Customer Churn Woes Lead to Iomart Profit Warning

Iomart Profit Warning: Shares in cloud services provider Iomart (LON:IOM) dumped 15% in early trade today after the company revealed that profits would be lower than expectations. This period in the markets has seen some negative action with a rotation into energy and value stocks. We also had two milder profit warnings: both Parsley Box (LON:PBOX) and Boohoo (LON:BOO) put out warnings due to the logistical issues that many companies are currently facing.

In the case of Iomart however, the decline has been prolonged and still ongoing. Here is the 5-year chart, which must be pretty painful for long-term holders:

The Iomart share price has basically been on the slide for over a year now. It is also now below the levels seen in the initial crash after the pandemic struck. Many companies – even tech ones – have posted massive gains in this period, so this is quite a surprise to see. A more detailed look is warranted.

Iomart are quite an interesting business. Whilst the name may not be that familiar now, the company offered the first consumer broadband connections in the UK (under the name madasafish). Setting up this new venture were former executives from Scottish Telecom. However, the telecoms business was exited and for over 15 years the company has provided web hosting and cloud services, most notably under the Easyspace brand. Over the years the company has been heavily acquisitive, making many bolt-on acquisitions to broaden their suite of products.

What did the Iomart profit warning say?

This comes in a trading update today. This explanation is short and sweet:

While the majority of the customer base has remained stable (with recurring revenues in the period accounting for 93% of revenue), the slightly higher than usual customer churn seen in the final months of FY21 continued into the first half of this current financial year. In addition, non-recurring revenue, principally hardware reselling and one-off consultancy activity was £2.0m lower than the equivalent period last year and we do not expect this revenue to be recovered during H2. As a consequence, the Board anticipates results for the full year to 31 March 2022 being below current expectations.

One of the drivers of this churn may be the repositioning to being a ‘hybrid’ cloud services provider. Clearly times have moved on since the introduction of this.

We have it quantified in terms of profits:

For the six months to 30 September 2021, the Group expects to report revenue of approximately £52.0 million (H1 FY21: £56.3 million), adjusted EBITDA(1)of approximately £19.5 million (H1 FY21: £20.8 million) and adjusted profit before tax(2)of approximately £9.0 million (H1 FY21: £9.8 million).  

Revenue on Stockopedia implies £115m for this year, so this is a modest miss. A research note this morning cuts the forecast by 10% for revenue and 11% for EBITDA; thus the share price movement appears pretty much in line with this.

Iomart: The Business

The software as a service (SAAS) is littered with companies that promise a lot, but don’t deliver. Or have suddenly have a spurt of growth but run out of cash. Loopup (LON:LOOP) is one example that comes to mind, having to raise cash at a heavy discount to keep the show on the road. Another commonality is that many of these new technologies face extreme competition from goliath competitors. For instance Amazon started out as a bookseller, but quickly moved into the cloud services space and dominates. The pandemic brought around an acceleration of implementing new ways of contacting and collaborating, but arguably this battlefield could be entered by any of the tech giants (Google, Facebook, Apple, Amazon).

However, Iomart is not really a story of jam tomorrow. This has been consistently profitable:

And also had been paying out a progressive dividend, at least it was until 2020. The last dividend for 2021 totals 7.1p, so a reasonable yield given the current share price. The company generates solid cashflow – most of its billings are recurring, meaning customers continually pay up and often well in advance. Capex costs have been around 40-50% of operating cash flows which means that these dividends have been easily covered.

Another thing is that the company has been very acquisitive. These are mainly customers in the cloud space, which bolsters their target market. Shareholders have not been diluted for this, at least recently. These have been paid for with debt, and quite a bit of it. Net debt has climbed steadily from £17.5m in 2018 to £54.6m in 2021. As a result, there is a heavy amount of goodwill on the balance sheet, which is in excess of the amount of PPE. As of the last statement this is not being depreciated. However, acquired customer relationships are depreciated and this cost flatters the adjusted earnings. This is relevant as this is the metric the warning references, and also makes up the bonus target for executives.

Depreciation and amortisation charges are also very heavy – the largest item is computer equipment. Arguably this makes the EBITDA less meaningful to use as technology may end up expiring relatively quickly, meaning it needs to be replaced. However, as we can see from the net profit figures above this still means that the business is returning real profits.

Also worth noting that the long-term founder Angus MacSween has stepped down from his role as CEO, although he still sits on the board as non-executive director for a temporary period to oversee the changeover.

Is the Iomart profit warning a buying opportunity?

One curious aspect is that Iomart have gotten cheaper and cheaper without really seeing a bounce in their share price. One of the bearish points here is that revenues appear to be not growing, despite the constant stream of acquisitions. This has also affected the returns margins. All of operating margin, ROA, ROCE, ROE have taken a shallow decline over the years as the level of returns has not matched the increase in revenues.

It is difficult to see the effect of the acquisitions as reporting is done all under the Easyspace segment. However, as referenced to in the warning today customer churn is an issue; in this space I can imagine it being quite competitive. This being said, I don’t know it that well.

In terms of valuation, with a market cap of £200m after todays warning, this could look pretty cheap if you are still inclined to believe that this is just a blip. The research report today references a target price of 325p (although these are almost always bullish). The bull points are more pertinent here: the company has cash and could still make further acquisitions. Debt has gone up but the interest payments are pretty manageable and cashflow is strong, so no real fears of solvency. Perhaps the biggest draw is that Iomart might simply become an acquisition target for someone bigger; that could become more likely as the share price declines.

So all in all I think the case is quite balanced, and not enough to offer any strong opinion. 3/5.

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