Description

S4 Capital | 320p 2024 PT (70% Upside) 

£1.06b Market Cap | £1.22b Enterprise Value | £3.5mm ADV

Investment Thesis:

• S4 Capital is a digital advertisement agency and technology services business poised to benefit from its differentiated business model in a high growth segment (digital ads) where it should continue to win new business and take market share from disjointed, traditional advertisement holding companies. The opportunity to own S4 exists largely due to operational and financial missteps, including an audit delay in March 2022 and a profit warning in July 2022 due to the poor management of expenses. Through our research, we have sufficient confidence that S4’s financial/audit issues are behind them, and operational tune ups have been made to better manage the business going forward, with both of these issues stemming from the breakneck speed of M&A over the last 4 years. Now with less focus on M&A, S4 can tighten up the business and grow organically until M&A can resume. No deals will be done unless the equity component (deals are 50/50 equity/cash) is struck at 425p – the pre-audit delay price of the shares.
• S4’s offering is fundamentally different than the traditional holding companies (WPP, Omnicom, and others). S4 operates a purely digital strategy on a single-P&L basis, meaning the global staff base is mobilized to tackle client engagements rather than the disjointed multi-P&L traditional model. S4’s three business segments – Content, Data & Digital Media (DDM), and Tech Services (TS) – each stand differentiated to peers to varying degrees. We find the non-Content segments (1/3 of revenue today) to be particularly advantageous in that they are less levered to advertising cycles and present compelling cross-sell opportunities to clients to enhance their work with the Content practice, specifically using data and software to drive enhanced ROI of ad spending and restructuring clients’ data systems to better manage marketing efforts.
• The business is not very levered (1.25X net debt to adjusted EBITDA on our estimates for FY22) and has strong FCF generation potential for 2023, 2024, and beyond.
• We believe the shares present a highly attractive risk adjusted return driven by near-term catalysts. In our base case, we model a 320p stock in 2024, representing a two-year IRR of 31%.
• Upside beyond that price exists, especially if the shares can appreciate into the 425p range allowing S4 to restart its M&A engine. Owning the equity in the midst of the rebuilding and cleanup stage would offer very attractive returns that would get further enhanced by the ability to resume M&A, as it would contribute to growth and some investors owned S4 because of its M&A capabilities.

Business Model

• S4 Capital operates a pure-play digital advertisement business across three segments. Its Content practice (68% of revenue) produces content of all forms – from banner ads to video game demos to mobile apps to short-form video – and manages campaigns and social accounts. The DDM practice (21% of revenue) is a tech business that utilizes a vast data repository with software and other analytics tools to drive more effective campaign implementations. This segment also includes a growing in-housing business where S4 employees work full-time onsite with clients to help them transition elements of the data and analytics ad management side away from third-party providers to the detriment of the traditional holding companies. The Tech Services segment is smallest (11% of revenue) but growing quickly and includes specialized engineering and systems design engagements often directed at full or partial digital transformation efforts. This engineering-heavy segment is a highly differentiated offering for S4 and drives multiple synergies with DDM, which also benefits Content.

Sources of Competitive Advantages

• Pure Digital and One P&L: Being a purely digital player is advantageous to S4 because clients know there is no other ad agency at S4’s scale that has this focus and expertise. Further, a single-P&L model means different offices and practice groups do not compete with one another internally to drive business, which is how the traditional holding companies operate.
• Faster, Better, Cheaper: This is S4’s motto. Speed to market matters immensely in this world, and S4 consistently provides quick deliverables. Being better means driving higher ROI on ad spend, which affects all three of S4’s segments. S4 often gets a single engagement with a prospective client by offering to materially improve ad efficiency, and S4’s history of doing this better than peers has won them a lot of business. Cheaper is always better for clients. Because S4 does not operate on an FTE-billed basis, it offers faster and better services at a lower price in most cases.
• Digital M&A Focus: S4 has won over acquired companies also bid on by the traditional agencies due to its startup culture, digital focus, and opportunities for growth. We believe this will continue to support M&A efforts when they resume.
• MightyHive (DDM): The DDM business is the crown jewel of S4’s offering. Within it, S4 holds the keys to an industry-leading data repository seated next to experts who can drive higher ROI ad spending on tech platforms like Google, Meta, Amazon, and others. This segment enhances the Content offerings and also operates very well standalone. Given hiring freezes at Big Tech, this and the Content segment also are gaining good contracts for outsourced work.
• Diversification Away from Content: While Content is a robust and well-growing business, it is more levered to cyclical ad budgets than DDM and Tech Services. Recent acquisitions benefit these two segments and have much whitespace to capture across existing and prospective clients. This insulates S4 more than a traditional agency as the revenue mix is more durable.
• Management: Sir Martin and other key executives have been in the industry for decades, often leveraging longstanding relationships to win big business. Sir Martin has pulled in multiple whopper clients who were former clients of his at WPP in the last two years. Further, new CFO leadership began in January of this year, and Mary Basterfield has been instrumental in redesigning and hiring the corporate finance, accounting, and internal audit teams.

