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SMS Management Struggles To Transform

Small Caps | May 05 2016


-Struggling with transformation
-Core business not reflected in price
-Potential takeover target

By Eva Brocklehurst

SMS Management & Technology ((SMX)) is struggling as it transforms into a managed services provider from a consultancy. The company announced another large downgrade to guidance, now expecting FY16 earnings to be in the range of $15.5-16.5m. At the mid point this is down 45% on the prior year.

The company has attributed the downgrade to a lack of contract wins for the consulting division in the second half, which attracts substantial costs, with margins reduced as a result of a fall in staff utilisation.

Morgans believes the company is in a difficult situation where its business is being re-positioned while it also defends its core. The broker suggests the transition is a long process and key staff are likely to have left, so it makes it challenging to ensure the core business remains intact.

This is underscored by the departure of the CEO, Jackie Korhonen, who has resigned after 14 months in the job, effective immediately. The board has appointed CFO Rick Rostolis as the new CEO and, given his history in professional services, Morgans believes this a positive development.

The board has also signalled it will continue with the on-market share buy-back, subject to prevailing market conditions. As the stock appears to be trading below book value, with minimal debt, Morgans considers this a low-risk strategy and should create more value rather than via acquisitions.

The market has changed over the past five years yet the core business has strong relationships which are of considerable value. Moreover, the underlying performance of the core consultancy is not being reflected in the short-term share price. This makes the company a potential takeover target, the broker contends, but if earnings can be stabilised then there is upside potential for the stock.

Morgans believes the key to the stock is how long it takes for earnings to re-base. The value appears compelling for long-term investors but given uncertainty and current conditions, this may take time to be realised. Given the poor operating performance, the broker expects the company may be hit by other one-off costs and reduces FY16 and FY17 forecasts by 32% and 17% respectively.

Macquarie observes the billable head count is down by 100 to 820 and drives a negative impact of $4-5m to the earnings numbers. Earnings visibility is low and given the transformation is in its early stages the broker is cautious about any rebound in the short term.

Despite the measures to diversify, the consulting business remains a large proportion of revenue. There are risks associated with operating such a high fixed cost business model in the current environment and Macquarie highlights the downside risk to earnings. The broker retains a Neutral rating given the potential for a takeover bid.

UBS incorporates the revised guidance into forecasts and its estimate of FY16 earnings at $15.5m sits at the bottom of the range. The broker assumes a more stable head count in FY17.

Earnings leverage to any improvement in utilisation is substantial, yet the broker's data checks suggest IT job vacancies have peaked and are starting to decline. This, combined with the potential uncertainty generated by the forthcoming federal election, should mean a more subdued operating environment in FY17, UBS contends.

There are three Hold ratings and one Sell on FNArena's database. The consensus target is $1.72, suggesting 9.0% upside to the last share price. This compares with $2.31 ahead of the downgrade. The dividend yield on FY16 and FY17 forecasts is 7.2% and 7.8% respectively.

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