In reality, the shares aren’t quite as cheap as the historic P/E of 2.6 implies. Accusations that the company’s revenue recognition policy was too aggressive proved prescient. A trading update in July revealed that a change in accounting policy meant revenue would be £4m to £4.5m below previous management expectations.

It went on to explain that “given the Group’s relatively fixed cost base, substantially all of the shortfall in revenue will impact the profit before tax of the Group.” 

As a result, 2018 profit before tax will reduce roughly 40%. For some investors, this significant profit warning might come as a shock, but the warning signs were there all along for anyone keeping an eye on the balance sheet. 

The company’s accounts receivable, or revenue that has been recorded but not yet received, as of 31 July 2016 was a massive £19.7m. When the receivables figure is greater than an entire year’s worth of profit, I begin to feel uneasy.

On top of this, the company has discontinued the practice of seeking cash advances from the utilities it works with, meaning net debt could balloon by £16.4m to around £26m at year-end, unless my calculations are off. 

Utilitywise looks set to book a profit before tax of £11m if its estimates are accurate, but I’ve lost faith in its commentary and don’t consider it investible at the moment given the sudden change in expectations for both cash flows and profits this year. 

Contrarian dividends

I consider Saga (LSE: SAGA) a more attractive, yet still risky, value investment. The shares trade on a P/E of nine and offer a prospective yield of 7% to investors. Shares in the over-50s insurance and travel company tumbled roughly 30% earlier this month after revealing that underlying profit before tax is expected to grow 1% to 2%, compared to the previously expected 5%. 

The news doesn’t seem all that bad to me given the company’s strong cash flow, so I presume the market is expecting further downgrades in the near future. Perhaps the shares are currently so depressed because the insurance arm, where the business generates the majority of its profits, is performing slugglishly, or perhaps it is due to fears that conditions could deteriorate further after Brexit. 

Regardless, I believe the current valuation offers a significant margin of safety for those willing to take on a little more risk for the chunky payout. Promisingly, it seems that CEO Lance Batchelor agrees with me, having purchased over 70,000 shares since the profit warning. 

If I were to invest in the company, I’d consider a smaller  speculative position to benefit from the gigantic dividend because it is still covered 1.5 times by earnings per share. 

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The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Shares in Purplebricks Group (LSE: PURP) crashed 8% in early trading today despite reporting 150% revenue growth. Despite this rampant expansion, the company still lost £8.3m at an operational level in the first half of 2018 after generating £46.8m in revenue.

The company continued its recruiting drive, increasing the number of local property experts to 650 in the UK and 105 in Australia to cope with its burgeoning portfolio.

It has clearly disrupted and revolutionised the UK and Australian property sectors and has its sights firmly set on US next. Its American dream is progressing ahead of schedule: the company already has a presence in LA and now expects launches in San Diego, Sacramento and Fresno in January next year.

Great expectations

With momentum firmly on its side, many investors are clamouring to buy shares, but I fear the heady valuation attached to this lossmaking business could prove a dangerous entry point for would-be shareholders.

Right now, the company is valued just shy of £1bn. That’s a massive sum for a business whose losses seem to be increasing, rather than contracting. If we take analyst forecasts of £97m in revenue for 2018, then the company trades on a demanding price-to-sales ratio of roughly 10 times at the time of writing, despite a forecast full-year loss of £12.7m. 

Putting the valuation aside, there is no guarantee that Purplebricks will be able to maintain its furious expansion. Perhaps the most prominent criticism of the online estate agent is that it has little motivation to help sell a property because it receives payment regardless of outcome. A number of bad reviews on the website allAgents complain about poor customer service and a low frequency of viewings. 

The review website has been in a long-running legal battle with Purplebricks over the validity of these customer complaints, which I find disconcerting. allAgents director Martin McKenzie described the legal action as “the bully-boy tactics of a company unwilling to deal with the concerns of genuine customers”. 

This, combined with the fact that Purplebricks does not release sales figures does not inspire confidence. The company clearly completes sales – in the first half it completed on £4.6bn worth of property – but I believe a more transparent approach would empower sellers to make informed decisions. Is the firm worried that revealing these rates could deter would-be customers?

Other obstacles await

Additionally, entering multiple new geographies necessitates expensive brand-building that could hold back profitability for a while yet. The company spent £12.9m on marketing last year and this sum seems likely to rise going forward. 

My final concern is the state of the UK property market, which by all accounts has cooled off a little recently. Traditional brick-and-mortar estate agent Foxtons said it could face a “challenging” end to 2017 due to tough conditions in London. Admittedly, Purplebricks is likely better equipped to deal with a slowdown than other agents, but believing it could escape completely unharmed would be naive.

