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This share’s metrics look awesome on paper, but here’s why I’m avoiding it!

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If you look at the valuation and quality indicators, XL Media (LSE: XLM) seems quite attractive.

The firm operates as a provider of digital performance marketing services to the gambling and gaming industry. And with the share price close to 62p, the forward-looking earnings multiple for 2020 is just below six and the anticipated dividend yield is above 8%.

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Meanwhile, the return on capital has been running near 19% and the operating margin at about 37%. All those figures look tasty and make the enterprise appear to be a quality operation selling at a low valuation. But there’s a problem.

A challenged business

Indeed, revenue, cash flow, earnings and dividend payments have been volatile, and the share price has fallen back around 70% in just under two years. As I write, the shares seem to be continuing their descent, so it doesn’t look like Monday’s half-year results report helped much.

In the first six months of the year, revenue declined by almost 10% compared to the equivalent period last year and profit before tax plunged by nearly 22%. The outcome mirrors last year’s interim results, which featured similar declines. But on the bright side, earnings per share came in flat compared to last year, and the directors increased the interim dividend by just over 5%, maintaining the group’s progressive dividend policy.”

The report claims the firm has a “strong” balance sheet with $43.1m of cash and short-term investments on 30 June. However, in last year’s interim report, the company had $51.3m of cash and short-term investments, so some of the money it did have has gone. But in fairness, the company has spent some of it buying back its own shares over the 12-month period. Meanwhile, borrowings and lease liabilities offset the current cash position by about $15m. However, the balance sheet does look sturdy.

Trying to diversify

The firm is in a state of flux and is trying to diversify its operations, such as with the fast-growing personal finance division, which represents 14% of the revenue reported, up from 7% of the total a year ago. But “industry-wide regulatory headwinds” are taking their toll on trading with the “key” Swedish, German, UK and Swiss markets “creating near-term challenges.”

Trading in July and August, after the period end, has been weaker than the directors expected and on top of that, acquisition activity has slowed down. So, they’ve revised revenue expectations down to $80m for the full year and estimate that Earnings Before Interest, Tax, Depreciation and Amortisation will be around $34m.

Despite its tempting-looking metrics, XL Media is actually struggling and shrinking in a challenged sector. It’s trying hard to diversify, but there’s no telling how long it will take for the firm to return to growth. Meanwhile, the shares could have much further to slip. We don’t know for sure, and that’s why I’m avoiding the stock for the time being.

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Kevin Godbold has no position in any 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.

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