STW losing the message

The market can’t decide what kind of stock STW Communications (SGN) is, and this confusion has made for a volatile ride for shareholders with the stock suffering its worst two-day dive in over five years following the release of its disappointing result.

Anyone who thought Australia’s largest advertising and marketing group was a play on growth would be rushing for the exits after management told investors not to expect organic growth for the current calendar year (STW’s financial year ends in December).

This sent the stock tumbling more than 12% to around $1.26, with STW continuing to struggle to regain composure.

The outlook was a clear disappointment and it seems management had been over-selling the earnings growth story earlier this year. Clearly, marketing is the lifeblood of the group and the stock is being rightfully caned for under-delivering.

I was not expecting much earnings growth and had only pencilled in a 5% increase in operating revenue, but management couldn’t even meet that goal.

The end result may not sound like much of a disaster, but STW will likely spend some time in the “sin bin” for management’s transgression, and I have cut my price target on the stock to $1.50 from $1.70 a share. Factoring in the weaker top line figures would see my price target drop to $1.50 from $1.70.

Dividends are safe and the yield is likely to reach around 10% once franking credits are included, but I don’t think that’s enough to win back investors – not in the nearer term anyway. The truth is STW will likely spend some time in the “sin bin” for management’s transgression, and I have decided to cease coverage on the stock – at least until I can see stronger earnings per share growth coming through.

While dividends are important, Eureka Report’s primary motivation for looking at smaller companies is to pick out those that can deliver robust earnings growth over the next few years.

STW has a strong market position but limited growth options. Its aggressive expansion into the shopper marketing industry through the recent acquisition of Active Display Group (ADG) is likely to help lift total revenue by around 11% to $459.6 million for the year ending December 31 2014, but earnings per share is only forecast to increase 4.6%.

The problem is that margins in the shopper marketing segment (the in store promotions you see at the supermarket) is only around half that of STW’s traditional businesses even though the industry is tipped to keep growing at a double-digit pace.

Meanwhile, the jury is still out on STW’s expansion into Asia, which is also driven by buying existing advertising and marketing agencies. The issue is the lack of synergies between the different parts of the group.

The biggest risk, in my opinion, is not earnings growth, but management becoming even more desperate to “buy growth” using the group’s healthy balance sheet. This fear may stem from worries of a takeover should the stock fall much further.

UK-listed WPP owns about 20% of STW and Bloomberg data states it has over £2 billion ($3.9 billion) in cash. Buying STW could well be earnings accretive given that the Australian company is trading at around a 25% discount to WPP on an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) basis.

Until we get more clarity on STW’s growth potential, it will be better to focus on other higher growth options at the junior end of the market.

I would have preferred to suspend coverage on a higher note, but the stock is only a little below where I initiated formal coverage on June 4. The stock was trading at $1.335 back then before running up to $1.50. The stock is last trading at $1.29 a share.