2023-11-27 11:42:26 ET
Summary
- ScanSource reported lower quarterly revenue but expects growing recurring revenue, hybridization of technologies, and expanding margins.
- The company is trading at lower multiples than competitors and offers cloud services and IoT services, which could improve Adjusted EBITDA margins.
- Stock repurchase agreements and undervaluation suggest potential stock price improvements, despite risks from changing legislation and cybersecurity.
ScanSource, Inc. (SCSC) recently reported lower quarterly revenue than expected. The management also announced incoming growing recurring revenue, hybridization of technologies, and expanding margins. Currently trading at significantly lower multiples than competitors, SCSC is offering cloud services and IoT services, which will, in my view, most likely bring Adjusted EBITDA margin improvements. As a result and thanks to new stock repurchase agreements, we could see stock price improvements. Yes, there are risks from changing legislation, failed introduction of products, or cybersecurity, however, the company does look undervalued.
ScanSource
ScanSource is a technology company that offers a varied portfolio of services for business integration and device connectivity to the Internet, including software as services, cloud storage, and hardware. The company functions between service provider companies and their clients as it offers these companies the improvement in their networks and solutions in relation to the use and scope of their own services.
Among its clients, which by the end of 2022 numbered more than 500, we find leaders in the communications industry, payment systems, security systems, connectivity, and digital services in general.
Due to the variety of origins of its clients and the different end markets they serve, ScanSource finds a large number of channels for the commercialization of its products. The company maintains active operations in Europe, the United States, Chile, Mexico, Colombia, and the United Kingdom. None of these clients seems to account for more than 3% of annual sales in the company's historical sales.
The operations are divided into two reportable segments: Specialty technological solutions and communication and storage technology solutions. The second segment mainly includes technologies for the communication of virtual meetings and different visualization functions, security, data processing, and related services, and enjoys the benefit of being supported by the same IP network, which makes it easily transferable to the structure and verticality of other businesses.
The first of these segments is called specialty technology as the products of this segment are developed specifically for the needs of each client, and consist of payment processing systems, mobile computing, barcode printing and capture, data capture, cybersecurity, and physical security.
Lower Quarterly Earnings Than Expected, But Beneficial Expectations, Including Positive FCF In 2024 And 2025 And Net Sales Growth
Even though ScanSource did not report higher quarterly net sales and EPS GAAP than expected, in my view, long-term expectations are worth having a look at. Quarterly revenue stood at $876 million with EPS GAAP of close to $0.61 per share.
Source: SA
I believe that having a look at the expectations of other market participants makes a lot of sense in this case. Other investment analysts are expecting net sales growth in 2024 and 2025, net margin growth in 2025, and positive FCF in 2024 and 2025. With these expectations in mind, I decided to run my own DCF model.
I expect 2025 net sales of close to $3.917 billion, with 2025 EBITDA of $184 million, EBIT of $156 million, and EPS close to $3.73 per share. Finally, investors are also expecting a 2025 free cash flow of about $94.8 million.
Source: Market Screener
Balance Sheet
As of September 30, 2023, ScanSource reported cash and cash equivalents of about $42 million, accounts receivable close to $691 million, and inventories of $656 million. Total current assets stand at $1.507 billion, and the current ratio is over 1x, so I really do not see liquidity issues. Property and equipment stands at close to $36 million, with goodwill worth $215 million and identifiable intangible assets worth $63 million. Total assets were equal to $1.898 billion, and the assets/liabilities is 2x. In my view, the balance sheet is quite stable.
Source: 10-Q
With accounts payable close to $617 million, ScanSource appears to receive financing from business providers. As a result, the company does not need to receive financing from banks for this, which I believe is ideal.
ScanSource also reported accrued expenses and other current liabilities close to $67 million, with a current portion of long-term debt worth $8 million, long-term debt of $141 million, and borrowings under a revolving credit facility of $98 million. Total liabilities were equal to $983 million.
Source: 10-Q
Trading Multiples In The Sector, And Cost Of Capital
I had a look at the valuations in the sector, which seem to be significantly higher than that of ScanSource. On a forward basis, the EV/EBITDA median for the sector stands at close to 14x, with a Price/Cash flow of about 21x and a P/E ratio of about 22x.
Source: SA
ScanSource reports debt agreements with close to the SOFR interest rate and a revolving credit facility of about 6.92%-6.74%. With these figures, I assumed that a WACC close to 7.5%-10% would be conservative.