All that aside,with £64.4m net cash on the books, it has the financial firepower to see itself through a few more years of losses and I’d consider an investment in the company if the valuation wasn’t so demanding. 

The post Why I’d avoid Purplebricks Group plc despite 150% revenue growth appeared first on The Motley Fool UK.

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The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

I’ve closely followed the company for years now because the unique intellectual property that it has created since the late 1990s helps it earn outstanding returns. The company has averaged roughly 19% return on capital over the last five years, while operating margins last year peaked at a whopping 23.7%.

The group’s operational gearing meant that a 9% revenue increase in 2017 turned into a 27% jump in profit before tax. In all, it made £4.6m profit last year, leaving the shares on a P/E of 17.5. 

Low visibility warning

This might seem a bargain given that huge step forward in profits, but Zytronic hasn’t got the best visibility on sales and I believe it is possible it will experience a bad year that could significantly knock the share price. 

This happened back in 2013, where poor orders saw profits slide from £3.3m to £1.7m, sending the shares tumbling. While I believe it is a great business, the market has a short memory. I think investors would be best off waiting for one of these down years to purchase the shares. Those that got in at the bottom in 2013 are now up over 200% before dividends.

For truly long-term investors who are willing to weather some share price volatility, however, I believe now could be a good entry point. The company’s 3.7% yield is nicely covered by cash flow and should survive a bad year or two given the £14m cash on the balance sheet. 

There are certainly worse buys out there than Zytronic right now, but I’ll bide my time for a lower shower price before initiating a position. 

Patent-protected, profit-free

Shares in Versarien Technologies (LSE: VRS) shot up from 14.5p to 80p after releasing interim results in November. The company’s expertise in advanced materials with thermal management properties has clearly chimed with investors and customers alike, with revenues jumping 167% to £4.38m in the first half. 

Despite this progress, I wont be investing in the company for a few reasons. Firstly, I find it hard to tell whether its products are truly unique enough to deliver long-term, market-beating returns. I’m no scientist or engineer, after all, and many companies have struggled to turn a profit from graphene. Secondly, Versarien is not profitable, although it admittedly is taking solid steps towards break-even. Losses before tax halved in H1 to £0.77m. 

Given its rapid growth, I imagine the company will be profitable in a year or two. A successful placing in November has also raised £2.8m net of expenses, so the balance sheet looks secure for now. 

I believe that Versarien has a great shot at becoming a soundly profitable business, but it’s market cap is a massive £108m. That seems quite optimistic given its £1m cash burn in the first half.

I’m not in the business of making speculative investments and, in my opinion, the current valuation would have to come down considerably before I’d consider taking a position in the company. Perhaps I’ll be interested after the company publishes further details on the deal it has signed with two large consumer goods companies, but until then I’ll remain a little wary given the valuation.

The post Why I’d sell Versarien plc and this overpriced growth share appeared first on The Motley Fool UK.

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Zach Coffell has no positions in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

If you’re feeling nervous about Brexit’s impact, then perhaps Begbies Traynor (LSE: BEG), the UK’s leading corporate rescue and recovery practice, could be an interesting counter-cyclical stock to add to your portfolio. 

Founded in 1989, the company has longstanding relationships with banks and businesses alike and stands to profit from the misfortune of other companies. If our economy struggles after Brexit, there’s a good chance that Begbies will profit from managing insolvent firms. 

Here comes the crash

Given its reliance on faltering operations, Begbies keeps a close eye on the state of the economy and releases a quarterly ‘Red Flag’ to share its findings. On 1 November, the company said: “Nearly half a million businesses across the UK are in a state of ‘Significant’ financial distress, even before the effects of a potential interest rate hike are felt.”

It argued that low interest rates and a flexible labour environment had acted as life support for thousands of “zombie companies,” or organisations that are ambling onwards, barely profitable, heavily indebted and narrowly surviving. 

The company predicted that a hike to the minimum wage combined with rising interest rates could finish off these struggling organisations. Julie Palmer, partner at Begbies Traynor, even described consumer credit as being in bubble territory. 

I’m not sure I agree with this rather glum view of the UK economy, but if these statements are accurate, perhaps it could be due to a glut of business. Considering that Begbies has used the low-interest rate environment to snap up other corporate rescue firms at bargain prices, its performance in a downturn could be impressive. 

