stw communications review

Market mauls STW
The risks have increased at this company, although
management’s tone is at odds with the market’s
pessimism.
STW COMMUNICATIONS GROUP (SGN) $0.67
29 Oct 2008
SECOND LINE INDUSTRIAL
$141m
$0.59–$2.59
3.5 3.5
BUY
INFORMATION CORRECT AT
STOCK CATEGORY
MARKET CAPITALISATION
12-MONTH SHARE PRICE RANGE
BUSINESS RISK out of 5 SHARE PRICE RISK out of 5
OUR VIEW
A lot of investment analysis from August 2007 looks
pretty silly right now. And the case I made for advertising
and communications conglomerate STW Communications
on 16 Aug 07 (Long Term Buy—$2.22) is no exception.
The share price has since fallen 70%.
In a world that was still talking about the sub-prime
crisis (not the general credit crisis it has become), my
pessimistic case for STW’s 2008 earnings per share was
16 cents. If it were to achieve that now, it would be trading
on a lowly PER of 4.2. And, if you think that sounds
ludicrous, consider that not one of the six stockbroking
analysts that follow the stock expects it to post earnings
per share below 20 cents this year, placing the stock on
an expected PER of 3.4.
Today’s price clearly implies that the analysts (and my
former numbers) will be a long way north of the mark, if
not for 2008, then certainly for 2009.
Market depressed
Mr Market is in a generally depressed state at the
moment, but a few things are really ticking him off, and
STW Communications is guilty of two of them: it has a
lot of debt and is particularly exposed to the looming
downturn. He’s marked the price down accordingly, but
is he right to be concerned or is it just another of his wild
mood swings?
The biggest swing factor concerns the company’s debt.
After subtracting free cash on the balance sheet at 30 June
($15m of the reported $65m in cash is required for operations
and therefore not ‘free’), the group’s net debt stood at $150m.
That equated to a net debt-to-equity ratio of 54%.
That ratio doesn’t look too bad. But it should be noted
that STW carries $328m in intangible assets, and has
negative net tangible assets. So the net debt-to-equity
measure is not as reassuring in this case as it would be
for a business with lots of hard assets.
In the half-year to 30 June, the interest bill was covered
a mere 2.9 times by earnings before interest and tax (EBIT).
Even adding back the one-off costs associated with the
group’s significant office move, the ratio would still be
3.9, down from 9.3 in the corresponding period last year.
The company revealed with its full-year results that
it had covenanted to keep its interest cover (defined as
EBIT/total interest expense) above 5.0, presumably on an
annual basis, so it will need to rely on its customary
second-half profit bias to get it over the line. Though it’s
worth noting that the figures look much better on a net
basis (that is, setting off the interest received on the group’s
hefty cash pile). STW’s cash should provide a reasonable
amount of peace of mind for shareholders.
Tough choices
The group also revealed (for the first time, we believe)
$73m in deferred acquisition costs, up from less than
$13m at the same time in 2007. These are payments related
to previous acquisitions (‘earn-outs’ in the lingo) and may
not be payable if the businesses don’t deliver on agreed
profit targets. While the exact timing of these payments
was not disclosed (some of them could be up to five years
away), it’s nonetheless a significant impost for a business
expected to report a normalised annual profit of
around $40m.
Management will have to make some tough choices
regarding its cash flow. Shareholders will no doubt be
keen to receive the 12 cents per share in fully franked
dividends that management cut back from 14.7 cents in
2006. If the dividend is to be maintained, then that will
be $25m out the door (less any proceeds from the dividend
reinvestment plan).
Bankers will likely be baying for some repayments
in the current environment (or, at least, higher interest
payments). And, if covenants are breached, then perhaps
repayment of a hefty slice of debt will become a priority.
On top of regular dividends and potential debt
repayments, management also has a share buyback
program outstanding. The last time any shares were
bought back was June, though, which may be an
indication of more cautious cash flow allocation (earn-outs,
dividends, interest and principal repayments).
Sharp downturn
By savagely selling down stocks such as Photon Group
(STW’s closest listed competitor), Mitchell Communication
Group, Fairfax, West Australian Newspapers, APN News
& Media, Austereo and Ten Network, sharemarket
investors are clearly bracing for a sharp industry downturn.
The cautious but not pessimistic rhetoric from STW’s
management is clearly at odds with the market’s drastic
view. If business conditions have taken a sharp downturn
over the past couple of months, then there is a chance
that STW could fall victim to a crisis of confidence, given
its debt levels now exceed its market capitalisation.
That’s why we’ve increased both our fundamental and
share price risk ratings to 3.5 out of 5.
So far, though, management hasn’t seen fit to
downgrade expectations. And if the financial results come
in as expected for the year to 31 December and the outlook
from there does not deteriorate markedly, then one of
two things is likely to happen.
Firstly, the share price could surge. The current low
PER and high fully franked yield shouldn’t last long in a
rational market. Secondly, even if the market isn’t rational,
STW’s largest shareholder is likely to be. Sir Martin Sorrell’s
acquisitive WPP Group owns almost 20% of STW and may
well take the opportunity to swoop in and pick up the
rest of the group while it’s deeply out of favour.
The share price is down 42% since 15 Aug 08 (Buy—$1.16)
and, while the risks have increased, we believe the
investment equation is favourably skewed at today’s price.
STW Communications is a BUY, although we recommend
you limit purchases to less than 5% of your portfolio.
Disclosure: Interests associated with the author, Greg Hoffman, own
shares in SGN. Other staff members own shares in SGN, WAN
and TEN. First published online 29 Oct 08.