On March 31, 2023, the Company entered into an interest rate swap agreement to lock into a fixed SOFR interest rate with a notional amount of $25 million and a maturity date of March 31, 2028. Source: 10-Q
The average daily outstanding balance on the revolving credit facility, excluding the term loan facility, during the quarters ended September 30, 2023 and 2022 was $200.9 million and $200.5 million, respectively. There was $251.9 million and $171.0 million available for additional borrowings as of September 30, 2023 and June 30, 2023, respectively. The effective interest rates for the revolving line of credit were 6.92% and 6.74% as of September 30, 2023 and June 30, 2023, respectively. Source: 10-Q
Growing Recurring Revenue, Hybridization Of Technologies And Physical Solutions, And Expanding Margins Could Bring Net Sales Growth
The current strategy is oriented towards long-term growth and margin expansion through the scale of its model of hybridization of technologies and physical solutions. In my view, partnerships for the development of new products will most likely play a key role since they allow the company to deepen the development of its technologies besides having a direct reach to the market in addition to multiplying the presence of its products.
Relationships are expected to be supported by training and coaching programs, enabling consumer preference functions and generating product sales strategies and other types of inventories for business management through the same hybrid systems.
In addition, ScanSource noted in a recent presentation that recurring revenue is also expected to grow, which I believe most investors out there will appreciate. It makes financial modeling easier as net sales growth is more predictable.
ScanSource also reported that cloud services, connectivity, IoT, IaaS, and managed services could bring significant margin improvements in the coming years. As a result, I believe that we could see FCF growth improvements.
ScanSource Promised Both Adjusted EBITDA Margin Expansion And Working Capital Improvement Plan For 2024
ScanSource also reported expectations with respect to future sustainable top-line growth, adjusted EBITDA margin goals close to 4.5%-5%, and consistent FCF generation thanks to a new 2024 working capital improvement plan.
I believe that these new announcements could bring significant attention from the investment community, and may accelerate the demand for the stock. As a result, we could see stock price increases.
Share Repurchases And Low Net Leverage Could Bring The Interest Of New Investors And Stock Demand
I also believe that the further stock repurchases, acceleration of strategic acquisitions, and a targeted net leverage ratio of 1x-2x Adjusted EBITDA recently presented could bring new attention from investors.
Source: Investor Presentation
It is also worth noting that the company acquired shares at an average price per share of $31, which is not far from the current valuation. In my view, ScanSource would not buy shares at $31 per share if management believed that the shares were expensive.
Given Previous Cash Flow Statements And My Own Assumptions, I Designed A DCF Model
My expectations include 2033 net income from continuing operations of close to $264 million, 2033 depreciation and amortization worth $6 million, 2033 share-based compensation of close to $15 million, no change in fair value of contingent consideration, and changes in contingent consideration.
Source: DCF Model
With 2033 changes in accounts receivable of close to $589 million, 2033 changes in inventories close to -$523 million, and 2033 prepaid expenses and other assets of $42 million, I also included 2033 changes in accounts payable close to -$211 million.
Additionally, with changes in accrued expenses and other liabilities of about -$87 million, 2033 CFO would be close to $104 million. Finally, with changes in capital expenditures of close to -$47 million, 2033 FCF would be $57 million.
Source: DCF Model
With FCF ranging from $57 million to $369 million, FCF/Sales of 3.7%-8.9%, a WACC of 7.5% and 10%, and EV/FCF of about 5x-7x, the implied price forecast would be $69 and $81 per share. The market capitalization forecast would also stand at about $1.7-$2 billion.
Source: DCF Model
Finally, I obtained an internal rate of return between 12% and 17% with a median IRR of close to 14%-15%. I believe that my figures are conservative.
Source: DCF Model
Competitors, And Risks
The competition is high and is given by large, medium-, and small-sized companies as well as regional suppliers or even resellers of third-party services through their own distribution networks.
Ingram Micro, TD Synnex (SNX), Wesco (WCC), and BlueStar are the companies that stand out competitively for the specialty solutions segment, while for the communication and storage segment, the main competitors are Avant, Telarus, CloudBlue, Pax8, Ingram Micro, and TD Synnex.
Along with the risks inherent to competition and international exposure, in addition to what arises from the open acquisition strategy that the company maintains, I must point out that ScanSource currently has a great centralization for the provision of its services, which may cause a slowdown in the response to problems in its clients' networks. In addition, the inability to solve failures in peripheral networks represents a major risk factor.
Furthermore, the company maintains highly changing operating results from quarter to quarter, which translates into significant volatility in the price of its stock. In this sense, the value of the product inventory could really be affected by changes in market behavior as well as future legislation that restricts the use of networks. In addition, user data capture can force the company to make major changes in the operation of its products.
Conclusion
Even without better quarterly EPS than expected, in my opinion, ScanSource could bring business expansion thanks to growing recurring revenue, hybridization of technologies, and expanding margins. The company does not only trade at significantly lower trading multiples than other peers in the sector, but management also announced stock repurchase agreements, acceleration of M&A growth, and consistent FCF generation. There are obvious risks from the failed introduction of new products, like cloud services or IoT, or lower EBITDA margin growth than expected. With that, I do believe that the company appears quite undervalued.
For further details see:
ScanSource: Working Capital Improvement Plan Announced, And Cheap