Booming business

For now though, business is looking solid enough. First-half results released today showed revenues up 6.4% to £26m and underlying profit before tax up 16% to £2.9m. The interim dividend was increased 17% to 0.7p and if the final payout is increased concurrently, the shares today could offer a yield of 3.8%. 

The outlook for the full year is promising and analysts expect the company to achieve a £4m profit. This leaves the shares on a forward P/E of 18, so it seems the market could already be pricing-in a slight uptick in profits. 

I’d consider buying into the company if it weren’t for its decision to diversify into property services over the last few years. It is now in the business of auctioning and managing properties and advising clients on leases, valuation and rent rates. It is possible a slowdown in property could take the edge off the rising fortunes of the insolvency business. 

Building a solid understanding of the relationships between these two business units is essential if you are considering an investment in Begbies, but given the attractive dividend yield and rising interest rates, I believe the company could be worth a closer look.

The post Why Brexit could boost this dividend star appeared first on The Motley Fool UK.

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Zach Coffell has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

The shares now trade on a P/E of 17, but I believe the company’s ambitious growth plans and solid track record justifies this valuation. The company grew revenues by 24.5% in 2017, with profit jumping 55% to £12.9m, driven by strong growth across all of the group’s categories.

Perhaps the company’s most promising avenue for future growth is North America. Treatt USA has flourished since it moved to its Lakeland site in 2002. Spectacular demand for its tea and sugar reduction products has outstripped production capacity at the facility and the company has announced a second expansion project that will double the factory’s output for these key product categories.

Today Treatt announced a £21.6m placing to fund this expansion along with a relocation of UK operations from the existing Bury St Edmunds site to a brand new purpose-built facility.

Of course, there’s a chance that Treatt’s migration won’t go smoothly or could cost more than expected, which of course could put a spanner in the works in the short term, but on balance I believe demand for its products and sectoral headwinds, such as the rise of diet drinks, should help Treatt maintain growth for years to come. 

Internationally scalable business model

Shares in online holiday broker On The Beach (LSE: OTB) have had a rip-roaring 2017, increasing 58% and have almost doubled since the IPO back in 2015.

As its name suggests, the company specialises in short-haul beach holidays. It boasts 20% of the UK online market and I believe it could go on to take an even greater share. The company doesn’t partner with hotel chains or airlines like its competitors, which gives its in-house technology a wider remit from which to construct the perfect trip for customers.

So far, this approach has been wildly successful, with UK revenue up 26% and international up 48% last year. The company plans to roll out its platform to more countries in the future, but has its eyes on Denmark next, targeting an entry into the market for early 2018.

Given its online software-based approach, the company does not have to invest in brick-and-mortar stores like traditional travel agents. The resultant low-fixed-cost base means incremental growth goes straight through to the bottom line, meaning profits could really explode if revenue growth can be maintained. This model also makes entering new territories far less costly – the main expense being marketing.

I’d expect this scalable business model to grow margins and return on capital as it keeps expanding, as demonstrated between 2015 and 2016, where the operating margin ballooned from 11.1% to 23.6% after 13% revenue growth.

The company’s expansion has been driven by founder and CEO Simon Cooper, who has significant skin in the game, owning 11m shares worth over £45m at time of writing.

I believe the combination of a scalable business model and motivated management team just about justifies the forward PE of 22. In today’s toppy market, there are worse growth options out there. 

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Zach Coffell owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

After the rise the shares trade on a P/E of 20, but this seems a fair price considering the momentum behind this rollout story. The company opened 20 new locations in 2017, ending the financial year with 199 branches.

This rapid expansion is self-funded too: the company generated £24m in cash from operations and spent only £9.3m on growing the estate. Given the significant free cash-flow thrown off by the company and a £21.5m net cash position, it has scope to increase the pace of this rollout in the future. 

The firm has impressed me with its cost management skills – while other casual dining outfits are suffering from increasing cost pressures from the rising minimum wage and weak sterling, gross margins have held steady at Patisserie Holdings.

After successful English expansion, the company has turned to Ireland and Scotland to drive further growth. It has only just begun testing the waters in these markets, operating from only five locations, but given its past operational excellence, the growth plans seem promising.

Auto Trader motors on

Shares in Auto Trader (LSE: AUTO) have struggled this year as Brexit cast a shadow over the UK auto market. Weakened sterling has resulted in price inflation for purchases of imported vehicles. Sales of new vehicles have fallen for seven straight months, so its no wonder investors are cautious of the firm.

The company is the UK’s largest automotive marketplace for new and used cars, with an audience three times larger than its nearest competitor. Roughly 80% of UK automotive retailers advertise on the website.

