Priced at 970p a pop almost exactly one year ago, the same shares now change hands for just 267p after dipping another 11% in early trading. That’s almost 75% wiped off the company’s value in just 12 months. 

But as buying when everyone is selling can sometimes be very lucrative, is now the time for value aficionados to consider begin taking a closer look?

Profits plummet

System 1 saw revenue sink 18% (17% in constant currency) to just under £27m in the year to the end of March. If you think that’s bad, consider that pre-tax profit slumped 68% to just £1.99m compared to the £6.28m the year before. To describe that sort of financial performance “disappointing” — as the company did earlier today — is something of an understatement. 

The reason for such a dramatic fall was known in advance, of course, with CEO John Kearon confirming that System 1 had been “slow to appreciate the speed and scale of change” in its market. Having ascertained that the marketing budget cuts implemented by its clients were “significant and probably permanent“, Mr Kearon went on to state that 2018/19 would be “a period of transition” for the firm as it attempts to push its “more competitive and scalable offer” in the tough environment.

Considering the push towards low-cost automated solutions is likely to “continue unabated” and the fact that rivals are now adopting the firm’s previously unique approach (using behavioural science to inform marketing strategies) with greater frequency, that certainly won’t be easy. 

Despite the limited revenue visibility, it’s not all doom and gloom. The balance sheet still looks decent with £5.78m left in cash at the end of the reporting period and no debt. The final dividend of 6.4p per share was also maintained, although the possibility of a cut in the future can’t be ignored. 

Having been positive on the company in the past, I admit to being disheartened by the speed of System 1’s decline. While I can see value at this price, it’s clear that the road to recovery will be long and painful. Only patient investors need apply.

Better prospects?

For those who regard System 1 as too risky, small-cap software-as-a-service provider Dot Digital (LSE: DOTD) could be a decent alternative.

Despite some impressive interim numbers in February — including a 25% jump in group revenue (to £18.8m) and 8% rise in EBITDA (to £5.7m) in the six months to the end of September —  the Croydon-based company’s stock has fallen back in recent months, perhaps influenced by the Facebook/Cambridge Analytica scandal. I see this as an opportunity.

Right now, analysts are predicting a 30% rise in earnings per share for the 2018/19 financial year, leaving the stock trading at 19 times earnings. For a business that boasts partnerships with goliaths such as Microsoft and strong international growth ambitions, that looks pretty reasonable to me. Returns on sales and capital employed — a couple of the hallmarks of quality companies — are consistently high and a lack of debt (and cash balance of £10.5m) should appeal to investors who like their holdings to be in rude financial health.

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In a trading update published this morning, the firm warned that “Q3 trading continued to be worse than anticipated” and thanks to its “normal lack of revenue visibility” management now “anticipates gross profit for the year to 31 March 2018 will be around 20% less than the prior year.”

This is the latest in a string of warnings from the company which have helped push its share price down from a high of 1,040p during May of last year to 330p at time of writing, a decline of nearly 70%. 

Emerging problems 

System1’s issues first appeared during the first half of 2017 when it revealed that trading had slowed following the end of its fiscal year. The market didn’t punish the company too much at first, but then in mid-August, the firm confirmed investors’ worst fears, reporting “the slower than expected start to our fiscal year which we noted at the time of the announcement of our 2016/17 results on 15 June 2017 has continued since.” Thanks to these headwinds, management estimated a “6% to 11% fall in gross profit” at the time.

Unfortunately for the rest of the year, trading only deteriorated. At the end of October, management announced that due to the deferral of some major contracts, gross profit had actually declined 12% (in constant currency) year-on-year in the first half. 

Today’s dire update followed. 

Buy, sell or hold? 

How should investors react to this news? Well, it’s clear System1 is struggling and the company can no longer achieve the rapid rates of growth it once could. Still, management has been actively cutting costs and developing products in new markets. 

According to today’s update, while trading is proving slower than expected in the UK, the group is “on track to be close to break-even in Europe and to make an anticipated small loss in the US.” To help support growth, the company has £4.6m of cash in the bank with no debt. 

However, while there are green shoots to the System1 story, the outlook for the group is quite uncertain at the current time. A lack of profitability makes it harder to value the business, and even though management is undertaking initiatives to re-ignite growth, its success will ultimately depend on overall advertising spending growth, which management has little control over. As noted at the top of this article, the company is well aware of this, reflecting its statement highlighting the “normal lack of revenue visibility.“

So overall, until there’s more clarity regarding the group’s outlook, I would avoid System1 for the time being. I believe that if a turnaround does take place, investors will have plenty of time to buy in again before the shares take off.

