Stockwatch: A small-cap at an inflection point

The right Brexit deal would cause sterling and risk assets like this one to re-rate, but companies analyst Edmond Jackson also thinks it could buck a downturn.

Can a focus on "digital transformation" steer a marketing services group through difficult times if the UK and/or global economy slides?  Or is this more a buzz-word label in a sector exposed to a company's first choice of spending areas to cut?

I've covered £150 million Kin and Carta (KCT) as a turnaround play when it was known as St Ives Group (SIV), which proved a rollercoaster – initially 90p on a 7% yield in 2012, soaring to 247p then hitting trouble in 2016 when lumpy contracts in book printing got cancelled or deferred. 

Challenges also erupted on the "marketing activation" side geared to the grocery industry hence its competitive pressures, with the stock down to 37.5p mid-2017.  At around 80p last March I judged it worth accumulating on the basis disposals would go ahead as intended and a cleanly-honed operation emerge, better-attuned to the times. 

Re-launch of the company in a growth space

Under a new chief executive from last August the group has recently re-launched as Kin and Carta, which sounds a bit cute if astutely oriented towards "digital transformation".  Mind this does include what were previously described as 'strategic marketing' services – which happen to focus on digital, data and insight – as if an aspect of re-labelling to capture the Zeitgeist.  Yes, it's vital to adapt to digital, but if sudden choices involve redundancy costs or cutting dividends, marketing-spend can be an early casualty.  As yet however the declared progress and prospects are good.  

Usefully, the stock appears to have dropped off most people's radar as disposals and a re-naming went through: databases such as Company REFS no longer include K&C, hence I've cited recent full-year figures given past performance is quite irrelevant.  Market price has at least kept relatively firm around 100p: arresting October drift to a low 80p area and reaching 105p earlier in December. 

WPP is an interesting comparator

It's useful to benchmark against the FTSE 100-listed bellwether of international marketing services WPP(WPP) despite over-expansion that has left it out-of-step versus the likes of Google and social media.  By contrast K&C has restructured towards a relative sweet spot in the industry. 

WPP's last update in respect of Q3 2018 declared overall flat revenue figures, but a deteriorating trend in most areas especially the UK, But K&C said around the same time that its year from early August had started in line with expectations "with a strong pipeline and a number of exciting project wins from existing and new clients..." 

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K&C talks of more cross-selling, if a typical theme of listed groups with a spread of smaller operations, and a deepening focus within key sectors like financial services, transport, retail & distribution, healthcare, industrials and agriculture.  Excepting healthcare, I'd mind how these are prone to cyclicality and agriculture currently seems panicked about a no-deal Brexit. 

Page 116 of K&C's 2018 annual report cites 55% of revenue derived from clients in the UK, 36% from the US and 9% rest-of-world; so, even if client firms have international operations, owning this stock assumes neither the UK nor US economies are teetering on downturn.

Consider valuation contrasts also. WPP shares are down 55% in two years to a forward price/earnings (PE) ratio of 7 (assuming forecasts) and a dividend yield of 7% (twice covered according to consensus); whereas K&C shares hinge on earnings given their historic yield is barely 2% and goodwill/intangibles are 143% of net assets.  Their recent multiple of adjusted earnings is a modest 10 times and double-digit earnings growth is entertained for the 2020 financial year, but that's a long way out, who knows what the UK/US economies will herald in the meantime. 

So, mind K&C is a small-cap exposed to any change in its narrative, and with tighter liquidity, whereas near £11 billion WPP is a genuinely global business with UK revenue/profit in low-teen percentages of group total. 

WPP superficially appears to have the advantage, cash flow of a long-established big company should support its dividend payout, but this may still be in question if asset sales for debt reduction conflate with reduced demand for its services.  K&C is better positioned strategically without the clutter of many years' acquisitions, if lacking any props.  It's potentially attractive to buy into, albeit a question of timing.

Looking further out, if K&C distinguishes itself henceforth it could become a useful bolt-on for the likes of WPP to help recover growth. 

'Digital transformation services' growing at 18%

Management claims this segment is growing globally at an annual compound rate of 18%, and its operations have critical mass versus rivals who "are finding it challenging to adapt to the right operating model to succeed in this space."   

It's hard to cast a verdict on the calibre of K&C services though, with descriptions and client referencing being opaque, for example - helping "the world's largest companies to invent, operate and market profitable new products and services." Presentations and images involve happy staff and high principles about the client experience, leaving any financial observer to guess exactly the client gets. 

Investors will, therefore, take their cue from results, where the last financial year to 3 August was at least promising: adjusted pre-tax profit up 38% to £18.5 million on revenue up 9% to £178 million, a 19.5% advance in gross profit meeting near-same selling costs, are key explanations for the pre-tax advance.

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Continuing operations generated £20.5 million cash versus total capital expenditure of only £4.6 million, but mind a caution how a seemingly modest £2 million investment in the current financial year "may impair 2019 earnings but we believe the payback thereafter will outstrip the short-term drag on profitability." 

The operating margin is projected to rise from over 10% in the current financial year to a minimum 12%, with revenue rising from mid-single digit growth this year to double digits in the year to August 2020 – geographic expansion aims to "leverage our already strong presence in Chicago, New York, San Francisco and Buenos Aires."

It's a positive narrative but frankly 2020 is conjecture given it's impossible to say for sure what the next few months could herald for Britain and the global economy. 

Business at an inflection point; what of the shares?

K&C's accounts should clean up henceforth, despite selling the book printing operations and marketing activation services for a total net cash inflow of £32.4 million; £15.5 million of which went on deferred consideration for past acquisitions and halving net debt to £26 million, so a £2.7 million interest cost should fall going forward.  A total £47.8 million for amortisation impairment and considerations for past acquisitions meant a statutory after-tax group loss of £29.2 million. 

My conclusion is the business now at an inflection point operationally, if hard to claim the same for any marketing services share right now.  If MP's capitulate to pass the EU withdrawal agreement in January, sterling and risk assets like this one should re-rate, however, the market is casting only a low probability to the no-deal Brexit it fears.  Who knows what the alternatives would herald.  So, overall K&C shares rate Buy on weakness.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.