Management Incentives / Insider Ownership

• Sir Martin Sorrell (Founder and CEO) owns 10.3% of the company and has a single voting B share giving him control over management hires and changes in control.
• Other management owns an additional 18.6%, and directors own another 8.4%. Including the earnout shares and other equity holdings of employees, the total company ownership of the shares is around 40%.
• Management is compensated heavily on performance with equity awards based 70% on Like-for-Like Revenue growth and EBITDA margin and 30% on ESG goals. While we would prefer greater weight on financial metrics, we feel the goals set in the past have been strong and believe management is properly incentivized.

Key Investment Risks

• Central operations, until this year, have been lacking. So much so that a material profit warning and guidance revision was issued for FY22 in July. The company has remedied many of those issues but executing on new plans will be paramount to success.
• Accounting and finance issues at the practice levels and central level led to the audit delay. Those issues are behind them, we believe, but keeping a keen eye on any weaknesses here will be critical.
• Ad cyclicality and macro exposure: advertising budgets are expected to be flat in 2023, with digital still growing 10%. However, a worse macro environment could shift these figures to -5% and 5%. This would limit S4’s ability to grow as fast as expected. S4 has outpaced the growth of the digital ad platforms (Google, Meta, Amazon, etc.) each year, but S4 is still a cyclical business subject to these risks.
• Related to central operations is the risk of expense management. If S4 finds itself over-hired once again, it would drag profitability and FCF and fall short of our expectations. Keeping a consistent dialogue with management can provide color.

Primary Research

• Former Senior Sales Director at MightyHive: “Because the Content practice was built with a digital mindset, it does a lot of dynamic testing for iterative ads to specific consumers. Utilizing the DDM data and software, S4 drives materially more effective campaigns.”
• Former Lead of Partnerships at Google (Customer): “S4 is often selling against legacy holding companies, who are slow to move and operate with dozens of independent companies. S4’s purely digital approach and the data/software side in MightyHive give it plenty of opportunity to take market share.”
• Former Controller at MediaMonks: “The growth weighed on an understaffed accounting department. The steps to remedy the issues would be relatively simple – hiring more people, new CFO leadership at Content, and better internal controls.” (All steps that S4 has now taken.)
• We also have spoken to management multiple times since initiating the position.

Valuation and Returns Expectations

• We believe the business is temporarily depressed due to the audit issue and the profit warning, which highlighted more operational weaknesses in matching additional expenses (headcount primarily) to revenue. Put simply, investors have lost some faith in the management team – not without reason. However, the opportunity to acquire shares at depressed multiples should not exist for long given the 2022 FY results, which should come with a clean audit, will occur in early 2023. We believe the shares will naturally rerate higher as the company reports well-managed quarters and publishes audited results.
• The shares trade at 11.0X 2023 EPS and 8.8X 2024 EPS as well as 11.8X FCF per share in 2023 and 9.7X in 2024 (accounting for dilution). On a TEV basis, S4 trades at 7.2X 2023 EBITDA and 5.45X 2024. This business trades at comparable multiples to the traditional holding companies (WPP, Omnicom, IPG, Publicis, etc.) despite focusing purely on digital ads, running a more streamlined organizational structure, and growing much faster. We believe this primarily exists due to the operational mistakes made in 2021/2022 and not due to any deterioration in the future earnings capacity of the business.
• We model out 15% topline growth in 2023 and 23% in 2024, figures that should prove achievable. Without walking through each line item in the model, just know we are moderately conservative in our assumptions.
• FCF Valuation: We believe this business should trade at no more than a 6% FCF yield given the growth characteristics. If we apply a 6% yield to our 2023 FCF/share, this results in a 256p share price. Using the same yield on 2024 estimates, this results in a 309p share price. These present 36% and 28% one and two-year IRRs respectively.
• EPS Valuation: This business should trade at mid-to-high teens even in a slower growth environment. Using a 16X multiple on EPS for 2023 and 24, this results in prices of 257p and 320p. These present 37% and 31% one and two-year IRRs respectively.
• EBITDA Valuation: Using an EV/EBITDA multiple of 10.5X 2023 and 10.0X 2024, this results in share prices of 270p and 346p. These present 43% and 36% one and two-year IRRs respectively.
• Looking to downside scenarios, we consider scenarios in which the company were to miss our estimates on FCF by 25% in 2023 and 2024 due to less growth, less conversion, etc. If instead of 17X FCF/share we apply a 12X multiple (which would be quite low for a business of this nature) to our discounted estimates, you would see downside risk to 135p in 2023 and 163 in 2024, resulting in total losses of 28% and 13% respectively.
• The downside figures above would result from less growth opportunities or poor execution by management. There could be much more significant downside should the company delay an audit, issue another profit warning stemming from poor management of expenses, or any other operational missteps. As mentioned, we assess this as a low risk.

Catalyst

• The 2022 FY results will likely be shared in late February or early March. We have confidence that audit issues are behind them and publishing a clean audit letter on time will help instill broader investor confidence in the business.
• Each sequential quarter update helps restore investor confidence. While there has not been high existing shareholder turnover despite the issues, it has certainly held back new investors from engaging with the company. We believe this will result in incremental re-ratings as this overhang abates.
• The 2023 FY guide will occur alongside the 2022 annual report announcement. We believe there may be incremental upside of 200-400bps of topline growth in the guide above our estimates.