Stockwatch: Underrated and a 5% yield

Which traders are casting the better verdict? Straight after prelims for FTSE Small-cap marketing services group Communisis, the chairman designate snapped up 100,000 shares at 49.9p, and Richard Griffiths, a Monaco-based investor and the group's largest shareholder, continues to raise his stake to over 21% as of 9 March.

It appears Griffiths, who owned only 13% a year ago, is picking up stock from Slater Investments who, I recall, was an enthusiastic holder but has sold down from about 5% in early February to below 3% where it need make no further disclosures.

Slater may not altogether be casting a verdict on the business, rather "top-down" caution towards the sector now that the business cycle is mature. Ad giant WPP has already warned that client spending in the US and UK is slowing, although the shift to digital marketing may help specialist firms to thrive.

Communisis manages customer communications – billing, statements, marketing campaigns and the like – in direct and digital aspects. Some big organisations are involved, e.g. Lloyds Bank, Centrica, Amazon and BP, with management proclaiming good medium-term visibility and an average contract of five years.

What looked a quality win and helped turn the stock up from last December's 35p low, was an initial three-year contract with HMRC (with a two-year extension) for all outbound customer communications. HMRC issues some 185 million letters annually yet has a "digital by default" agenda. The value of this contract hasn't been specified, but since the stock rebounded so strongly afterwards, with material buying from those well-connected, it could be considerable.

If Communisis can grow such business it ought to be less cyclical than marketing services in general. Also, its overseas turnover is up from 18% to 26% of group revenues, hence results should benefit from translation into weaker sterling. The US market is now being accessed via a New York office this June, initially to provide content-marketing services to Linked-In.

Chart suggests positive trend-reversal

The stock was in a three-year downtrend to end-2016 despite a decent set of prelims in March 2014 and an outlook statement at the time citing: "early indication that confidence is returning and budgets will generally increase to drive business growth."

On a normalised basis, profits/earnings have grown (see table) and revenue also, helped by acquisitions, but the stock's historic annual average price/earnings (PE) multiple halved from 14.4 times in 2014 to just over 7 in 2016/17. The long-term context was a strong rise in the QE years, e.g. from 40p to 68p in 2013, when investors piled into higher risk cyclicals, then a consolidation became a protracted fall.

I drew attention at 40p in January 2016 when it appeared risk was excessively priced in; the price then rallied to 49p after digesting the 2015 prelims in March, but it was downhill to 35p by mid-December. The HMRC contract then fuelled a rebound, reinforced by a positive 19 January update; a three-year contract with Sony Europe; strong free cash flow helping net debt down 23% to £30 million; and the pension deficit trimmed 3.5% to £55 million. It was nothing exciting, but reassurance enough to help the stock higher.

2016 results maintain "in line with expectations"

A chief reason why, at 53p, the stock is priced on a modest forward PE of 8.5 times and a material 5% yield despite strong earnings cover of 2.4 times, is an intangibles-heavy balance sheet due to acquisitions in a "people industry". It also means a contrast in profit measures according to depreciation and amortisation charges, which some investors simply dislike and can help explain why such a stock gets driven by sentiment changes.

The underlying story is robust, if graded: 2016 adjusted pre-tax profit up 15% to £16.7 million and adjusted earnings per share by 17% to 6.1p, though adjusted operating profit rose a modest 6% to £19.5 million, or 2% at constant currency. Revenue is only 2% ahead at £362 million or flat at constant currency.

The income statement shows the only real cost reduction was "other operating expenses", down 5.7% to £45.9 million, while "raw materials and consumables used" rose 5.4% to a lumpy £191.2 million – and one wonders about further rises as inflation takes hold.

So, management has taken out costs such as personnel, as implied by "a simplified group structure", although saying "important new contracts were won in 2016" may belie some lost given revenue is flat overall. The outlook statement is respectable if blasé, saying 2017 has started "in line with expectations". Altogether, it explains why the stock is supported after its recovery rally, if not advancing further as yet.

Balance sheet issues do not constitute a bargepole

There are £188 million intangible assets in context of £118 million net assets and it doesn't help that St Ives, another acquisitive small-cap in marketing services, has ended up writing down its goodwill by £40.9 million in the last year, if mainly on its "marketing activation" side which has suffered from tough times in grocery retail.

Also, the pension deficit has risen annually from £9.7 million in 2010 to £55.5 million in 2016. Notes to the latest accounts say "this is primarily due to a reduction in the latest year in UK corporate bond yields, resulting in a significant decrease in discount rates from 3.75% to 2.7%, together with higher inflation assumptions in the actuarial calculation..."

If the bond bubble (another effect of QE) is bursting, then yields should improve, time will tell. Meanwhile, and to deal with the deficit, last December £22.5 million distributable reserves were generated from various balance sheet reserves.

Longer–term debt is down 5.5% to £58.7 million while cash is up 17% to £38.3 million, and current liabilities are covered 1.2 times by current assets. So, altogether I wouldn't be swayed by critics who say this is a bargepole stock due to its balance sheet.

The stock's risk/reward profile looks well-balanced at the current share price, but its modest rating means further contract wins can drive upside into a 60-70p range. Possibly, Slater got jaundiced by the sluggish top line, while Griffiths is clearly more confident as Communisis is positioned to capture further sizable contracts.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.