The bursting of the tech-stock bubble has deflated many egos and portfolio values. In just over two years, companies that once boasted multibillion-rand market capitalisations have been reduced to microcap status and almost R60bn has been wiped off the IT sector's total market cap.
Few have been spared, whatever their size. As a group, IT companies with market caps of more than R1bn in the sector's heyday have fallen by about 85%. The average fall of what were mid-cap stocks in early 2000 is 90%.
The once seemingly invulnerable Didata has slumped 80% from its R75/share peak in September 2000, deflating its market cap by R65bn. Datatec has skidded 95% lower, shedding R10bn of its market cap along the way. Siltek, once capitalised at R800m, has gone to the wall. Still more companies are likely to follow.
This is part of an inevitable cull that has reduced the number of listed IT companies on the main board, development and venture capital sectors from 55 two years ago to 38. Using IT companies trading below 20c/share as a rough indication of potential failures or acquisitions, at least 10 may still disappear.
Viewed from another perspective, the 80% fall in the IT index since March 2000 would require a 400% rise to restore it to peak levels of two years ago. And p:e ratios, now in single digits, were 60 and higher in the days of speculative glory.
Unfortunately, low p:es are also attracting value-seeking predators. In one of the most intense battles for control seen in SA in years, Idion's unique continuous availability software attracted a hostile bid from Canadian group DataMirror. Less spectacularly, Unihold is being swallowed by a private venture capital group backed by Absa.
The chances of returning to the heights are remote. It is not only investor sentiment but the market confronting most IT companies that has changed radically over the past two years.
"The frenzy to achieve efficiency that drove companies to spend lavishly on IT projects and equipment in the late Nineties is over," says Arnold Garber, CEO of one of SA's highest-rated IT groups, Compu-Clearing Outsourcing.
Company CEOs now want concrete evidence of bottom-line profit benefits of any capital expenditure. In particular, the heavy depreciation burden that IT equipment adds to income statements is a key consideration.
Echoing Garber's view, US research group Gartner says "caution and scepticism will characterise business investment in IT in 2002". For the longer term, Gartner predicts that the corporate approach to IT investment will become permanently more prudent and sophisticated.
For many product vendors that add little or no value by providing services, this shift in corporate strategy is not encouraging. Other fundamental shifts are also evident in sectors where competition has become intense and operating margins are under pressure.
In networking, for example, exceptional skills were required until recently. Now, says Garber, "plug-in" software requiring little skill is in general use. This has resulted in new operators streaming into the market and squeezing margins.
"Supplying services has become the key to future success - it's all about people who can make software work," says Global Technologies (Glotec) CEO Ray Leonard. This has positive implications particularly for groups focused on services in the high-level systems integration and outsourced service sectors.
Gartner says that with the negative impact of depreciation on earnings per share in mind, companies will shift spending away from capital budgets to operating budgets. Companies will choose the outsourcing of IT services as a method of transferring IT assets off-balance sheet and reducing capital expenditure. Well-capitalised IT groups regarded as "trusted suppliers with a strong heritage in their industry sector" will come to the fore.
Groups well established in IT service sectors and with strong annuity-based revenues are likely to gain investor support at the expense of companies heavily dependent on product resale.
From an investor's perspective, high service levels impart the added comfort of earnings stability, through strong and consistent annuity revenue flows and relatively low working capital demands on balance sheets.
But, though most IT groups emphasise their service or "value added" operations, in reality, companies that concentrate on services make up a relatively small group. AST, CS Holdings, Compu-Clearing, Datacentrix, Faritec, EOH, MGX, Paracon and Glotec stand out from the crowd.
An average operating margin of 13% from these groups reflects their high-margin service operations; Compu-Clearing is top with 24%.
By contrast, the operating margins of four big distribution orientated groups, Didata, Datatec, Rectron and MB Technologies, average about 5%. Rectron's is highest at 8,5% and Datatec's lowest at 3,6%. Datatec's margin reflects the dominance of product sales and the competitive US market in which most sales are generated.
Didata achieved a 7,4% margin in financial 2001. But this was boosted by the relatively high service orientation of its African operations, which produced 18% of total group turnover of US2,46bn and 34% of operating profit.
