Top tips for investing in ASX-listed cloud computing stocks
As traditional IT departments give way to cloud computing services there are opportunities to invest in the future of business networking says investment analyst Callum Sinclair from Celeste Funds Management.
How much substance is there amid the excitement around cloud computing?
We have seen a real shift to the cloud of late. There is a lot of talk about moving that way and the consulting work that is required to do that. We have seen a transition from IT consultants simply running IT projects to a broader range of services and more reseller-type facilities.
There has been an increasing uptake from customers for cloud solutions, whether private or public cloud, and for client demand shifting from the traditional IT department towards increasing conversations and engagement from the operating business divisions
Cloud providers engage customers in different ways – some direct to market while others like Microsoft sell on through channel partners.
Who are the major players in the small cap IT service market at the moment?
Below a market cap of $300 million the largest is Data#3 on $269m, then DWS ($179m), RXP Services ($136 m), Empired ($99m) and Rhipe ($90).
How are Australian tech service companies positioned against those larger operations overseas?
Traditional IT consultancies have faced a natural head wind as some larger Australian corporates have reduced their spend over the past few years. Part of this is driven by shifting some of their IT spend offshore to places like Manila or Bangalore, and part from an increasing focus on costs, with both impacting some traditional consultancies.
That being said, we have seen a a continued trend towards international participants purchasing Australian IT service providers. We’ve seen this with Oakton (which was acquired by Dimension Data in 2014), UXC (acquired by CSC in 2016), ASG Group (acquired in 2016 by Nomura Research Institute) and which then acquired SMS Management and Technology recently in 2017.
We think this trend is likely to continue as large international participants look to expand into overseas markets, especially where they are struggling to generate revenue growth in their core markets and given credit funding costs are relatively low
While it is difficult to know exactly how each company is performing post take-over, typically the acquiring is the easy part and in some cases there has been difficulty successfully integrating and operating these businesses. Anecdotal feedback suggests that this has been the case in at least some instances and there have been write-downs of the carrying value of the acquired asset.
Where this has occurred it has provided some opportunities for local listed players to pick up market share.
How can retail investors see past the buzz to the true value in a cloud computing service provider?
Cloud has become somewhat of a buzzword and you need to differentiate between companies who are genuinely meeting the needs of changing customer demand and those who aren’t.
While there are a number of advantages for clients the real benefit from cloud revenues to shareholders is the subscription nature of the revenue and if the customer base is sticky it can lead to recurring annuity-style revenues over time. We see this in both the software companies and service providers or resellers of those solutions. The returns of some software companies may also improve over time if they are able to re-allocate R&D spend that was previously related to patching multiple legacy versions of a product, towards increasing spend on new product releases that are revenue generating.
In the service provider space we like companies such as Data #3 (DTL) that are genuinely benefiting from changes to demand from their customers and, as a major reseller of Microsoft Azure and Office 365, they will likely continue to benefit from the increasing uptake of these software solutions.
Over the past several years, DTL has seen its cloud revenue grow from a relatively small base to $169.5m in FY17 and while this currently represents only about 15% of revenues, a meaningful proportion is recurring which over time will provide an annuity-type revenue stream.
Whereas traditional IT consulting service providers have faced rate pressure from large corporates looking to take costs out, certain government departments and the health and education sectors have seen increased spending
What do you look out for in a cloud computing stock?
Pick the stocks that are providing the right services to their customer base and have a track record of delivery. This is relevant in picking any stock but especially applicable in the IT service provider space.
It all comes back to bottom up analysis of where they fit in and what services they are providing and finally, valuation.
Callum Sinclair started his career at ING Australia in 2007 working part time as a financial accountant during university before starting as an audit analyst at Deloitte in 2011. He joined the wealth division of NAB as a senior finance analyst in 2013 before returning to Deloitte in early 2014 as a senior analyst in the corporate finance team where he was involved in the analysis and due diligence for transactions, IPOs and government advisory work. Callum joined Celeste Funds Management in November 2014.