Data#3 Guilty Of Miscommunication

This story features DATA#3 LIMITED., and other companies. For more info SHARE ANALYSIS: DTL

While Data3#’s earnings result confirmed its January trading update, the market was not impressed with how profit growth was achieved.

-Data#3’s profit growth misleading
-Share price pulls back to pre-update level
-Brokers retain strong longer term views
-Short term consolidation ahead

By Greg Peel

Data#3 ((DTL)) engages in the provision of information technology solutions and services in Australia and the Pacific Islands, with a focus on cloud and AI adoption.

In mid-January Data#3 provided a first half trading update including key profit metrics. The market responded to the update by pushing the stock up some 20% ahead of last week’s official result.

The January update suggested first half profit would be within the range of $30-31m. The final number was $30.8m which was up 30% year on year. Revenue was up 13%, gross profit 9%, and earnings per share 32%. The dividend was up 25%, representing a 90% payout ratio.

What’s not to like? In response to the result, Data#3’s share price has since fallen -20%, wiping out the rally from January.

While the numbers were in line with the pre-release, the problem was the company issued a quantitative update in January with no qualification. If it had, it would have avoided the share price round trip which would have left investors rather annoyed.

Investors had assumed the strong performance, with profit up $6m in the period, would have been due to recurring profit from operations. But in fact some 67% of the increase was due to increased interest revenue, which in turn had a lot to do with higher rates. What’s more, second half interest income has been guided to only $2.5m.

This “transient” profit is of lower quality than an ongoing, recurring profit lift, Wilsons notes.

Morgans still saw a reasonable first half performance on an underlying basis. It was still a record result, with or without the extra interest income. Data#3 delivered continued growth but there was a 'misunderstanding' as to where it came from. Receiving extra interest income is a great outcome, the broker suggests, but investors were surprised to discover the operating growth, excluding interest income, had slowed.

If the January trading update had been more specific, recent share price volatility may have been avoided, Morgans declares. Higher interest income is likely to remain a theme going forward.

The Outlook

On its conference call, Data#3 stressed it is seeing slowdown only in the networking category, as customers implement projects post supply chain improvements, which is transitory and will rebound, Morgan Stanley reports. Rest-of-business is still seeing increased tender activity, and now a rebound in PC sales, and robust growth rates (low-teens in Product and acceleration in Services) are expected to continue.

Product gross profit grew a softer than expected 4%, UBS notes, driven by cycling strong order demand of networking products a year ago, leading to delays in new orders. The softer performance is consistent with Cisco's networking sales – US-based leader in networking — which slowed in the first half, and consensus estimates are expected to bottom in the second half before recovering through FY25.

That said, the company noted increased tender activity recently. Looking through the cycle, the broker’s analysis of IT market spend data highlights Data#3's historical outperformance, which UBS expects to remain supported by its exposure to software and major vendors like Microsoft.

Wilsons points out Data#3 is only one of seven companies in Australia, and one of 600 companies globally, to participate in the Microsoft 365 Co-Pilot ‘Early Access Program’, (ie AI). The broker sees three benefits, being improved efficiencies within Data#3 itself, preparing enterprises for Microsoft 365 Co- Pilot, and commission on Co-Pilot sales.

Wilsons remains constructive on the outlook for Data#3, expecting the robust, above-system growth in the core business to be accelerated by Generative AI over time. That said, the stock could consolidate in the $8-range in the second half, the broker suggests, before resuming its uptrend.

Goldman Sachs does not expect the softening of networking equipment demand to be a lasting headwind given the structural tailwinds for cloud spending over the long term, although this broker notes commentary from Cisco suggests softer new orders could continue for another three-six months.

Underlying demand trends are tracking softer than the broker expected, but mid-term growth remains robust at an estimated 13%-plus FY23-26 earnings compound annual growth rate, and Goldman remains attracted to the company's high returning, cash generative business model.

With demand slowing, margin pressure from a more competitive environment is occurring, Morgans notes, and this is expected to continue into the second half, putting margins under pressure. This is expected to temporarily slow but not stop growth. Infrastructure projects are some 20% of the company’s revenue and low-to-medium margin.

Data#3’s revenue mix is roughly 50/50 enterprise/government and is consequently somewhat economically insulated, Morgans points out. The business is focused on defensive areas such as health, education, public service and resources so, overall, should remain well placed to continue its growth trajectory.

Responses

Wilsons has retained its Overweight rating but cut its target by -5% to $9.12.

UBS notes the stock is trading at 28x one year forward earnings, which is a 25% premium to peer Dicker Data ((DDR)) and 37% above offshore resellers. While this broker believes a premium is warranted, that’s bit rich. UBS pulls back to Hold, while lifting its target to $8.40 from $8.20.

Morgan Stanley has long backed Data#3 and really likes the business, given its strong competitive position, robust growth outlook with AI optionality, history of execution, and tenured management. This fundamental view is unchanged, but valuation is now enough for the broker to also pull back to Equal-Weight. Target $8.10, down from $8.20.

Goldman Sachs has stuck with its prior Neutral rating while cutting its target to $8.10 from $8.30, while Morgans retains a Hold rating and $7.50 target.

Analysts at Jarden waited until this morning to publish their review. Their Buy rating has been retained, while Jarden's price target lifted to $9.15 from $9.02. This broker retains a positive outlook overall on the basis that growth looks firmly correlated with the success of Microsoft products and services.

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