STW Comms

STW Communcations’ share price has shot past our ‘Sell’ price of $1.60 and we’re taking the opportunity to bank our gains. The result has been excellent, with a total return of 109% or, if you prefer, annualised total returns of 63% since upgrading in The mad men of STW from 08 Dec 11 (Long Term Buy – $0.85).

Although the share price has almost doubled some may wonder why we’re selling a business on a fully franked dividend yield of 5.1%.

It’s a fair question. The answer goes to the heart of what we do at Intelligent Investor Share Advisor.

We bought STW on the basis that the market was misjudging its earnings potential: where the market feared a collapse in earnings we saw the potential for growth.

Growth is exactly what we got. Over the past two years earnings per share increased 1 cent to a forecast 12.5 cents in 2013. The result would have been better still if the Asian expansion plans hadn’t increased debt or required a capital raising.

But as the meagre increase in earnings demonstrates the share price rise is result of Mr Market coming to his senses rather than stellar operational performance.

We’re selling now because STW is more fragile than many appreciate. Services businesses habitually appear fantastic right up until their earnings collapse. Just ask competitor Enero (formally Photon). Advertising spending is correlated to the economy, and with local economic growth slowing STW's earnings may stall. Overseas expansion may provide a cushion, but it's one with potential risks. Although expansion has been measured and successful so far even the best managers hit hiccups. And the market is now pricing in success.

STW’s capital management is also a concern.  Aggressive growth plans combined with the peculiar Australian habit of maintaining dividends at any cost have seen debt creep up from 20% debt to equity to 30% today. This may sound low but it's not. Service businesses produce ample free cash flow and have few, if any, tangible assets. They have little reason to carry any debt. We hoped STW learnt its lesson during the GFC – where excess debt forced a dilutive capital raising – but we have our doubts.

If we’re right and earnings growth slows, or a there’s a hiccup in the Asian expansion strategy we could get another chance to buy. For now, with the share price up 9% since 31 May 13 (Hold – $1.50), we’re banking our gains and recommend you SELL.

Note: We’re selling 4,000 shares from the model Income Portfolio for $1.64 each netting proceeds of $6,560.00.