Market research agency System1 Group (LON:SYS1) posted a profit warning today as revenues from smaller clients failed to materialise. The share price was down by around a quarter at time of writing:
The longer term trends for this share are quite striking. Firstly, the share price actually went up by 25% in the last week, so today’s profit warning actually just pushes us down to where we were before. In the bigger picture the share would either have been very successful for investors, or a big disappointment. The company posted one great year in 2017, sending the stock over 1000p. Since then that momentum has not been maintained and it has been rather flat since then.
System1 are an interesting company, specialising in behavioural science in the field of advertising. Clearly this will be of interest to most large companies wanting to squeeze more from their advertising budget, and System1 have developed into a kind of boutique advertising agency as well as a consultancy of sorts, offering a much-vaunted ‘AdRatings’ system where advertisers can bring their ads for assessment.
What’s gone wrong at System1?
The bad news comes in a trading update. We get straight into it, and it looks like recent trading has been bad:
After H1 single-digit growth, followed by modest further progress in Q3, trading in Q4 to date has been disappointing, due in the main to the ongoing transition of sales talent, and subsequent disruption and decline in adhoc revenue from smaller clients. Given the limited visibility in some areas, it is difficult to predict the full year outturn, but the Board believes Gross Profit will be slightly down compared to the prior year.
‘Ongoing transition of sales talent’ is quite a nice term, which I would take to meaning being poached by competitors. The effect is kind of quantified, albeit not very accurately:
The lower than expected Gross Profit and increased costs are expected to result in a normalised 2019/20 Profit Before Tax (i.e. excluding Share Based Payments and AdRatings) materially below the current market expectation.
Some better news for shareholders:
The Company has £4.2m cash, and no debt, and in line with the Company’s approach to capital allocation, the Board intends to conduct a share buyback program of up to £1.5m of the Company’s shares, following its normal post year-end Trading Update in April, subject to the Company’s share price and cash balance at the time. This would be by way of market purchases.
This makes some sense, as the share price will be at a low for the near-term.
System1: Well regarded by Stockopedia
System1 rates well on the Stockopedia system, attaining a Stockrank of 89, amidst some very favourable metrics. It is not difficult to see why: the company has been consistently profitable, pays out dividends, and as it mentioned in the trading statement, carries no debt. On the balance sheet side, it is not an acquisitive company, and neither does it capitalise much of its expenses on average (although the charge for the last year was disproportionately large to the previous ones).
The company also seems to treat investors well: there has been no large dilutions (although in retrospect it may have been a mistake not to in 2017), and the CEO has plenty of skin in the game, owning over a quarter of shares.
These profit and loss figures go to demonstrate just what an anomalous year 2017 was for the company: a huge jump in profits at whopping margins, leading to mass investor excitement. But take this out, and the trend is that of a company that is barely growing at all, and pressures on profits increasing. Maybe this is endemic in the industry: M&C Saatchi warned on profits last year.
Talking of investors, there has been plenty of generous dividends paid including two large special dividends which returned over £4m of cash to holders following that bumper year. But since then the cash position has dwindled slightly, to the extent where a dividend cut might be favourable. One of the clear expenses here is the new AdRatings product (now rebranded as TestMyAd). This gobbled up £3m in development costs last year, and from the trading statement today, this spend seems likely to continue.
In the context of the company this is a very large project, but may deliver the attractive type of regular, recurring revenues, as opposed to the lumpy, uncertain ones that many firms in this industry face. But at least there is not heavy customer concentration here: System1’s largest customer contributes no more than 6% of revenues.
In terms of balance sheets, this is not a problem. System1 have very few intangibles (although this may build up with the development of the new product). Their net cash position is disclosed, and leaves a very healthy current ratio. Although the £1.5m earmarked for share buybacks certainly weakens this, and if dividends are upheld, this situation could turn quickly. Last year’s dividend cost the company almost £1m.
Are System1 shares good value?
One of the worrying things I can make out is that momentum is going backwards here. Losing sales staff may be indicative of further problems not disclosed, and certainly there is plenty of competition out there for them. Revenue declines from smaller customers may also continue into the future given recent world events having knock-on effects for everyone. So this System1 profit warning may be the the first of several.
The AdRatings product weighs down results massively here. This lost £2.2m in the previous year, which offset the £3.7m the rest of the business earned. If we are to assume that profits are down and expenses are up, this year may end up pretty close to breakeven.
So much will depend upon how this new business fares. If spending on development drops off sharply in future years, profits will increase, and if the new business gains traction, again profits will increase. But it does seem that there is some way to go before the new product is proven: the last annual report shows that AdRatings had £3,000 in revenue, and even in the interims this had only gone up to £21,000. Considering that over £3m+ has been sunk into it, the earnings curve from here would have to be steep. Unfortunately, there are no broker notes on Research Tree indicating what this might achieve.
It is worth pointing out that the underlying agency business is (or was) performing well, but the size of AdRatings spend means that much of the profits is being used here. So without taking an opinion on AdRatings it may be difficult to value the company as a whole. I think it’s interesting, but would be prepared to wait for more information before deciding either way. 3/5.