Technology consultancy SMS Management & Technology Limited (ASX: SMX) has finally stemmed its earnings decline after management posted what can only be described as a solid full year result.
SMS will be re-rated by the market and I believe we will see analysts upgrading the stock on the back of the profit announcement, which has sent the stock surging 11% in early trade to a 10-month high of $4.05.
But it wasn't so much the 34% surge in net profit to $17 million for the year ended June 30, 2015 that is exciting investors. If anything, the number was slightly below consensus estimates.
It's not profit but margins that will be the foundation for the re-rating, which is when the market removes some of the discount on the stock valuation due to a lower-than-expected risk assessment of the business.
One of the biggest reasons why investors have shunned the stock in recent times is because of fears that SMS' traditional business of providing pay-by-the-hour consultants is facing structural challenges.
Government and business clients are moving toward flat-rate projects and managed services where clients pay a monthly fee to gain access to IT services from a third party provider instead of paying large upfront capital costs to build their own capabilities.
SMS is a relative newcomer to the managed services space and many analysts assumed that the company's operating margin will continue to decline for a number of years based on the structural headwinds.
So the real surprise in SMS' result is the 200 basis point (two percentage point) increase in earnings before interest, depreciation and amortisation (EBITDA) margin for its core consulting division to 14.8% in 2014-15 compared with the previous financial year.
This trend towards paying regular but smaller fees for services is very much alive but management should be commended for steering the company through a challenging patch with SMS better positioned to capitalise on the market trend towards replacing capital spend with operational expenditure.
What's more, SMS's total revenue jumped 13% to a record $356.2 million when analysts polled on Reuters were only expecting a figure of $350.9 million.
The 2014-15 result breaks a two-year downtrend in the company's earnings and we are likely to see analysts upgrade their 6% net profit growth assumption for the current financial year on the back of SMS' expanding margin and upbeat outlook.
Management said that strong demand for its services from all sectors such as financial services and government is underpinning a pick-up in billable utilisation rates and that project margins have stablised.
However, the sharp run-up in the share price today puts the stock close to what I consider fair value. There might be another 10% upside to its share price but the stock can't be considered a bargain.
