Description

Three facts about Insight Enterprises:

1)      It is a Fortune 500 company with 11,000 employees worldwide.

2)      If bought on the 1995 IPO and held since, the stock returned more than 15% annually.

3)      It has never been written up on VIC.

I think that at current prices, Insight provides an opportunity for a 2-3x return in the next couple of years with a limited downside risk.

Introduction:

Insight provides hardware, software, and IT services to customers globally.  For the most part, the company focuses on large corporate customers (5000+ employees) and government entities.

Why would a customer work with Insight?

1)      Inventory management. 

a.       Efficiency.  The IT department doesn’t want to stock enough inventory of everyday computing items like laptops from any brand, in any configuration, just in case someone will require one.  Instead, Insight manages this inventory and quickly fulfills the orders made by employees. 

b.       Scale.  Thanks to bulk purchases, Insight can get better pricing on the equipment than an individual corporate buyer.

c.       Advice.  Insight is OEM-agnostic, which means it can recommend the IT department to buy an HP laptop at one time and a Lenovo at another, depending on the best value-for-money deals prevailing at the time. 

d.       Configuration.  The laptop will ship preconfigured with the applications IT required and setup to meet the organization security / personalization requirements. 

2)      Global / nation-wide distribution.  Insight has the global footprint and the knowhow to plan and execute a global device distribution and configuration.

For example, the company completed a worldwide distribution of preconfigured tablets for a US based Airline to be used by flight attendants for in cabin purchases.  Another example is an overnight nation-wide deployment of self-checkout stations for a large US big box chain.

3)      Managing software licenses efficiently (along the lines of item #1, but for software).

4)      Solving problems.  I subscribe to Office 365 and in the past 5 years I had 3 separate issues.  Microsoft does not support end customers and so they referred me to a local IT company to get help.  The IT company didn’t bill me for the support, so I assume they bill Microsoft directly.

In addition, that IT company switched my monthly invoices to go through them rather than through Microsoft.  I pay the same price as before, and Microsoft compensates the IT company through the subscription. 

Larger companies than mine with bigger, more complex and more frequent issues, work with Insight.

5)      Planning, guiding and executing anything from moving workloads from a data center to the cloud, configuring or upgrading a school’s network, providing an IT support call center for the corporation’s employees and so on.

Another obvious question is why don’t companies like Cisco or Microsoft cut the middleman and work directly with customers?  The first reason is that they are not set up to provide the sort of service their customers need.  They can of course develop the skillset, but their operating margins are about 10x those of Insight, so they don’t have an incentive to cut the middleman.

The other part of it is that the vendors give Insight shorter payment terms than Insight gives its customers, which means that the end customers get a better deal while the vendor can keep an asset light business and not worry about working capital (WC), collections and so on.

The business operates through three segments (Hardware, Software and Services), but is easier to analyze if cut into two parts:

1)      Selling products.  This is a low-margin, high velocity game.  It can be viewed of as a classic low / medium value-add distribution business with low margins and high volumes.

2)      Providing service.  45% of gross income comes from providing services.  More than a 1/3 of that from cloud sales.  This is a higher margin business with a little more predictability.   Services had been growing as part of the mix and are expected to continue growing, driving margins higher (more on that later on).

Industry

The IT “Worldwide Solution Provider” industry (Gartner’s definition) is highly fragmented, with the top 3 companies controlling only 7% of the market.  Most of the industry participants are small shops that support the 1-10 employee businesses.  The companies that are serving the 1000+ employees had been consolidating, a trend which is expected to continue.  Per the recent conference call, COVID and work from home had been accelerating the move to single large supplier that can simplify matters for the corporate buyers.

Within the industry, Insight is second to CDW, which serves the smaller customers and consequently gets better margins, better returns on working capital and trades at a far higher P/E ratio.

Connection is the third largest company and is serving the mid-market.  Its margins fall right between Insight and CDW.

