Two weeks ago, shares in Sir Martin Sorrell’s S4 Capital (SFOR) were sent tumbling after the digital advertising group warned that 2023 profits would come up short of expectations. Net revenue in the second quarter was below budget, as clients pulled in the reins on marketing budgets in response to mounting economic uncertainties. Nowhere has this been better illustrated than in the broader technology sector, normally a source of substantial fee income. With clients “very focused on the short term”, the impact will be most keenly felt at the company’s core “content” business, which normally accounts for 65 per cent of net revenue.
The group’s financial performance is weighted towards the second half, but it is now targeting like-for-like net revenue growth in the range of 2-4 per cent, down from 6-10 per cent previously, while lower-end operational cash margin guidance has been trimmed by 50 basis points to 14.5 per cent. Hardly disastrous on the face of it, but it might suggest that the accelerated digital transformation synonymous with the pandemic has lost impetus. At any rate, it is doubtful whether early backers of the S4 business model would have done so in expectation of low to mid single-digit margin growth.
Net debt at the half-year mark is put at around £115m, but it is forecast to reach between £180m and £220m for the full year as the group makes good on earlier merger-related payments. This is within management’s target range and not altogether surprising given S4’s aggressive acquisition strategy. It should fall appreciably next year, according to the company.
And lest we forget; tech stocks, like all growth shares, are disproportionately sensitive to monetary tightening, as the value of future cash flows is amplified when the discounting mechanism is based on a lower interest rate. This is doubly significant given that S4 has been pursuing a “buy and build” strategy focussed on the tech arena.
Shareholders won’t need reminding that the group put out an earlier profit warning during the summer of 2022 after it was forced to delay publication of its annual figures due to procedural and staffing issues. Yet, enthusiasm towards the stock started to wane as early as September 2021, since when the value has decreased by 87 per cent. It’s interesting to note that budgets for US digital advertising increased by 37.6 per cent in 2021, according to analysis by eMarketer. Admittedly, that rate is anomalous given the successive lockdowns. More revealingly, however, this year the growth rate is pitched at 7.8 per cent, the first time it hasn’t registered a double-digit increase in 14 years.
S4 is clearly operating in a straightened environment, yet its recent performance has fallen short of some large peers. Omnicom (US:OMC) revealed that the organic revenue growth rate at its advertising & media segment stood at 5.1 per cent for the second quarter, while Publicis Groupe (FR:PUB) trumped that with a rate of 7.1 per cent. You could argue that these aren’t wholly meaningful comparisons given S4’s heavy reliance on the tech sector, but investors would be justified in wondering whether the group is overly exposed on that basis.
It might be an exaggeration to suggest that S4 is joined at the hip to the major tech platforms, but the businesses are certainly aligned in a sense. This is a point worth remembering given the focus and capital the big tech platforms are devoting to the development of artificial intelligence (AI) functions, an area of endeavour which Sorrell sees as a “net positive” where S4 is concerned. You would certainly imagine that it poses a greater threat to traditional advertising agencies than it does to an industry disruptor like S4, particularly as it promises to further drive what is termed “hyper-personalisation at scale” – the ability to tailor products and services to meet the needs of consumers by employing real-time behavioural data, advanced analytics, and AI.
Last year, GLG Partners became the first hedge fund to reveal a short position S4 Capital, which seems prescient in view of the recent downgrade. Yet the US digital advertising growth rate is expected to return to a level in excess of 10 per cent in 2024, and the group’s shares now change hands at nine times forecast earnings and at a 53 per cent discount to the consensus target. Annual revenues are expected to be maintained above the £1bn mark, while cash profits are predicted to rise by 15 per cent to £145mn. However, the key consideration for investors is the likely impact that AI will have on S4’s business model – and even ChatGPT doesn't know the answer to that yet.