Excluding the 14% operating margin delivered by African operations, Didata's other global operations produced a lower 5,9% margin, indicative that not much of revenue comes from services.
Vulnerability as a group that mostly sells products was exposed in Didata's interim results to March 2002. Total group operating profit plunged 67% on 10% decline in turnover, slashing the group's average operating margin to 3,7%.
Cash flow reflected as a glaringly high product component of turnover, as did low margins. Tighter payment conditions imposed by key product suppliers such as Cisco resulted in an operating cash outflow of $74,6m.
Management speaks boldly of Didata's "transition to a services and solutions-led model gaining traction". But annuity revenues equal to 24% of turnover show there is a long way to go before it achieves its objectives.
The reason for Didata's scramble to become more service-orientated is probably best summed up by IBM chairman Louis V Gerstner.
In an address to shareholders in 2001, Gerstner said: "Sure, you can sell just databases in this industry or just servers or consulting. But more and more customers want to partner someone who understands it all and who can deliver it all. That's why you see so many of our niche competitors trying to be solutions companies."
But changing the focus of any company is never easy.
Didata faces stiff competition in the service arena from companies such as IBM and EDS, global giants it will be challenging on their own turf.
The challenge is highlighted by a recent survey of US and European chief information officers (CIOs) by Merrill Lynch.
CIOs considered that under Gerstner's leadership and under current CEO Samuel J Palmisano, IBM had "turned its size into an advantage" by emphasising service solutions. IBM's greatest strengths were seen as breadth of products and services and its total solutions abilities.
More significantly, 85% of the CIOs surveyed were increasing or maintaining IBM's share of their IT spending and 51% expected IBM to gain market share.
For Datatec, the challenge of increasing its service profile appears even greater than that facing Didata. Turnover is dominated by US Westcon, mainly a "channel provider", or distributor, of networking and Internet access products. This is shown by Westcon's 4,9% operating margin in financial 2001.
Datatec's second-largest subsidiary, Logical, is focused on provision of services and IT network integration. But so far its results have failed to impress, with operating margins ranging from a best 6,9% in financial 2000 all the way down to 1% in the six months to September 2001.
Even with potential for far higher margins from Logical, the impact on Datatec's earnings is likely to be limited as Logical's turnover represents only about 18% of Datatec's total. The real carrot held out to shareholders is still the value-unlocking gains of a promised Nasdaq listing of Westcon. Unfortunately that promise dates back to November 1999, when Datatec was trading at R75/share.
Comparex is another home-grown group that's yet to prove itself fully in the international arena. Its most recent results (interims to November 2001) reflected a 66% higher operating profit of R249m, but this was primarily thanks to lower depreciation and a R216m foreign-exchange translation gain. Excluding only the latter, operating profits were R33m, 72% down on 2000's R118m interim level.
Comparex is transforming its European operations from a mainframe and networking focus into a data storage and electronic business infrastructure service provider. A wise move, given the trends in the networking sector, but not without risk.
The company has built and trained a formidable technical and sales force in Europe, so the slump in demand could hardly have come at a worse time. Management warns that Comparex Europe is unlikely to be profitable in financial 2002.
Comparex does have a strong balance sheet. But investors may demand that management does more with its R3bn cash pile than buy back shares, which, so far, has absorbed R950m.
For many IT service groups, staying in the market they know best - SA and neighbouring regions - has proved a wise strategy. The trend towards the outsourcing of IT services in SA is accelerating, says CS Holdings CEO Anette van der Laan. In particular there is a growing awareness among big corporates of the financial and technological advantages of outsourcing services to groups such as CSH.
Van der Laan says "higher levels of activity in the IT market are clearly evident" and 12 years of growing CSH's capabilities in the service sector are now beginning to pay off handsomely.
Confirming her optimism, research group BMI-TechKnowledge forecasts sustainable growth of 18%/year in the IT services market, which is worth about R18bn/year now.
AST's service and outsourcing focus, too, has produced impressive growth. Now one of SA's three largest IT groups in terms of physical infrastructure, it has almost trebled turnover from R700m in the year to June 1999 to an annualised R2bn at December 2001's interim stage.
