Buying into the SMS recovery story

The IT consulting sector is currently experiencing a perfect storm as both the private and public sectors are reluctant to invest in IT solutions.

While many corporate customers have an ongoing need to invest in IT in order to maintain their competitive positions, current trading conditions remain challenging and business confidence is weak. As such, many are looking for lower-cost alternatives or deferring IT spending altogether in response. To make matters worse, the looming federal election is causing further project deferrals from the federal and state governments, who are historically large customers in the IT space. This demand squeeze is evident across the listed players such as Oakton Ltd (OKN), DWS Ltd (DWS) and SMS Management & Technology Ltd (SMX), who have all reported stagnant or declining revenue and subdued utilisation of their skilled employees.

In tough times when the number of idle employees increases, the fixed-cost nature of an IT business works against it, as revenue per head reduces while costs per head remain. This impacts the bottom line considerably, which intensifies the impact of the downturn. As an example, the combination of project deferrals and the negative effects of operating leverage will be evident in SMX’s FY2013 net profit after tax (NPAT), which is expected to be around $21 million, a 30% decrease on the previous year.

However, attractive prices for long-term investment are often found during cyclical slowdowns, as the market fixates on one-year earnings, extrapolates current year performance and forgets the long-term potential.

IT spending can be deferred; but it cannot be deferred forever. For example, if the National Australia Bank (ASX:NAB) resists investment, applications such as its online platforms will trail its peers in functionality and this will eventually be felt in market share and business performance. Historically, business confidence has been a key indicator for IT expenditure and, while it remains weak, there are key catalysts for improvement emerging.

Elections have historically been strong catalysts for improving confidence, as the majority of the population feels better after voting for a new leader. It also bodes well for increased certainty over government project work, as government departments have a clear mandate for the foreseeable future.

When corporates feel more confident in their outlook for sales, they are happy to invest in IT to strengthen their offering to customers and to increase back-office efficiencies. As demand increases so does utilisation of skilled labour and eventually margins, which provides a double benefit to the bottom line. It is at these times that operating leverage becomes a strong positive, as NPAT advances much faster than revenue. The third benefit is provided by the market that becomes happy to pay a higher multiple due to the now rosy outlook of increasing profits.

One can never be certain when business conditions will improve. In order to be successful with contrarian investing, it is imperative to invest in a business that has staying power and one that can provide adequate compensation in the interim while we wait for a cyclical improvement. It is for this reason that I am including SMX, the strongest player in the IT space, into the growth portfolio.

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Source: StocksInValue

Financial strength and solid yield

SMX is the largest listed player, with exposure to a diversified client list across industries. Indeed it counts 85% of the ASX 20 as customers. It is well represented throughout the financial, information communication and technology and transport sectors, which are expected to be firmer in the medium term. SMX also has a reasonable exposure to government-based contracts, and provides a mix of role-based and outcome-based work predominantly across SAP, Microsoft and Oracle solutions. Its target market is positioned between the niche providers, who lack the resources and capability to complete the medium-sized projects, and the large multinationals that target the $100 million - $500 million jobs. SMX has access to international low-cost labour through established offices in Singapore, Hong Kong and Vietnam.

Firstly, there are no question marks about the business’s financial strength, as the balance sheet has no debt and $29 million of cash. This robust financial position provides flexibility and optionality to capitalise on the downturn. IT businesses are also incredibly capital light and cash generation from operations is sound, which allows the business to self-fund its investments for growth and dividends to shareholders.

Secondly, SMX offers an 8.8% grossed-up yield assuming $0.27 of dividends are sustained. This is a sufficient return to receive in the interim while we wait for business conditions to improve. Future dividends are virtually certain to be fully franked given the $25 million of franking credits (as at June 30, 2012) sitting idle. The possibility of capital management such as buybacks being used to opportunistically grow business value is also increasing as the market price remains subdued. Management think and act like owners, and this stems from long-term tenures and high levels of insider ownership. The CEO Tom Stianos owns 2.6% of the business, and the chairman also owns a considerable portion, which aligns the interests of management to that of the minority shareholders.

SMX has the most corporate-focused management team relative to its peers, who operate more entrepreneurial-styled leadership. The results of the success of the management team is evident in the following two charts: SMX is able to consistently generate the greatest revenue per employee while also employing a minimal portion of assets per employee. These two factors combine to deliver market-leading normalised return on equity. As a people-based business, high levels of employee productivity is a positive sign of employee engagement as well as effective internal processes and systems.

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Source: Clime Asset Management

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Source: Clime Asset Management

SMS on a growth path

The risk to the investment thesis is that the business is not experiencing a cyclical slowdown and that the downturn is a structural shift or one that is unique to SMX. It appears that Australian corporates are currently more willing to outsource IT functions to lower-cost foreign destinations; a move which increases the execution risk of projects relative to a local trusted name. SMX is positioned higher on the food chain and is therefore less susceptible to price competition, relative to its peers OKN and DWS, who compete more directly in the commodity end. At this point in time there is nothing to suggest SMX has lost market share, as employee reductions and soft revenue have been evident across the smaller players and right through to the top, as we saw with IBM announcing job cuts last week.

With excess cash on the balance sheet and soft current conditions, management has been pursuing acquisitive means as a source of increasing business value. It is encouraging that management is targeting acquisitions in the weak point of the cycle, as too often we see business managers look to divest instead of invest at the bottom of the cycle.

The growth challenges of the listed players is likely to extend down to their private, smaller peers, which bodes well for attractive acquisition multiples. Given SMX’s already strong market position, I expect any acquisitions to be small, incremental and opportunistic purchases, which will look to add a new capability to broaden its existing offer as well as an additional earnings stream.

John Abernethy is the Chief investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Growth Portfolio Statistics

Return since June 30, 2012: 29.87%

Returns since Inception (April 19, 2012): 20.76%

Average Yield: 6.13%

Start Value: $111,580.24

Current Value: $144,908.75

Dividends accrued since December 31, 2012: $3,842.64