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System 1 thinking, as the company describes it, is understanding that people make choices based on instinct, intuition and emotion just as often as logic. If you spend enough time observing how investors pick stocks, I reckon you’d probably agree.

The shares are 62% off all-time highs achieved in May, but has this decline been driven by an emotional reaction or has the company really lost more than half its intrinsic value in the last five months? 

Before its newsflow turned sour earlier this year, the company had been on a tear. Profit had nearly doubled over a four year period, it had built up an £8m cash pile and had won the ‘most innovative agency’ award in the annual market research GRIT awards for six years on the trot.

Predictable profit warning

So how did things suddenly go so wrong? I’d been avoiding an investment in the company despite its solid progress because of some candid management commentary. Back in February, System1 tempered expectations: “The business still remains predominantly ad hoc, with limited revenue visibility, and as always we need to acknowledge that we cannot predict with very much certainty how revenue growth will unfold over the coming financial year.”

Further to this, the company has always made very clear that the majority of the cost base is fixed. You didn’t need to be a genius to realise that this combination could produce a terrible quarter or half-year. 

Here’s how the underperformance came about. A few significant clients cut budgets, a few large projects from 2016 did not repeat, and the company spent time fixing internal issues after the rebrand. That, combined with a 23% increase in overheads in anticipation of further US growth, eroded profits. 

Some of that sounds temporary, but the update contained rather worrying commentary regarding market trends that could imply deeper issues: “Ongoing shifts within the industry backdrop are resulting in clients moving research spend towards automated lower cost research data.  Whilst we have seen this trend over a number of years, it has gathered pace more recently.”

I’m not entirely sure what to make of that but it implies the company’s offering is not keeping pace with what customers need. Q3 has not shown any improvement yet either and I worry things could get worse from here. 

The company has launched new products that should encourage repeat revenues but also stated that slow adoption means there would be no impact on current year results. We’ve got no way to know if these offerings will turn things around. 

Buy business models, not low P/Es

Marketing is always going to be a cyclical business, so a bad year every now and then seems inevitable for a company like System1. While I’ve always been very impressed with the candid management speak, there are some worrying implications in this communication and I don’t think the business model is ever going to produce wonderful shareholder returns. The shares might be a little undervalued now, but I’ll not be making an investment.

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But should recent falls in international toy distributor Character (LSE: CCT) and marketing group System 1 (LSE: SYS1) be regarded as a warning to stay away, or an opportunity to get involved? Here’s my take.

Devoid of character?

Having traded as high as 540p at the start of September, shares in Malden-based Character have since lost 30% of their value, driven partly the bankruptcy of Toys R Us in the US and Canada, but also by the company’s international customers becoming increasingly careful with their cash.

Last week’s trading update seems to have stabilised things for the time being. The company reiterated that is had witnessed a “solid finish” to the 2017 financial year with underlying pre-tax profit expected to meet market estimates. Moreover, sales in the UK remain comparable with those of last year and similar to trends witnessed in the toy industry in general.  

So long as investors are able to look beyond the short term, the outlook doesn’t look too bad either. While Character’s management already believes that the company will perform “significantly below” previous market estimates over the next year, a return to growth on the back of new product launches is expected in H2 2018, even if the full effect of this reversal won’t be seen in the numbers until the 2018/19 financial year.

Right now, you can pick up shares in the £82m cap on a bargain-basement valuation of just eight times predicted earnings. That looks a seriously good deal for a business boasting consistently high returns on capital, no debt, and a chunky, fully-covered 4.6% yield.

Big faller

Character’s investors will no doubt sympathise with the owners of  System 1, formerly known as Brainjuicer. Following a number of concerning updates, the latter’s shares have now halved in value since momentarily breaching the £10 mark in May. 

Perhaps unsurprisingly, last Monday’s six-month trading statement appears to have done little to attract investors back to the stock. Confirmation was given that H1 trading had been “slower than expected” after a significant reduction in spending by some of its clients. Indeed, pre-tax profit from the first half is now expected to be around £800,000 – over 70% less than that achieved over the same period in 2016. Factor in reports that the company’s market has become increasingly more competitive and it’s not surprising that System 1’s management remains “cautious” on the outlook for the rest of the financial year, citing a “usual lack of revenue visibility“.

With so much uncertainty around and the stock still trading at 17 times forecast earnings, it would appear many market participants are waiting for signs of improvement before making a move. Next week’s interim results will certainly make for interesting reading.

