S4 Capital ready to lap up digital growth

When Sir Martin Sorrell left advertising giant WPP (WPP) in the spring of 2018, he did so as the longest serving chief of a FTSE 100 company. Indeed, although it was allegations of misconduct that prompted his departure, it seems the market cannot get enough of him. S4 Capital (SFOR) listed only a few months later. And Sir Martin’s second invention seems to be a similar creature to the first: a marketing company that has grown rapidly by hoovering up smaller firms. S4 has undertaken more than five mergers or combinations over the course of 2020 alone. Indeed, progress has been so rapid we feel it is worth revisiting his new venture less than a year after originally tipping the shares.

But this time Sir Sorrell’s focus is on the digital aspect of the advertising industry: the group bills a “holy trinity” model of first-party data, digital content and programmatic advertising. This puts it at an advantage in a rapidly evolving media landscape that revolves more around data analysis and targeted advertising. While WPP only created a central technology team in 2019, S4 Capital has put a tech-first approach at the centre of its strategy from the beginning.  

The digital Darwinism in advertising

But this year the advertising market has not been a forgiving one. The industry has struggled as corporate clients prioritised core spending over discretionary expenditure such as marketing. Traditional advertisers have suffered the most: Omnicom’s (US:OMC) revenues dropped 12 per cent in the last quarter, while Interpublic Group (US:IPG) reported a 5 per cent fall. WPP’s shares are down 28 per cent in the year to date, with its top line down 5 per cent in the three months to September. 

Yet some research suggests that, overall, the market was hit harder by the 2008 financial crisis than by the 2020 pandemic. GroupM, WPP’s media buying agency, and Magna, part of IPG Mediabrands, have pointed to a rebound in 2021, although they both expect traditional media to quickly lose ground to digital advertisers. 

Investors should bear in mind that any advertising group, including S4 Capital, is sensitive to economic ebbs and flows. But data on consumer spending also suggests that there is a recovery on the horizon. Research from Barclaycard shows that while spending fell 0.1 per cent in October year on year, online consumption grew by 11 per cent. Assuming a vaccine-based return to normality in 2021, it follows that there should be a rebound in advertising spending and further growth in the digital market, especially if consumers’ move to online shopping sticks.

This is good news for companies that have tech-oriented methods of operating, as well as tech-based clients. Indeed, S4 Capital says that clients that operate in the technology sector contribute around half of the company’s gross profit. S4 counts deep-pocketed customers such as Google parent Alphabet (US:GOOGL) and Facebook (US:FB) among its top clients. As such, it is perhaps not surprising that the group’s share price has detached from the trajectory of the rest of the UK’s media sector this year: its shares are up 165 per cent in the year to date and have more than doubled since we suggested buying the shares in May.

The stellar performance of tech companies this year means that the coronavirus will probably not have affected most of S4’s client base’s ability to spend. And its customer count is growing rapidly, especially so-called “whoppers”, customers that bring in at least $20m (£15m) in revenue, of which the group secured three in the three months ended in September. The company has recently developed a 20-squared client objective, which is to develop twenty $20m “whopper” clients each year.

Of course, not all of the group’s clients will have emerged from 2020 unscathed: some will still be realigning their budgets, particularly those in hard-hit sectors such as travel and retail. This may affect the company’s ability to get customers to pay up. It has noted that it is watching trade receivables (unpaid bills) “like a hawk” as some clients try to extend payment terms. Trade receivables represented 23 per cent of pro-forma billings at the year-end (revenue plus pass-through costs) and 44 per cent of pro-forma revenue. While the majority of receivables are either not past their due date or are still within the one- to 30-day excess period, given the economic backdrop this does represent a risk and a relatively small number of clients make up a significant part of its debtors.

Growth at a cost 

Management has said that it aims to double both its top and bottom line organically as a key objective of its three-year plan for 2021 to 2023. This was also the aim of its original three-year plan from 2018 to 2021, which it looks set to achieve. We view the chance of S4 repeating the success as good given its robust trading this year, and its high-growth market on the brink of a recovery. But much of S4’s rapid growth has also been the result of acquisitions – Sir Martin, true to past form at WPP, has been acquiring left, right and centre.

Despite merger cash payments in the third quarter of around £19m, net cash still averaged around £87m, up from around £13m in the first half, thanks to an equity issue at 315p a share in July that raised £113m of net cash proceeds. S4’s ability to raise fresh money has kept it operating well within its means in terms of debt, with more than £100m to spare before it reaches its maximum target net debt to Ebitda (cash profit) multiple of between 1.5 and 2.

Return on capital employed, which measures how effectively profit is generated from investments made into the business, does sit at a lowly 1.5 per cent in 2019. However, this is not unusual for a company that is recently off the blocks and growing so fast. Consensus forecasts give sales growth of 62 per cent this year, followed by 43 per cent the year after. Meanwhile, strong trading and new deals have led to frequent forecast upgrades over the past 12 months.

In S4 Capital, Sir Martin appears to be creating a beast that is similar to WPP, but with a more modern edge. There are risks associated with integrating and funding the deals, but we think that there is a high-quality operation being built here. With a 2021 forward price/earnings multiple of 58, S4’s growth does not come cheap. But rapid growth means it is worth looking further into the future, with progress likely to continue to outstrip forecasts, especially given the potential for further deals. The group has strong momentum behind it, a smart data-first approach and is targeting a rapidly growing market. That is on top of a tangible recovery in the wider advertising industry next year, as well as the secular digital transformation progress across the market in 2020. As the group now sets its sights on its next three-year plan, there is still time to get in on S4’s digital growth.