Stockwatch: A cheap share with 6% yield

FTSE small-cap marketing services group St Ives continues to enjoy support from brokers, but is it poised for further re-rating?

On 10 January, Peel Hunt reiterated its 'buy' recommendation with a 175p target that suggests 35% upside from its current 130p level, backed by a yield of over 6%. Other fair value targets include N+1 Singer's 182p and company broker Numis's 190p, representing 40% and 46% upside respectively.

Like so many cyclicals, the stock soared over 2013-14 from 105p to 225p, as quantitative easing prompted investors up the risk curve, but things soon turned volatile.

In particular, the price slumped from 247p to 71p last year after an April warning that profit in the 2016 financial year would be materially below expectations and that weak trading would impact 2017.

All three of the group divisions were affected: strategic marketing was hurt by shrinking client budgets in the face of global economic uncertainty, ongoing pressures within UK grocery had weighed on operations in marketing activation, and industry de-stocking had hit the book printing business.

Like-for-like revenue from strategic marketing actually jumped 11% in the yearHighlighting poor revenue visibility, by August the board had already backtracked with an update saying that the issues in strategic marketing (39% of group revenue and 58% of operating profit) had been short-term.

Despite cancellation and deferral of a number of projects during the fourth quarter, like-for-like revenue from the division had actually jumped 11% in the year - by 30% including acquisitions.

Still, the marketing activation business (42% of revenue) remained challenged, with revenue down 7% at the October prelims, although books (19% of revenue) had risen 3%. The stock rebounded to about 140p, before profit-taking clipped it back to 124p.

Brexit

Well-positioned with about half its revenues deriving from digital, the crux is how resilient the strategic marketing side proves.

St Ives presents itself as an international marketing services group, with operational reviews citing business in Dubai, New York, Singapore and Shanghai. But it derives 85% of its revenue from UK-located customers, with US business representing 10%.

A pre-referendum warning highlights the question of Brexit's effect on near-term client budgetsBetween the narrative and the figures, it's hard to judge the extent to which St Ives is geared to international markets. This is significant if domestic consumer spending becomes constrained by inflation, debt and hard Brexit.

Last April's warning in the run-up to the EU referendum also begs the question of what effect a hard/clean Brexit would have on near-term client budgets.

So there's a lack of clarity over the true source of revenues, and also a currency factor where other listed firms benefit from translating overseas revenues into weaker sterling. A 6%-plus yield partly reflects such uncertainty.

Profit to jump twofold

Beware the historic figures as they appear in the table; they take a more austere view of normalised profit than the City does.

A normalised pre-tax profit rebound from £10.7 million to £32.1 million looks improbable, but St Ives actually reported £30.4 million adjusted pre-tax profit for its year to end-July 2016, down 8% on £33.0 million.

This is explained by the £9.3 million amortisation of acquired intangibles, £12.7 million goodwill impairment and £8.2 million contingent consideration treated as remuneration.

A yield of over 6% implies the price will grind higher if the next update reassuresSome investors won't like a big gap between statutory and normalised profit. Integration/remuneration costs can get side-lined this way, but the sense is for modest earnings progress.

Last year's operational cash flow fell from £35.5 million to £23.7 million, mainly due to higher working capital from growth in strategic marketing; but the table shows that, amid modest capital spending needs, there was enough cash to grow the dividend.

The latest outlook said the new financial year's trading had started in line with expectations and "we have the necessary cashflow capabilities both to support our dividends and to reduce debt".

A circa 127p share price continues to reflect fear that St Ives might caution again, but a yield of over 6%, more than twice covered by normalised earnings, implies the price will grind higher if the next update reassures.

Stretched balance sheet enhances volatility

The chief executive describes the balance sheet as "sound", though it's hardly what investors want to see. At end-July 2016 it had £96 million long-term debt, £21 million pension obligations and £14 million cash - in context of £200 million intangibles, thereby a £55 million deficit on a net tangible assets basis.

Group finances don't appear strong enough to maintain the dividend through a recessionSuch a profile accentuates equity downside if a recession beckons. The income statement shows £2.9 million of interest costs against £33.3 million of operating profit. A near £1.0 million pension finance charge shows that finance costs are covered 8.5 times.

St Ives' balance sheet isn't excessively risky but it helps explain why the stock dropped so far last year; group finances don't appear strong enough to maintain the dividend through a recession.

Watch out!

Some extent of company guidance looks involved in broker forecasts considering projections vary little within the outlook to 2018.

On 1 December Peel Hunt published a pre-tax profit forecast of £32.3 million for 2016, giving earnings per share of 17.8p. In 2018 this is set to rise to £33.7 million and 18.3p respectively. Two other brokers published similar projections last October, although N+1 Singer downgraded its target from 227p to 182p.

Numis is the company broker and has the highest target of 190p from last October. According to Company REFS it published a note on 10 January which remains embargoed as yet.

If the profit forecasts are realistic then the stock should indeed be trading higher; it all depends on the tenor of updates - so watch out in the next fortnight!

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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.