Despite the gloomy outlook, it grew revenues by 7% and profit before tax by 10% in the first half. The shares are currently 24% down from their 2017 peak and, trading on a P/E of 18, it looks an interesting prospect given its clear dominance in online used car sales.

The company’s capital-light business model continued to generate tons of free cash-flow that was used to reduce debt to £347m, to buy back £36m shares and to pay £34m in dividends.

According to CEO Trevor Mathews, Auto Trader’s dominance in the used car markets explains the company’s resilient results. It looks set to meet full-year profit expectations of roughly £171m. Given its dominant position, 65% operating margins and solid free cash-flow generation, I believe Auto-Trader could beat the market for years to come.

While the shares might perform weakly in the short-term due to tough market conditions, the sheer size of its marketplace grants it a competitive advantage over its peers that should facilitate long-term outperformance. 

In my view, both Auto Trader and Patisserie Holdings could be wonderful, durable investments for those following a buy-and-hold strategy. 

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Zach Coffell owns no position in any shares mentioned. The Motley Fool UK has recommended Auto Trader and Patisserie Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

The company operates in notoriously tricky sectors where competitive bidding processes often results in wafer-thin margins. As a result, it has averaged an operating margin of only 5% over the last five years. 

To make matters worse, the fees for these lengthy and complicated contracts are often agreed upfront and are therefore vulnerable to cost increases or unforeseen issues. Combined, these factors leave little room for error. 

Most recently, management announced that delays to both a significant contract and to PPP disposals means the company will close 2017 with between £875m and £925m in net debt and will certainly be breaching banking covenants. Given that the firm only made £124.2m last year, that’s a significant chunk of debt. There’s also no guarantee that it can return to these levels of profitability.

The balance sheet therefore needs significant rebuilding. The banks are onside for now and have extended the deadline for it to hit all-important financial targets to 30 April 2018. Carillion may have bought itself some breathing space to recapitalise, but I expect the imminent and essential fundraising to be incredibly dilutive to shareholders after the collapse in share price. 

Because of this virtually inevitable increase in share count, investors would be foolish to value the company on historical price-to-earnings ratios. Until the balance sheet has been repaired, I consider the shares un-investible. After all, the company’s financial fragility would put me off hiring it for any long-term contracts. 

A more favourable turnaround play

IT company NCC Group (LSE: NCC) has had a tough time of it recently too, but unlike Carillion, I believe its future could be very bright. The shares have fallen from highs of 350p in September last year to 226p today, but I believe the the company’s refocused strategy and growth headwinds in its markets means now could be a good entry point for investors. 

It has two segments that provide services, rather than products, creating repeat income. These are Escrow and Assurance. 

Assurance provides cyber security services including strategy building and testing. NCC claims that 90% of businesses have been the victim of some form of cyber crime and points out that a common DDoS attack costs on average £275,000 to recover from. The Assurance market is growing and NCC expects double-digit revenue growth form the department. 

The Escrow business acts as an intermediary between software users and developers, maintaining a copy of the original source code and therefore ensuring a business does not suddenly find itself unable to use a mission critical program. It is a cash-cow business with high-margins that is expected to show mid-single-digit growth.

The company has struggled to integrate a number of acquisitions. Over the next few years, it plans to focus on ‘self-help’ measures, indicating a break from bolt-ons until performance can be smoothed out. 

It trades on a P/E of 30 but given its impressive growth track record, I believe this is a fair price to pay for a good business in a growing sector. 

Don’t reach for yield

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Zach Coffell has no position in any shares mentioned. The Motley Fool UK owns shares of NCC. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Fashion powerhouse Burberry (LSE: BRBY) has been around for over 150 years, so you might presume that it could thrive under any management team. Of course you’d be wrong, because since 2009 the brand has been reforged and dominated by its visionary head of design Christopher Bailey. 

Shares in the company have smashed the market under his tenure, increasing 207% compared to the FTSE 100’s 12.5% over the last 10 years. This morning, Burberry announced that Mr Bailey will leave his role next March and the entire company at the end of 2018 to pursue new creative projects. 

He will remain President and Chief Creative Officer until 31 March, when he will step down from the board, although has agreed to continue in an advisory capacity until 2019. 

The question on everybody’s lips is “can Burberry thrive without Christopher Bailey?” 

A business issue

When Angela Ahrednts became Burberry CEO in 2006, she quickly realised that the issues plaguing Burberry’s brand were caused as much by the business model as by design flaws. 

