Is System1 Group plc a falling knife to catch after dropping 25% today?

Shares in marketing experts System1 (LSE: SYS1) have crashed 25% this morning after a 10% revenue drop in H1 led to a 70% reduction in profits. Ouch. The company, formerly called Brainjuicer, claims to be “at the forefront of a revolution in applying behavioural science to understand how people really make decisions.” 

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.

I believe investors would be better off focusing on business models that don't struggle with fixed costs and low earnings visibility. If you do, you best be prepared to weather a few bad years. 

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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.