Is SMS Management a value trap?

Last week we wrote about 'value traps' – declining businesses that always look cheap but are never quite cheap enough. One that can be added to the list is DWS, which we got sucked into a year ago in IT Services under a cloud on 16 May 14 (Buy – $1.12), thanks to its price-earnings ratio of about 10. Thankfully we baled in February following this year's interim result (see DWS: Interim result 2015 on 18 Feb 15 (Sell – $1.09)). The chief executive has since left, earnings are expected to fall 20% this year, and with the stock down 28% since, that PER is still 10.

Such is the way with value traps, and it begs the question of whether the same fate might befall SMS Management & Technology, the other stock we recommended buying in IT Services under a cloud. Coincidentally (we hope) SMS has also lost a chief executive, with long-standing boss Tom Stianos departing in February. The difference here is that Stianos's departure was flagged back in August, and he therefore had a planned replacement, Jacqueline Korhonen, an IBM veteran of 23 years whose latest role was a six-year stint as boss of Infosys in Australia and New Zealand.

The other major difference is that far from falling 20% this year, the consensus is for SMS's earnings to rise by around 28% to 25 cents. The 11% fall in the share price since SMS Management: Interim result 2015 (Hold – $3.70) suggests investors may be beginning to doubt those forecasts, but so far we've heard nothing from management. Indeed the company has even been buying back shares, which suggests that trading can't be going too badly.

In broad terms, the Australian IT sector has been suffering due to a couple of major factors. First, the global giants have made themselves cheaper by doing more of their work in low-cost locations like India. Second, online computing services (aka cloud technology) have made systems more flexible, reducing the cost of upgrades and improvements.

Smaller pot

This has reduced the size of the pot for local IT consultants, but it has also meant a shift away from root-and-branch consulting projects and towards ongoing managed services work. The latter promises recurring revenues, although it tends to be at much lower margin.

Importantly for SMS, it has been shifting towards this type of work for a while. Before 1999, 90% of its revenue came from design work, but this was down to 36% by 2014 and is expected to fall to 31% in 2015, almost hitting management's medium-term target of 30%. Managed services have come from just 2% in 2013 to an expected 25% in 2015, with a target of 35%.

The move has involved the shifting of personnel, as well as some niche acquisitions. Indicium, a cloud-based managed services provider purchased in 2013, is performing particularly well.

So it's easy to see why SMS might be bearing up better than more project-based consultants like DWS, but the size of the gap is nevertheless surprising and slightly alarming.

Broken investment case

Our original investment case for these two stocks – of a cyclical recovery in overall work, particularly following the federal election – hasn't worked out, but SMS seems to have saved our blushes with its shift to managed services. However, profitable growth will be harder to come by in future, so this is not a sector we're keen to be in over the long term. That said, SMS's PER of 13 for 2015 looks attractive given its apparent performance and cash generation.

Generally speaking, it's dangerous to hope for a higher price to exit a stock that's not working out as hoped – indeed this is the common fare of value traps – but that's where we find ourselves with SMS. We're cutting our price guide to Buy below $2.70 and Sell above $4 (from $3.50 and $5 respectively), but in the unlikely event that you're overflowing with other investment ideas right now, then it might make sense to take your money and put it to those better uses. HOLD.

Disclosure: The author owns shares in SMS Management & Technology and is hoping for a higher price to exit the stock.