The Great Sharemarket Return: SMS's IT challenge

In a market that has run rampant for the best part of a year, seeking value can be akin to finding sewing equipment in a barn full of hay.

That’s why value seekers now are scouring the ranks of cyclical stocks; companies likely to benefit from any rebound in business confidence and the broader economy.

Cyclicals generally have lagged defensives and financials for most of the rally. A few have gone backwards.

One of those is SMS Management and Technology, a company that concentrates on management advice and the labour recruitment for the Information Technology sector.

For the analysts at Clime Asset Management, SMS has been a regular inclusion in its top tier category where very low returns are required to justify an investment.

This week it has moved up a notch into third place, behind BHP Billiton and Monadelphous Group, which retains the top spot as a value investment.

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(Source: MyClime)

In late October last year, SMS was trading around $6.50. But a trading update warning of a serious drop in revenue and earnings saw the price plummet as analysts clamoured over one another to downgrade the stock from its previously exalted position.

The impact was as astounding as it was immediate. SMS shares shed close to 25% in a single session and continued to labour under selling pressure until it plumbed a $4.50 nadir just prior to Christmas. Since then it has edged back towards $5.30.

Almost every major investment bank rates SMS as a hold, apart from BA Merrill Lynch, which has a buy recommendation.  While they generally agree SMS has an appealing list of blue-chip clients, the climate of cost control that has permeated the domestic business environment has resulted in the deferral of capital expenditure in the short to medium term.

So the pressure on revenue and earnings is likely to be maintained this year, which has kept a lid on the share price.

Clime analysts have forecast a Normalised Return on Equity of 33%, which is below its average of 40.7%.

At that kind of return, they value SMS at $5.79, well above its current trading price of $5.31. Hence its attractiveness as a value play. The value/price margin at the required return is a healthy 9%.

Its half-year results, released in the last week of February, were in line with previous trading updates and most broker forecasts.

Revenue fell 14.6% to $144.8 million and net profit dropped 15.1% to $12.9 million. Trawling through the accounts revealed that the weak revenue largely was the result of depressed spending from the company’s transport and IT clients because of subdued business confidence.

“As this appears to be industry wide, we regard this as a cyclical slowdown which is augmented by an election year,” Clime analysts note.

That subdued spending environment is likely to be maintained in the year ahead, creating possible margin pressure on the firm. For that reason, Clime has a caveat over the stock. While it represents value, and while it is in its top tier, it is exposed to the whims of the economy and the current environment could present some issues.

But its long-term attractiveness lies in that very same exposure. A recovery, particularly in the non-mining sectors of the economy, could propel earnings and its value.

“Looking forward, we anticipate a longer-term recovery in IT spend leveraged to improving business confidence and revenue growth across sectors,” Clime adds.

Credit Suisse analysts share this view. They also point out that on top of its blue-chip client base, SMS Management’s balance sheet is exceptionally strong.

This is a typical feature of Clime’s top tier picks. With no debt and $29.3 million of cash, it is well placed to ride out difficult times. Working capital increased slightly in the first-half to $62.7 million and cash from operations was sound at $13 million. If there is one gripe about the balance sheet, it is that intangibles of $62.3 million comprise about half of the equity.

UBS analysts, who also rate it a neutral, expect the company to continue trimming staff this year as SMS Management switches from growth to cost containment mode. While second-half revenue is expected to remain under pressure, they note that management expect a number of new contracts to be finalised within the next six months.

Macquarie analysts, while also rating it a neutral, were slightly more bearish. With limited apparent earnings growth over the short to medium term, they noted the stock continued to trade at a premium to the Small Industrials Index and as such, there was room for further falls.

The general consensus though, is that if you are after exposure to an improving economy, SMS could be the vehicle.

Figures are sourced courtesy of Clime Asset Management. http://www.clime.com.au/. To experience MyClime and the insights they can offer, click here www.clime.com.au/eureka.