In the meantime, it’s worth remembering just how well System 1 has performed over the years. Like Character, it’s consistently generated high returns on the money it invests and boasts a net cash position. Free cashflow is excellent. And while its growth status means that System 1 offers little attraction to income hunters, its nine-year dividend growth streak isn’t to be sniffed at.

The company remains on my watchlist.

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The emergency callout specialist advised in July that “momentum in North America remains strong,” Homeserve adding 2.5m more households in the period spanning April 1 to July 20, thanks to 24 partner signings. It now has 53m homes on its books in the US.

But its Stateside operations are not the only reason to be optimistic. Indeed, it also continues to invest heavily in its non-US divisions to deliver brilliant revenues growth.

In August the firm paid £5m to acquire Help-Link, a major player in the UK domestic boiler installation market, a decision that will help it on its path from just dealing with emergency callouts to becoming a significant operator in the much larger home repairs and improvements segment.

One I’d buy…

So it is unsurprising that City brokers are expecting earnings to keep on growing by double-digits in the medium term at least — bottom line rises of 16% and 11% are predicted for the years ending March 2018 and 2019 respectively.

Homeserve’s share price has detonated 33% since the start of the year, illustrating the groundswell of optimism surrounding the FTSE 250 star.

So while the company deals on a forward P/E ratio of 26.4 times (sailing outside the broadly-regarded value territory of 15 times or below), I reckon the potential for explosive earnings expansion in the near term and beyond still makes it a share worth loading up on.

… and one I’d sell

Investor appetite for System1 Group (LSE: SYS1) has certainly been less impressive of late. Its market value has slumped 36% since the middle of August, and Monday’s trading statement does not suggest that it will be reversing these losses any time soon.

The marketing services specialist advised that business has remained slower than expected during the first half of the fiscal year, forcing gross profit for the April-September period 9% lower year-on-year, or 12% at constant currencies.

Meanwhile, pre-tax profit is said to have collapsed to just £800,000 for the half year from £2.8m in the corresponding 2016 period.

System1 said that the drop was “due in the main to non-recurrence of large one-off Innovation projects as a result of some significant client spending reductions and a more competitive market.”

And the London-based business does not see any light at the end of the tunnel either, cautioning today that “[we] remain cautious about our prospects over the remainder of the financial year due to our usual lack of revenue visibility.”

It took a tumble back in August when it announced that continued trading troubles would see half-year profit fall between 6% and 11%. Although the business advised that it had witnessed “more encouraging signs recently,” this has not been borne out in today’s market release.

The City is expecting earnings to rise 14% in the year ending March 2018, with a further 7% advance chalked in for fiscal 2018. But today’s statement suggests that earnings could fall well short of these forecasts.

While a prospective P/E ratio of 15.4 times is hardly eye-watering on paper, this could still lead to further erosion in the share price should market conditions continue to slide, a very real possibility in my opinion.

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Recurring revenue is a big part of the potential appeal of CentralNic Group (LSE: CNIC). This unusual internet company makes most of its money by selling subscriptions for domain names. Its speciality lies in so-called top-level domains (TLDs). These are the end part of a name, such as .uk or .com.

This market is changing and there are a growing number of non-geographic TLDs, such as .xyz, which is used by Google’s parent company Alphabet, among others. CentralNic’s growth proposition is that it has long-term contracts to manage and wholesale many of these TLDs. Today’s half-year results provide a chance for us to check on the firm’s progress.

Mixed results

Revenue rose by 19% to £10.6m during the first half, while adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) rose by 50% to £1.4m. However, an increase in acquisition-related charges, non-recurring costs and other non-cash charges meant that CentralNic’s adjusted pre-tax profit fell by 29% to £670m.

The group’s accounting is quite complex. But one positive measure from today’s results is that cash generation appears to remain healthy. Net cash rose slightly, from £7.5m at the end of 2016 to £7.7m at the end of June.

Management remains confident of meeting full-year expectations. This puts the stock on a forecast P/E of 15. The company doesn’t currently pay a dividend, but if cash generation remains positive, then this might change over the coming years.

I think CentralNic’s full-year results will provide us with a clearer picture of the firm’s progress towards being a recurring revenue business. In the meantime, I’d rate the stock as a speculative buy.

Is this setback just a blip?

Shares of marketing company System1 Group (LSE: SYS1) — formerly known as BrainJuicer — tripled in value between February 2016 and May this year. But they’ve since collapsed in spectacular fashion, falling from a 52-week high of 1,050p to just 557p at the time of writing.

