ten-year track record of growing BV/share in dollars at 23%/yr.

Background: ADI is run by CEO Sbu Shabalala and COO Tiffany Dunsdon who have been with the business for 13 and 18 years respectively. ADI has large insider ownership with Shabalala, Dunsdon and other insiders owning 9%, 3% and 9% of the company respectively. 

ADI operates in six verticals and is a roll-up of many individual products. Management is remunerated based on ROIC and has a strong history of capital allocation. To illustrate, between 2014 and 2018 ADI issued 44% of its shares at 20x+ P/E for acquisitions and has since bought back 16% of its float for sub 7x P/E. ADI is disciplined in M&A, requiring multi-year earnouts and sellers to take a mixture of cash and shares. Notably, many of the vendors who sold their businesses to ADI over the years remain on the register.

Beyond the country wide discount applicable to small cap stocks in South Africa there are several idiosyncratic reasons that ADI trades at a discount today:

1) In 2017, EOH Holdings, a benchmark South African IT service roll-up was involved in a scandal for illegally tendering for Public Sector contracts. Over the following two years, EOH’s P/E de-rated from 20x to sub 5x and EOH’s shares remain down 95%+ from their highs. EOH’s scandal led to multiple compression across the South African IT sector, including ADI. For ADI, tender work from the Public Sector is less than 10% of revenues and management has consolidated all tenders into the hands of two employees to ensure proper oversight.

2) Over the past two years, ADI’s historically strong organic growth has flatlined. ADI’s segment performance is bifurcated between its SAAS segments (education, communications and financial services), which have seen continued organic EBITDA growth (8.7% in FY20), and its project- based or service segments (manufacturing, hospitality and energy) where EBITDA has fallen, masking the strength of the former. Today the latter segments have shrunk to 22% of overall EBITDA and ADI is taking steps to restructure each. As the latter bottom out, ADI’s overall earnings should return to organic growth.

3) South African companies are graded on Black Economic Empowerment (BEE) ratings which are a factor in a customer's choice of supplier. A component is a company’s black share ownership percentage. In FY19, ADI was looking to do an equity placement to improve its BEE rating. To reduce the earnings drag, ADI pre-spent the anticipated proceeds. ADI entered FY19 with a net debt to equity ratio of 17% and spent R182MM on acquisitions and R95MM on buybacks increasing its net gearing to 65% at year end.  Unfortunately, confidence in South African equity markets declined and rather than issue shares at dilutive levels, ADI chose to organically de-lever, which has taken two years. ADI has guided to resuming modest acquisition activity or shareholder returns post 6/30/21. In the interim, ADI’s BEE rating improved to a level 1 on its own due to open market changes in the register.

We believe the above three headwinds are transitory and 1) ADI should return to organic growth, 2) industry multiples will gradually recover as concerns over EOH subside and 3) ADI should return to deploying capital as its balance sheet recovers.

Valuation: There are no direct comps for ADI in SA. The closest peers are Capital Appreciation, a fintech and cloud services company and Datatec and Allied Electronics, two SA based global software services companies, which all trade at similar levels on an enterprise basis.

On an absolute basis we see the company earning ~R.9/share in earnings in FY21, up from FY20’s R.77/share as the company restructures its underperforming segments. This translates to ~20-25% levered free cashflow yield, which is cheap for an asset lite company which should be able to organically grow its bottom line even in a tough market. Lastly, within a couple of months ADI’s management team will once again return to deploying the company’s capital accretively. A modest 10x P/E multiple would be a double from today, but still represent a discount to ADI’s own historical trading multiples and international peers.  

A couple of other items:

1) Huge Group recently made a R5.5/share all share offer for ADI. The offer appears opportunistic and it is hard to see an ADI shareholder trading his shares for HUG shares at 10x P/E.

2) Cartrak recently announced a relisting from the JSE to the NASDAQ and received a multiple re-rating. While ADI has not commented on moving exchanges, they could be a candidate.

Catalyst

Company returning to organic growth and completing its delevering cycle.