Insight’s 2019 acquisition of PCM (more on that later) increases the mid-market share in the mix, which is one of the drivers for margins expansion.

The industry has been growing faster than GDP at around 5%, a trend which I can’t see why would reverse. 

Management

CEO Ken Lamneck joined 10 years ago and expanded Insight to new products, services, and geographies.  The expansion was done organically and through acquisitions.  Under Ken’s leadership the ROE averaged 16%, 3 points higher than it was in the decade before he joined.  This feat was achieved while using minimal debt.  Ken has a good track record as a capital allocator, making highly accretive acquisitions and initiating a buyback plan.

In the 10 years since Ken joined the stock returned over 400% (almost double the S&P 500 return), or 17% annually.

Employees seem to be happy too, giving Insight 4 stars on Glassdoor, vs 3.8 to CDW and 3.3 to Connection.  CEO approval is at 93%.

Finally, Insight keeps winning “Partner of the Year” awards and often gets its status upgraded (which is achieved through more sales and better execution).  I would imagine this means they are not doing a terrible job.

I was unable to gauge customers satisfaction, but organic growth might indicate that they too are not overly dissatisfied.

Growth

In the past 10 years the company grew revenue 8% annually while over the same period the EPS grew 19%.  Fine, 2009 is not a fair baseline year.  If we use 20 years period, the baseline year would be 2000.  I would argue that it is pretty much the worst year to use as a base for growth of an IT company and still the company grew revenue by 6% and EPS by close to 10%.  (please see the comment at the end of the section relating to revenue recognition which causes top-line growth to be understated).

Just because a company grew in the past, doesn’t mean it will grow in the future, so let me share why I think the company will continue growing.

As mentioned above, the IT industry has been growing faster than global GDP, at roughly 5% annually.  The large IT companies should benefit from the same level of growth and so I expect Insight to grow top line organically at least in line with the industry.

The next piece of growth comes from capital allocation.  Insight generates high teens ROE, but only mid-single digit organic revenue growth.  This means that after funding the WC needed for organic growth, the company is left with a large amount of excess earnings.  The earnings not used to fund organic growth are used in two different ways:

1)      Acquisitions.  The company is an acquisitive one, with a decent track record.  In a sense, for them to buy companies is like “shooting fish in a barrel”, because there is just so much low-hanging-fruit synergies to be realized that it almost doesn’t make sense for a target company not to be acquired.  For example, PCM was acquired mid 2019 for $660M (EV).  PCM had an EBIT of 45M, but Insight saw a $70M synergies opportunity, which makes the acquisition a complete homerun.

I am always skeptical of managements touting synergy to justify an acquisition, but Insight has a long track record for realizing the predicted savings, and then some.

Specific to PCM, 90% of the synergies have already been realized, but are not in the run-rate yet (will be starting 2021) with the rest coming in next year (to be fully visible in the 2022 numbers). 

The same synergy / scale play came with the 2017 Datalink acquisition (10 times EBIT purchase turned into 4.5 times when incorporating synergies that were fully realized by the end of 2018).

Important to note that the company had been using low cost debt to fund the acquisitions.  It then repays the debt while integrating the target and preparing for the next acquisition.  This means that most of the time the company has little debt or net cash (in the last 10 years it had Debt / EBITDA higher than 1 in only 2 years).  As will be explained later on, the company’s balance sheet is countercyclical, which protects it if the economy falls off a cliff right after an acquisition.

Side note:  some smaller acquisitions are done to acquire a skillset that the company does not have and that would be too costly / time consuming to develop.  Given their size, I’m ignoring them and treat those as the cost of doing business in an ever-changing industry, but just wanted to mention for completeness.

2)      Buybacks.  The company acquired over a quarter of its shares over the past decade.  Not exactly an uber-cannibal but certainly provides a nice tailwind.

Another part of Insight’s growth should come from margin expansion.  With scale and a better mix of services vs products, the company’s margins constantly improve and the opportunity there is quite material (see next section).

