Just prior to Christmas, technology consultants Data#3 Limited (ASX: DTL) and UXC Limited (ASX: UXC) both gave subdued earnings guidance for the first-half of FY 2014. This may be a signal that the companies are struggling to adapt to the globalisation of the IT workforce, the move to software-as-a-service and the advent of commoditised data storage.
The chairman of Data#3, Richard Anderson, blamed a soft and uncertain environment for significant capital investment decisions. He commented that: "It's very disappointing that with continued delays in decision making associated with IT capital expenditure, the business now appears unlikely to achieve its first-half budget. We are currently focused on maximising performance for the current half."
Similarly, UXC predicted that profit for the first-half of FY 2014 would be from $7 million to $8.5 million, compared to a profit of about $8.3 million ( $7.5 million from continuing operations) in the prior corresponding period. The announcement sent shares in the company plunging about 10%, but they have since recovered most of that fall, putting the company on a price to earnings ratio of over 15 and a trailing dividend yield of 5.4%.
Personally, I'm cautious of investing in IT and software companies, because the move to software-as-a-service and cloud hosting is changing the industry. It's not always clear how these changes will impact individual companies. In my opinion, data will increasingly be stored off-site in large data centres, such as those owned by Vocus Communications Limited (ASX: VOC) and Nextdc Ltd (ASX: NXT). Ownership of a fibre-optic network means that Vocus remains attractive at a P/E ratio of over 25, although I am far less keen on Nextdc, which is yet to report a full-year of profit.
However, data centres are essentially a commoditised product, with US giant Amazon.com, Inc (NASDAQ: AMZN) being one of the foremost providers. I believe that in the long run, server space will prove be a fairly low-margin product. However, one interesting play at current prices is Macquarie Telecom Group Ltd. (ASX: MAQ). Macquarie is attempting to differentiate its product by making it particularly secure, with a view to winning contracts to store top-secret information. Macquarie's significant capital expenditure is yet to pay off and the company currently trades on a trailing P/E ratio of about 23, with a dividend yield of less than 2%.
I've previously suggested that IT consultant company, SMS Management & Technology Ltd (ASX: SMX) is a decent investment because it is using its cash hoard to acquire smaller companies. This move should be earnings per share accretive, but it's not yet clear what the long term effect of the globalisation of the IT workforce will be. The company currently trades on a trailing P/E ratio of about 15 and a dividend yield of 5.7% fully franked.
Foolish takeaway
SMS, Data#3 and UXC will have to adapt skilfully to the maturing of their industry. In particular, I'm not sure how Data#3 will adapt its business model successfully because the company generates significant revenue from hardware sales.
The cloud allows the hardware to be situated offsite, so it seems unlikely that the company will grow hardware sales any time soon. I expect capital expenditure on IT to decrease as a cost of doing business over the next decade. Be wary investing in these companies: as Warren Buffett says, "turnarounds seldom turn."
