Wednesday, 11 April 2012

VTI Profit Margins Underwhelm

In the Spring issue of the Veracap Technology Quarterly we took a closer look at technology sector profitability.  While valuations have improved substantially, many mid-market technology companies still struggle with profitability.
On average only 55% of the technology companies included in the Veracap Technology Index (the “VTI” includes all technology sector companies trading on the TSX and TSX-V with a market capitalization between $10 million and $500 million) were EBITDA positive and, of those companies, the average margin was 12.1%.  The subsector with the most profitable companies was the IT Consulting & Services sector and the sector generating the highest margins was the Internet Software & Services sector with an average EBITDA margin of 15.3%.   In looking for an explanation of these results we believe the answer lies in the average size of the companies.  The average market cap of the VTI is only $81 million.  Of the companies not generating a positive EBITDA, 84% had a market cap of less than $100 million.  Canadian technology companies go public at a relatively small size and need to grow larger to achieve scale and improve efficiency.
The most profitable companies in the VTI were Mediagrif Interactive Technologies with an EBITDA margin of 33.6%, Enghouse Systems with an EBITDA margin of 27.2% and C-Com Satellite Systems with an EBITDA margin of 23.9%.  While nowhere near world leaders like Google and Microsoft which have generated EBITDA margins in the 40% range for years, these are nevertheless our strongest performers in the quarter. 
So do high margins translate to the best valued companies in the VTI?  In general yes, the above noted companies are in the top quartile in terms of an EBITDA multiple but there are exceptions as well such as C-Com Satellite Systems which ranks 3rd in profitability but was valued at less than four times LTM EBITDA.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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