Small Cap Value Report (18 Aug) - SYS1, MMC

Good morning!

The only RNS announcements which look reportable to me are SYS1 and Management Consulting (LON:MMC). But perhaps one or two others will crop up.

Cheers

Graham

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SYS1

• Share price: 637.5p (-23%)
• No. of shares: 12.4 million
• Market cap: £79 million

Trading Update

It's one of the worst days I've seen here in terms of share price value destruction, so bad luck to those holding it.

I've been watching this market research firm multi-bag over the last couple of years, and it has been a while since I thought it was good value (though I always considered it high-quality).

The problem is the lack of good earnings visibility: most money coming in the door has been to do with ad hoc projects. That implies forecasting results will be difficult, and  that should be compensated by a lower valuation (vs. companies which can get more of their customers signed up for long-term contracts).

As the CFO said in the final results statement in June:

..our business still remains predominantly Ad Hoc, with limited revenue visibility, and as always we need to acknowledge that we cannot predict with very much certainty how revenue growth will unfold over the coming financial year.  Trading during Q1 of our new financial year has been a little slower than we expected, but we remain confident of making further progress over the year as a whole.

Which brings us to today's update:

The slower than expected start to our financial year... has continued since then, and we now expect H1 Gross Profit (our main top line performance indicator) to be 6-11% lower than prior year.  This is mainly due to non-recurrence of large one-off Innovation projects as a result of some significant client spending deferrals and a more competitive market, although there have been some more encouraging signs recently.

The "more competitive market" is the most worrying element to this. I've been under the impression that System1 (AKA "Brainjuicer" in old money) has a completely fresh approach to Ad Testing/Brand Tracking, but this makes it sound like the competition is catching up perhaps.

In addition to lower gross profits in H1, costs are set to rise by 15% (or by 10% for the entire financial year), due to some new senior hires and some severance packages.

Updated guidance is thankfully made explicit, but it's a bit grim:

As of now, we anticipate a little over break-even in Profit Before Tax in H1 (prior year: £2.8m) and a decline in full year Profit Before Tax of approximately 10-15% from the £6.3m achieved last year.

My opinion

Given a £2.8 million reduction in H1, it sounds like a best-case scenario that the full-year result would only be a £0.9 million reduction (15% lower than £6.3 million).

Where does that leave the shares? Possibly still a bit overpriced, I think.

With a share like this, you need a margin for error for when things go wrong. And it's still very much a people business, as you can clearly see when new, senior hires are responsible for such a large percentage increase in costs.

At a 35% effective tax rate and assuming a 15% reduction in full-year PBT, net income should drop out at £3.5 million.

So ignoring the company's healthy cash position for a minute, the PE ratio on current-year earnings is c. 22x.

Especially considering the renewed threat of competition, I don't see how such a multiple can be justified.

One other thing which I've just noticed: System1 doesn't own www.system1.com, which is instead owned by a US firm of the same name (System1 is the name of a psychological concept created by Daniel Kahneman).

I wonder if it's possibly hurting them, since the name change, that they don't own the most relevant URL. Maybe it's causing some confusion for clients?

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Management Consulting (LON:MMC)

• Share price: 7.25p (-5%)
• No. of shares: 511.1 million
• Market cap: £37 million

Half year Report

This is a professional services group which provides advice to management teams under the Proudfoot brand.

Paul hasn't covered it since 2014, when he gave it a firm thumbs down at 20p per shares. Well done to him!

Having taken an initial look, it's not something I want to cover either.

It has produced steady losses for a few years now, resulting in it re-branding and "fundamentally changing its structure and operating model".

For a company which is all about helping other companies to undergo transformational change, how could it have gotten itself into such a mess in the first place? Couldn't it have hired its own consultants, at a discount, to tell it what to do?

It's now a much thinner operation focused on Industrials and Natural Resources industries. Staff numbers have significantly reduced, from 280 to 220.

The underlying operating loss for this period was £4.6 million.

And during the period, the cash balance reduced by £10 million to £28 million, of which £9 million is currently restricted (won't be restricted by the middle of next year)..

To me, that says it's not going to be in financial distress in the short-term. But the Going Concern paragraph strikes a tone of warning in relation to the longer-term:

The recent improvement in performance due to management actions is encouraging and the cost cutting measures implemented reduces cash utilisation. However, the outcome for the year as a whole for Proudfoot remains uncertain and will depend on sales made in the coming months. The Board has assessed the financial impact of potential downside financial scenarios, taking into account the principal risks to the business and recognises, as stated in the 2016 full year report, that should the Group underperform in the longer term, it will consider all options in the best interests of all stakeholders.

This sounds like an acknowledgement that Proudfoot might not return to profitability, despite their best efforts.

Which would result potentially in huge (non-cash) goodwill writedowns, affecting the shape of the balance sheet.

That balance sheet is a huge monument to opportunity cost: £60 million in notional assets are tied up here. Though I note that the balance sheet was as big as £400 million earlier this decade!

All in all, it seems like the sort of business which should be privately owned, not listed on the stock market.

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Ok, that's all I've got for this week.

Thanks for reading and see you next time!

Graham