Two European tech stocks that can weather a global downturn

Alvise Peggion, CFA

Fairlight Asset Management

The ongoing sustainability of businesses is a key concern for investors, especially within the current environment and for companies in the technology sector. A recent research trip enabled us to probe the investment theses for many of our fund’s stocks that are domiciled in Europe and the UK.

Historical records provide a good starting point when assessing the quality of our businesses. However, given that competitive and industry dynamics do evolve, significant work goes into monitoring the sustainability of our portfolio companies’ competitive advantages. Fairlight’s investment strategy focuses on owning wealth-creating businesses. This means we invest in those that consistently generate returns well above their cost of capital for the long term.

An example of our ongoing research efforts involved meeting with the management of IT value-added resellers Softcat and Bechtle, speaking with their competitors, and also with industry participants.

Scale players in growing markets

Whilst there are some differences between the two companies, most of what was discussed in our previous profiles of Softcat (see December 2020 and April 2021) is also valid for Bechtle, a German domiciled value-added reseller of IT hardware, software, and services. Scale advantages are important in this industry which leads to a dynamic where larger players tend to consistently gain share. 

On the demand side, larger resellers can offer customers a broader portfolio of IT products and deeper expertise than smaller peers. On the supply side, larger resellers allow IT vendors to gain instant access to an extensive sales network of trusted specialists. Bechtle is the largest player in Germany with a 3.3% market share.

Although Bechtle operates mainly in Germany, the same dynamics that have driven double-digit organic growth for Softcat in the UK are also present.

IT spending tends to grow about two percentage points faster than the broader economy as businesses require increasingly more complex technology to remain competitive, and the highly fragmented nature of the market gives Bechtle a long runway for market share gains. 

Since 2006, Bechtle has been growing business volumes at 9% per year, eclipsing German GDP growth. Importantly, growth has been highly profitable (EPS CAGR has been 14%) with excess capital returned to shareholders via dividends as this chart below shows:

Figure 1.

Source: Figure 1: FactSet, Company filings, Fairlight and Bitkom

Demand for IT infrastructure remains strong

One concern for Bechtle is that after a Covid-induced surge in demand for hardware and software there will be a natural slowdown. Our conversations with multiple executives suggest that while there is an element of this, particularly in the area of devices, investment in corporate cloud infrastructure remains buoyant and there is significant pent-up demand across product categories that require face-to-face or on-premise implementation.

Widespread hardware shortages and supply chain issues have also meant that not all demand has been fulfilled yet. Bechtle’s order book, for example, at the end of March was 80% higher than in the previous corresponding period. Moreover, the software is predominantly sold on subscription contracts linked to usage which provides a solid annual revenue base on which to improve upon every year as more features are introduced. 

Finally, we also received consistent feedback that government bodies are significantly lagging behind corporates and SMEs in their digitisation journey. Both Softcat and Bechtle have significant government businesses.

IT spending remains resilient during recessions

Investors are also understandably worried about the prospects for the global economy. We are well aware that higher energy prices and rising interest rates have substantially increased the probabilities of a recession in the near future, but we do note that, historically, IT investment has proven to be resilient during periods of weak economic activity. 

Softcat grew its revenues and earnings through the global financial crisis while Bechtle experienced a 4% decline in revenues in 2009 and a 28% decline in operating profits, which was primarily due to management’s decision to not fire staff and instead invest in future growth. This decision was vindicated the following year when revenues and profits rebounded quickly - as you can see in the chart below. 

If a severe recession occurred, we expect the margin for both Softcat and Bechtle to prove resilient given much of their expenses are variable in nature (due to the high percentage of staff remuneration linked to performance). Inflationary pressure on wages is also less severe than in other parts of the IT industry given their focus on hiring mostly graduates. We also take comfort from the fact that both businesses have net cash balance sheets.

Figure 2.

Source: Figure 2: FactSet, Company filings and Fairlight

Digital transformation a structural trend

The long-term industry outlook remains positive. The pandemic has accelerated the pace of change and highlighted the importance of investing more in IT infrastructure. Strong IT systems allow corporates and governments to remain operational under the direst circumstances, while also delivering their products and services in a more digital world. 

These systems also lead to better staff retention as more choose to work in a hybrid work environment. Our conversations with multiple executives from several industries corroborated the idea that digital transformation is a long-term structural trend. Both Softcat and Bechtle continue to hire new graduates and the latter has just announced it will almost double its warehousing capacity in Germany. 

As discussed in August 2021, we are supportive when our companies invest through periods of uncertainty without trying to optimise short-term earnings via myopic cost measures. This usually leads to strong organic growth over the following years.

The Fairlight View

Whilst Fairlight’s investment philosophy is long-term in nature, this should not be mistaken for a blind ‘buy and hold’ strategy. Investments are subject to ongoing scrutiny and if thesis drift is detected, sold. 

Our findings from this recent trip to Europe and the UK suggest that Softcat and Bechtle remain well placed to weather any short-term headwinds and deliver strong returns to shareholders over the coming years.

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The Information is not investment advice. It is general information only and does not take into account the investment objectives, financial situation or particular needs of any prospective investor. Before you decide to invest in the Fairlight Global Small & Mid Cap (SMID) Fund (Fund), it is important you first read and consider the Fund Product Disclosure Statement dated 29 June 2022. Copies of the PDS are available from The Trust Company (RE Services) Limited, ABN 45 003 278 831, AFSL No 235150 as issuer of the PDS, or from Fairlight. You should consider the PDS before deciding whether to invest, or continue to invest, in the Fund. Neither Fairlight, nor any of its directors, associates or related entities, guarantee the performance of the Fund or the repayment of capital or any particular rate of return. Whilst we believe the material in this website is correct, no warranty of accuracy, reliability or completeness is given, except for liability under statute which cannot be excluded. ACN 628 533 308 | Fairlight is Corporate Authorised Representative No 001277649 of AFSL No 000247293

Alvise Peggion, CFA
Portfolio Manager
Fairlight Asset Management

Alvise is a partner and portfolio manager for the Fairlight Asset Management Global Small and Mid Cap Fund. Alvise previously worked at Forager Funds for more than six years where he focused mainly on global companies.

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