This 50% drop came after the company issued a profit warning. Among the reasons cited were a 10% rise in organisational costs and deferred spending by clients. An extra worry was that competitive pressures were said to be increasing.

This concerns me, as my understanding was that the group’s services were quite innovative and unusual. If competitors are starting to offer similar services at lower prices, System1’s high profit margins could fall sharply.

Uncertain outlook

First-half profits are only expected to be “a little over break-even” this year. And although performance is expected to improve during the second half, the shares still look expensive to me. Broker forecasts put System1 stock on a forecast P/E of 18 for the current year, falling to 16.5 in 2018/19.

Although the company’s performance could spring back rapidly, it may not.  I’d prefer to avoid the risk of further losses, even if it means missing out on a potential recovery.

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The statement goes on to say that management expects gross profit to move back to growth in the second half of the year. 

It seems System1’s problems stem from higher costs relating to the group’s expansion plans. The statement today notes that: “H1 2017/18 costs will be some 15% higher than last year” reflecting “investment in senior hires in the US…to support future growth in both our Research and new Advertising Agency businesses.” One-off severance charges have also pushed costs higher, although these actions are expected to save £0.5m per annum going forward. For the full fiscal year, “costs are currently expected to grow by around 10%.“

After taking all of these charges into account, the group anticipates first half pre-tax profit to be a little over break-even, against £2.8m a year earlier. For the year, pre-tax profit is expected to decline approximately 10% to 15%. 

Re-rating 

Looking at these figures, it is no surprise that shares in System1 have been falling so fast this morning. 

Prior to the announcement, shares in the marketing services agency were trading at a forward P/E of 21.2 as City analysts have pencilled in earnings per share growth of 30% for the year ending 31 March 2018. Pre-tax profit was expected to rise to £7.9m from £6.3m achieved last year. 

These forecasts are now out of date, and a lack of growth means the growth multiple is no longer justified. As of yet, City analysts have yet to revise their forecasts based on today’s news. But based on historical figures, I estimate for the full-year System1’s earnings per share could fall back to around 27p, indicating that the shares still trade at around 24 times forward earnings. With this being the case, unless the company can instigate a dramatic turnaround, the shares could have further to fall as they re-rate to a lower, ex-growth multiple. 

That being said, considering the firm’s historical strength, and the investment in people to help improve overall performance, System1 looks set to return to growth next year. So, the market might think twice about marking the shares down further. 

If the company can return to growth next year, this could be a great buying opportunity for long-term investors, although if costs continue to rise faster than revenues, there will be further pain ahead for investors.

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Turning the market research industry upside down

Marketing and market research agency System1 Group (LSE: SYS1) has, in chief executive John Kearon’s own words, “built an international business challenging the market research industry.”

So far, the firm has built its success on applying behavioural science to understanding how people really make decisions. It’s probably no surprise to learn that most people use instinct, intuition and emotion in all of their choices, but the clever bit is how System1 Group has managed to monetise this realisation by producing marketing that “guarantees profitable growth & zero waste” for its client companies.

Targeting a leap in growth

The recent full-year results to March 2017 show that System1 has been growing fast with currency adjusted revenue up 13% and earnings per share ballooning 22% compared to the year before. Looking forward, the firm aims to build “a far bigger business challenging the marketing services industry.” Based on previous performance I reckon it has every chance of succeeding with this diversification strategy, which could drive further impressive investor returns from here.

However, in Thursday’s results statement, as well as delivering a positive outlook statement it owned up that “trading during Q1 of our new financial year has been a little slower than we expected.” Today, at 780p, the shares are around 24% off the high they achieved during May, which makes the stock well worth your further research, in my view.

A consolidating share

Since April, the shares of AB Dynamics (LSE: ABDP) have been taking a breather from their dash upwards and I reckon value could be building. The firm operates as a designer, manufacturer and supplier of advanced testing systems and measurement products to the global automotive industry for vehicle suspension, brakes and steering, and business has been brisk.

At today’s 571p, the shares are around 270% higher than they were in January 2015, fuelled by rising revenue and earnings. City analysts following the firm expect earnings to push 22% higher still for the year to August 2018, as growth shows little sign of easing.

Investing for growth

Back in April with the half-year results, the firm reported ongoing strong demand for its products and services and expects to take control of a new factory in Wiltshire during the late summer. It reckons the new facility will free up valuable manufacturing space for product development areas needed to create new laboratory test equipment, which should drive further growth.

It’s clear that AB Dynamics is investing for, and expects, further expansion and I reckon shareholders could benefit from such progress over the coming years. Any share price weakness now makes the stock look even more attractive to me.