Yet AST's rating remains lacklustre. It may be that the market feels AST is too dependent on one client, Iscor. This was true in 1998 when Iscor contributed more than 70% of turnover. But that contribution had fallen to under 20% in financial 2001 and will continue to fall in 2002.
An overhang of 28% of AST shares held by Kumba probably depresses the rating further. But the Australian factor could be even more significant, and not helped by the abandonment of plans to acquire the Australian Red Rock group. Management says existing Australian operations "are generating positive free cash flows". But SA investors are wary of the pitfalls down under, so greater clarity could help AST's market rating.
Another group with Australian exposure, EOH, is approaching that continent with circumspection. The small operation, run by expatriate South Africans, is profitable, but CEO Asher Bohbot says "no money is going that way". As for other First-World markets, Bohbot asks: "Why go there and get hammered?"
Instead, EOH is doing well in its primary offshore venture in Mauritius, in partnership with the island's largest corporation. Integrating systems of about 70 group companies will provide EOH with years of work, says Bohbot. It will also give EOH a base to expand into other Indian Ocean markets.
Looking to expand its SA market aggressively is MGX, which is finally emerging from the task of integrating Computer Configuration Holdings (CCH), acquired for R140m in March 2001. CCH and other, lesser acquisitions have boosted MGX's turnover by 300% and total assets by 250% over the past two years. The result, so far, has been a 21% increase in EPS in that time.
CCH has given MGX a far broader operational scope, says CEO Chris Hills. In particular, prior to the CCH acquisition, MGX's core data storage operations "were in narrow areas". It has added the Sun range of server and data storage systems to MGX's offerings and enabled MGX to become SA's largest business continuity service provider.
Stronger EPS growth looks likely. MGX has a high 59% service revenue content with, says Hills, recurring revenues of 42% of turnover. And, with no acquisitions ahead, cash flow of about R100m/year should soon reduce interest-bearing debt of R316m that came from acquiring CCH.
Faritec, similarly positioned in the server and data storage market, is another share to watch closely. The main difference between it and MGX, beyond size, is the dominance of IBM products in Faritec's line-up. "IBM is winning the technology race," says CEO Simon Tomlinson.
Judging from Merrill Lynch's CIO survey, Tomlinson is spot-on. "Will you buy Sun storage?" was one question asked. The replies were a 26% "yes" and a resounding 74% "no".
Another group that should gain from its strong ties with IBM in the data storage arena is Datacentrix, which has the added advantage of a strong black economic empowerment (BEE) profile through a 49% interest held by New CNI. But Datacentrix does not rely on its BEE credentials to gain business, says executive chairman Gary Morolo. Consistent results have come from a proven ability to deliver "on projects of any size". Adding weight to the drive to provide what Morolo terms the "IT must-haves rather than the nice-to-haves" is the recent addition of Microsoft-based integration to Datacentrix's service line-up.
Where do software developers fit into this new order? For the short term, Gartner's view is that many businesses will focus on "wringing out value" from existing software. More fundamentally, Leonard says, technology advances are rapidly pushing software towards becoming commoditised.
This does not mean that developers of unique or state-of-the-art software products will not be highly profitable. And, no doubt, in a sustained global recovery the profits of many top software developers will rebound. This was reflected in DataMirror's hostile bid to acquire Idion.
But, from an investment perspective, companies with strong proprietary software and service components will probably remain the safest bet. In SA, Aplitec is a prime example.
Aplitec has developed smart-card software especially for the Third World and applied this through service operations. The results are the long-term investor's best friends: formidable barriers to entry, high profitability and strong cash flow from recurring revenues.
SA's software developers with more global objectives have not fared as well. Prism was left scrambling for fresh capital and Softline's rating reeled from the debacle of SVI, whose "ring-fencing" has yet to convince the market that the problem is resolved.
Ixchange, which changed its name to FrontRange, has yet to produce a profit. But its CRM software is winning awards and could well be setting the group up to become the next target of a acquisitive bid.
Having experienced devastating losses, investors are likely to be wary of the IT sector for some time. But there is value to be had, particularly in the smaller-cap shares that are languishing at low p:es. Poor ratings are not a reflection of smaller IT companies' ability to survive and thrive. They are, rather, a result of a current institutional preoccupation with a handful of big-cap shares.