Why Data#3 is a tech company to watch

Data#3 (ASX:DTL) Key statistics: Closing share price 03-8-16: $1.295 52-week high: $1.310 52-week low: $0.900 Most recent dividend: 2.5c Annual dividend yield: 5.34% Franking: 100%

Data#3 is a small company with a market capitalisation of $192 million.

It is a technology solutions company, providing consulting services and software for business customers. A growing component of its business is providing cloud-based services.

Jargon aside, this means helping customers move from using servers and storage that they manage internally to using servers and storage managed by Microsoft. Microsoft is one of the top three global providers of cloud services, and Data#3 is Australia's leading Microsoft services provider. It has been in business since 1977.

The company's performance over the past 10 years has been a mixed bag.

It grew earnings per share (EPS) from 2003 to 2011 but then went into decline for the three years to 2014. It rebounded in 2015 and appears to be on track to report good earnings growth for 2016.

The half-year results to December delivered EPS growth of 19% and an announcement on July 25 said it expected 25% earnings growth for the full year. Recently it secured some significant long-term contracts with Brisbane Airport Corporation and Edith Cowan University.

As the business relies more on human knowhow than on capital equipment, the amount of investment required is quite low. There is only $35 million in equity and no debt.

This helps it achieve high rates of return on equity, currently about 37%. It is also spinning off a good amount of cash, with operating cash flow well in excess of net profits.

The challenge for Data#3 is its thin margins. The net profit margin (net profit divided by total revenue) has been around 1.5% in recent years. This means there is little margin for error. It takes only a small decrease in revenue or increase in costs for there to be a material impact on the bottom line.

Over the past 10 years the intrinsic value of the business has risen 6.8% a year but certainly not in a straight line.

As with earnings, it peaked in 2011 and retracted through 2014. Over the past 12 months the share price of Data#3 has increased by about 32%.

It is now trading a bit higher than our estimate of intrinsic value. However, if it is able to maintain strong growth, paying a bit extra may be justified. Just be mindful of the risks with a small business on tight margins.

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