The company’s faltering license model meant 23 different organisations around the world were creating Burberry products. The slack central design controls had left the Burberry range widespread and unfocused. In an interview with the Harvard Business Review, Ahrendts said: “In luxury, ubiquity will kill you—it means you’re not really luxury anymore. And we were becoming ubiquitous.”

To reverse the damage, she appointed Bailey as head of design and he has been in charge of approving every single Burberry product and fashion show since. Bailey reinstalled a sense of exclusivity to the famous check and the company’s fortunes have since turned around. 

Should you back Burberry? 

There’s no doubting Bailey’s importance to Burberry, but his ascension was supported by sensible changes to the business model combined with a sound strategic approach which cut out licensing issues, targeted millennials and propelled the brand back into the luxury strata. 

In all then, I have mixed feelings regarding the company’s prospects sans Bailey. 

The quintessentially British check is nearly 100 years old and will be a wonderful building block for a new head designer, but the Burberry brand has waxed and waned in popularity over time and is certainly not immune to the fickle tastes of the fashion industry. 

Importantly, new CEO Marco Gobbetti has experience managing luxury brands and has a lengthy transition period where he can work alongside Bailey to secure Burberry’s future.

Investors would be wise to keep a close eye on strategy going forward, but macro conditions look good for the business in the long term. I believe luxury spending will continue to increase as emerging classes across Asia seek out luxury goods as status symbols. If the company sticks to its roots, such as the British-made trench coats that earned it a royal charter, then I believe it has every chance to continue its expansion. 

The post Will Christopher Bailey’s departure cause Burberry Group plc to stutter? appeared first on The Motley Fool UK.

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Zach Coffell has no position in any shares mentioned. The Motley Fool UK has recommended Burberry. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

The market got excited when the company discovered significant reserves in licensed areas on the Rona Ridge, west of the Shetland Islands, but expectations were tempered by massive funding requirements needed to access the fractured basement reserves. Some analysts claim the company is sitting on the largest oil discovery beneath UK waters this century.

I’ve no doubt the firm has incredible potential if it can get the oil flowing, but in my experience this is rarely a straightforward task. Hurricane estimates that first oil will be achieved in 2019, but that leaves two years of operational development that could go awry before investors begin to benefit from those massive reserves. 

The company has already raised $547m to fund Lancaster and other discoveries. $220m of this was raised by bonds with 7.5% p.a coupon, amounting to a yearly $16.5m cost. The company spent a further $87.2m on “intangible exploration and evaluation assets” in the first half of this year alone. I worry this significant cash burn could erode that massive cash pile fast.

Furthermore, Edison Investment Research has estimated it will cost the company just shy of $200m to reach first oil via the Early Production System (EPS), although around $2.3bn could be needed for a full field development. A delay in the EPS could easily lead to another dilutive fundraiser. 

I can’t justify investing in a £560m company that has yet to sell a barrel of oil, although I can understand why investors are willing to take on the risk given the best-case estimate of 2.326bn stock tank barrels at Lancaster. If all goes off without a hitch, riches will surely be there. I’m deeply sceptical that they will, however. 

POS-GRIP potential

I’ll also be avoiding oil services specialists Plexus Holdings (LSE: POS). 

The company has struggled in the low-oil-price environment and swung from a £5.4m operating profit in 2015 to a £6.8m loss last year. Unlike Hurricane Energy, the oil industry at large has toned down capital expenditure so its been tougher for Plexus to sell its proprietary POS-GRIP wellhead device. 

The company recently sold its Jack-Up business to FMC Technologies Limited for £15m, with an additional sum of up to £27.5m payable dependent on the future performance during a three-year earn-out period, so its balance sheet looks secure despite high fixed costs. 

Plexus also signed a Collaboration Agreement with FMS which “establishes a framework to work together both on the development of existing POS-GRIP IP for applications outside of jack-up exploration, as well as future new technologies.”

The company’s strategy rests on increasing awareness of its POS-GRIP system, which it says improves safety and saves on both time and cost for users.

The company has already sold the system to illustrious companies such as Shell, BHP Billiton, ConocoPhillips and a number of other blue-chip clients, but regardless has struggled to post impressive results.

If the company is struggling despite such clientele, I don’t really see how this strategy will pay off. That’s why I’m steering clear of the business. 

The post Why I’d avoid Hurricane Energy plc and this value stock appeared first on The Motley Fool UK.

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Zach Coffell has no interest in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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.

The post Is System1 Group plc a falling knife to catch after dropping 25% today? appeared first on The Motley Fool UK.

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Zach Coffell has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.