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Although valuations are now higher than they were even a few months ago, there could still be opportunities for long-term growth investors to buy ahead of improving share price performance.

Uncertain outlook?

Reporting on Thursday was international marketing and market research agency System1 (LSE: SYS1). It announced a rise in revenue growth of 27%, with sales up 13% in constant currency. This helped to push gross profit 29% higher, while profit before tax was boosted by 25%.

This was a relatively impressive result in light of the transition the company is experiencing. It has now completed Chapter 1 of its growth outlook, and is well-placed to commence Chapter 2. This will see it build a larger business through challenging the marketing services industry. The company believes it can offer an improved product, as well as marketing that achieves profitable growth.

Following the update, System1’s share price has fallen by around 10%. The reason for this appears to be slower trading than anticipated during the first quarter of the new financial year. However, it remains confident in its outlook for the full year, with growth in earnings of 41% currently forecast by the market. This puts it on a price-to-earnings growth (PEG) ratio of just 0.5, which suggests it could offer high growth at a very reasonable price.

Resilient growth

Following the general election, the reputation of polling companies such as YouGov (LSE: YOU) seems to have been somewhat restored. After polls in the 2015 general election and 2016 EU referendum which were somewhat mixed, the polls for the 2017 general election were much more accurate in general.

Despite the challenges faced by the industry in recent years, market research company YouGov has been able to grow its bottom line at a relatively consistent pace. It has increased earnings in each of the last five years, with its growth rate averaging 13.6% per annum. This shows that it could offer a relatively defensive outlook at a time when the UK economy is facing significant uncertainty thanks to an unpredictable political outlook.

Looking ahead, YouGov is forecast to grow its earnings by 17% in the current year, which puts its shares on a PEG ratio of 1.5. This suggests they are not yet fully valued after growth of 330% in the last five years. In addition, the company is expected to increase dividends per share by 13% per annum over the next two years, which could act as a positive catalyst on its share price. Therefore, buying the stock now could prove to be a shrewd move.

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System1 Group

System1 Group (LSE: SYS1) shares have been on fire in 2017, rising over 60% this year. Formerly known as BrainJuicer Group, System1 is a marketing and brand consultancy, with proprietary market research and advertising solutions based on the field of behavioural science. In layman’s terms the company focuses on understanding how people make decisions.

In the past, the research industry has assumed that humans make choices consciously and rationally. However according to System1, a growing body of evidence suggests these assumptions are wrong and that humans often make unconscious decisions that are influenced by their social, personal and environmental context. This is where System1 adds value – by helping its clients understand how decisions are made.

The £104m market cap company has enjoyed robust revenue and earnings growth over the last five years with revenue increasing 50% to £31.2m for the 12 months to the end of 2016, and earnings more than doubling in this time, from 15p to 32p. Cash generation has been impressive and the company generated a high return on equity of over 40% in 2016. System1 also has no debt.

The group is changing its year-end date from 31 December to 31 March, and earlier this week updated the market on trading for the 12 months to the end of March. Revenue grew 27% (13% on a constant currency basis) to approximately £33m, gross profit increased 29% (15% constant currency) to £27m, and management stated that the company has “continued to trade strongly since December 2016.”

With the shares up 60% year-to-date is it too late to buy? City analysts forecast earnings of 39.3p per share for FY2017, placing the company on a forward-looking P/E ratio of around 22.5 at the current share price. The group’s enterprise value (EV)-to-sales ratio is approximately 3.1. At those multiples, the stock isn’t cheap, but in my opinion it’s not overly expensive either given the growth record. I therefore wouldn’t be surprised to see the share price continue trending upwards.

Swallowfield

Another small-cap performing well in 2017 is £55m market cap, Swallowfield (LSE: SWL), rising 24% this year.  

Swallowfield is engaged in the development, formulation and supply of personal care and beauty products, and owns brands including The Real Shaving Company and MR Jamie Stevens.

Revenue increased 10% in FY2016, and adjusted earnings per share spiked 91% to 12.6p. Analysts anticipate sizeable earnings growth for 2017, with 20.7p per share forecast. That places the company on a forward-looking P/E ratio of 15.9, a reasonable valuation given the growth in earnings in recent years. An EV/sales ratio of 1.04 is also undemanding.

Although Swallowfield recently stated that the fall in sterling and global inflationary pressures could bring uncertainty in the months ahead, the company also stated that it remains “confident that our strong overall trading momentum will compensate in the current year.” As a result, I see no reason why the share price can’t continue to move upwards over time.

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