And finally, the company is using COVID to hire savvy and experienced salespeople to help grow the business when the economy starts coming back.  According to the Q3 conference call, there are decent hiring opportunities to acquire talent right now.

To summarize the above, Insight:

1)      Operates in an industry that grows faster than GDP.

2)      Acquires competitors and realizes material synergies (using low cost debt to acquire companies at 5-6 times post-synergies EBIT).

3)      Becomes more efficient with scale, which improves margins.

4)      Increases services offering in the mix to further improve margins.

5)      Repurchases shares.

For those reasons I believe that top line and bottom line will continue growing for the foreseeable future. 

Comment on revenue growth:  note that FASB 606 was adopted in the beginning of 2018.  Under this accounting change, the sale of services limits what is recognized as revenue to the considerations due to the company.  As a result, if a $10 piece of hardware is sold for a $1 gross profit, the company will recognize $10 in revenue and $1 in gross profit.  However, if the company sells $10 worth of a cloud service, with a $1 associated gross profit, the company will recognize $1 of revenue and $1 of gross profit.  This has zero impact on the business itself or on anything below the gross profit line of the P&L, but it does make the last couple of years’ top line growth to optically appear understated (especially since the company had been working hard to expand this side of the business). 

Valuation

The company trades at 12 times 2019’s earnings and 10 times my estimated 2020 earnings.  I don’t think that 10 times earnings is expensive for a company that should grow bottom line at least mid-teens in the foreseeable future, but I believe that earnings are materially understated.  With the PCM acquisition (completed on the second half of 2019) and the synergy to be realized, looking at the rearview mirror is probably misleading in this case. 

We are 2 years into a 5-year plan that the company introduced to grow sales 8-10% annually and bring EBITDA margins to 5%-5.5% (translates to 4.5%-5% EBIT margins).  On the Q2 call they reaffirmed the plan, which is unsurprising because the largest piece of it is the PCM acquisition and the synergies to be realized from it.  The margin expansion is also not a major hurdle given the scale benefit, PCM’s better mix and the plan’s ambition to grow services from 45% to 50-52% of gross income.

At the low point of their guidance, 2023 revenue would be $10.4B and the EPS would be $10.4, giving the stock a P/E of 6.

At the midpoint of their guidance, 2023 revenue would be $11B and the EPS would be $11.6, giving the stock a P/E of 5.

Please note that this scenario assumes no further acquisitions nor buybacks.  The company already guided to repaying all the debt that was taken for the PCM acquisition next year, so the 2022 and 2023 earnings should build a ~$750M net cash pile, or more than $20 PS in cash.  I don’t see the company keeping so much cash on the balance sheet and the more likely outcome would be a $1B acquisition.  If would be done at 50% higher valuation than paid so far (6 times post synergy EBITDA and 7 times EBIT), it would add another $3 to EPS.

The average PE of the past 5 years was 12.5.  So, without the acquisition and ignoring the value of $20 PS in cash, at midpoint Insight will have an EPS of $11.6, which would put the target price $145.  Alternatively, with an acquisition EPS would rise to more than $15 a share and target price would be $188.  In this scenario the company will have $300M in debt (about 8 months’ worth of earnings).

The above ignores a couple of factors:

1)      Rising margins should drive the PE higher compared to the past.  CDW’s 5 years average PE was over 20.

2)      Assumes no buybacks.  To be fair, I also ignore the convertibles which convert at $103.  At $150 stock price they would net-dilute by 4%.  Obviously, a dilution at $150 will not be terrible news for investors who purchase the shares at today’s prices.

If management completely misses on their plan and COVID earnings stay with us for the next 7 years, the company will have its market cap in cash by then (assumes current earnings + realized synergies).  In the last two recessions it took the company 4 years to surpass the previous peak earnings (2000->2004, 2006->2010).  This time though they completed an acquisition just before the recession and that acquisition grew the business by 30%, so I don’t think we will need to wait 4 years for a new high in earnings.  In fact, 2020 is already tracking to be a high teens growth year over 2019 and I expect 2021 to be materially better than 2020 (just based on synergies realization and even before an improvement in the economy).

