Company: SMS Management and Technology (SMX)
Share price: $4.04
Future value: $5.29
Potential upside: 36.6%
Outstanding value-investing opportunities have been thin on the ground lately as the stock market has rallied and prices have risen.
However, as is often the case, broad sell-offs in a particular sector can result in the “baby being thrown out with the bathwater”.
One prime example today is the technology sector, which is experiencing an ongoing cyclical slowdown as companies defer IT expenditure, preferring to sit on their cash rather than invest in IT upgrading.
As a result, shares in IT management firms have slumped, but this has left gems like SMS Management and Technology (SMX) looking like bargains. SMX has seen its share price fall by 25 per cent in recent months despite having solid financials and, in my opinion, excellent prospects. At current levels the stock tops our list of value investing opportunities and we are buyers.
SMX is a broad-based management services company specialising in IT, with operations in Australia, Hong Kong, Singapore and Vietnam. It has clients across a diverse variety of sectors, reducing its risk to any one part of the economy, and currently services 85% of the ASX200 companies. It has a strong balance sheet, strong cash flows, and offers an attractive grossed-up dividend yield of 7%.
SMX is unusual in that it relatively little debt at around $12.5 million and $37 million of cash. It is using this strength to bolster its business proposition by acquiring excellent add-on companies to complement its existing skill set while prices in the sector are depressed. This is a very smart move.
Several months ago SMX announced the acquisition of Indicium, a cloud and infrastructure service specialist, for $22 million.
At the time we identified Indicium as an astute acquisition that will increase SMX’s exposure to different high growth service lines and broaden their client base. There is minimum overlay of clients, with the opportunity for synergies and cross-sell of products to the existing and acquired customer base. Close to 60% of Indicium’s earnings are recurring, and will contribute a significant boost in stable, long term, annuity earnings in FY14, an important contribution if soft business conditions continue.
Then in September SMX announced the acquisition of Birchman Asia Pacific, an IT solutions provider based in Perth for $25 million, with 50% of this paid for upfront by debt, leaving a large cash balance to focus on further acquisitions.
Birchman will add around $32 million in revenues to the group, as well as adding a broad range of clients across government, resources and enterprise sectors. Again, much of the revenue from Birchman is recurring so provides certainty of cashflow in an uncertain market.
With significant cash reserves still remaining, we believe there is a material chance of SMX executing another acquisition over the coming 6 to 12 months to capitalise on the weak market conditions. We expect further acquisitions to be small, incremental and opportunistic purchases, which will look to add a new capability to broaden its existing offer as well as an additional earnings stream. If this is again mainly cash funded, it equates to even further EPS accretion.
Although companies have delayed IT spending for some time, they cannot defer it forever because lack of IT investment is ultimately detrimental to business performance. SMX is positioned for a potentially more potent earnings recovery in FY2015 if the sector emerges from its cyclical low as business confidence incrementally improves.
In summary, SMX is continuing its run of intelligent management and investing. It has achieved a return on equity (a measure of its financial management) averaging 40% over the past five years. Our future value of $4.95 is based on SMX achieving an ROE of 13.5% over the next year – easily within its reach in our view. We regard the stock as a solid addition to a broad-based portfolio so we are acquiring right now.
++Fair or forecast value is the price placed on the share after calculating a range of factors including profitability, assets, debt and, most importantly, Return on Equity – the same measure used by Warren Buffett to assess long-term value.
Shares are assessed by Clime Asset Management to calculate which companies are undervalued or over-valued based on their return on equity. History has shown that the most successful companies are those that produce the highest returns per dollar of shareholders' equity, yet this is not typically how shares are valued. This system highlights shares that are undervalued on this key measure. Shares are expected to reach this value in 3-5 years, as price tends to follow value in time.
Information is intended as a guide only. For specific advice contact your financial services professional.