Finally, note that the company was profitable every year in its public history (ex. goodwill impairments), and has net debt equal to about 7 or 8 months of earnings.

Risks

1)      COVID.  Any recession reduces corporate appetite to spend on IT and a global pandemic may be no different.   There was an initial boom in some products (i.e., laptops for employees who suddenly had to work from home, school districts purchasing Chromebooks and so on), but obviously there could be a slowdown.  Contractions are when the counter-cyclicality of the balance sheet kicks in.  Since Insight provides better payment terms to customers than it gets from its suppliers and since it carries inventory, when revenues grow WC grows and when revenues shrink, WC shrinks.  When WC shrinks cash is quickly released.

In 2008-2009 the company’s WC shrunk by about a quarter.  A similar level of business decline would still keep the company profitable but would cover over 100% of the debt, moving the company into a net cash position.

2)      IT industry - what if changes make the company’s business obsolete?  My view is that someone will need to provide Bank of America’s employees the laptops they need when they need it.  That is not a service that Amazon can provide, because the laptops are shipped with the software needed, the security profile defined in the organization and the appropriate permissions.

For the reasons explained above I also don’t expect the company to be disintermediated by its suppliers.

Finally, change is not new to Insight.   Over the years the company evolved from selling hard drives off a catalog to having a fifth of the gross income come from cloud computing.  They evolved one hype at a time, developing or acquiring the necessary skills, and I don’t see why they stop doing that.

3)      Supplier concentration.  In 2019 61% of sales came from Microsoft, Cisco, HP, Dell and Tech Data.  As mentioned above, Insight has been an often winner of “Partner of the Year” award by its suppliers, so I don’t think that there’s a significant chance that any one of them will drop the company, but obviously a distributor thrives with a many (suppliers) to many (customers) relationship, not few to many.

The more scale Insight gets, the harder and more painful it would be for the suppliers to replace it.

4)      Device refresh cycle.  The last few years were pretty strong for hardware replacement and I suspect some believe that it would mean slower future sales.  While certainly possible, I think this is missing the shifts in the industry purchase dynamics.  There used to be major upgrade cycles (Windows XP, Windows 7 and so on) that drove the device refresh cycle.  I would argue that it is less pronounced today.  We move more and more to subscription services (Office 365) and to continuous updates, rather than the large upgrades we used to have in the past.  In addition, Insight management believes that its customer’s order patterns underscore a continuous device refresh rather than following any major OS release trigger.

The increase in reliance on services will certainly help here, but even if we would see a slowdown in device refresh, I don’t believe it would have a fundamental long term impact on the thesis (services will be over half of gross income and software sales will also not be impacted), but it may add a couple of years till the stock gets to hit the price targets.

5)      Receivables.  The company’s largest asset on the balance sheet is receivables and so if a lot of them will go sour it is obviously a concern.  The customers are predominantly large corporations and government entities, so historically the risk was low.  For example, in 2008-2009 insight had to write down 0.7% of the receivables at the peak.  That would translate to less than 1 month of earnings if applied to today’s receivables.

6)      Betting the farm on a large acquisition that doesn’t pan out.  Insight’s track record has shown that they are not likely to bet the farm on anything nor make a large acquisition they are unsure of, but obviously it cannot be 100% eliminated as a risk.  If we assume that each of the last two large acquisitions had zero contribution to earnings (complete flops).  The debt associated with each of the acquisitions would have been paid off within 3 years of the acquisition.  In other words, it would have been more of an opportunity cost than an existential risk.

7)      Execution risk on PCM integration.  Most of the integration is behind us and the stock is already trading at ~8 times earnings (including only the synergies that were already realized), so I do not view it as a major risk at this point.

Catalyst

1. PCM acquisition synergies reflected in the numbers.

2. Move to net cash next year.

3. Further acquisitions / stock repurchases