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Is this promising IT small-cap a buy?

Empired Ltd (ASX: EPD) is an IT services company that provides outsourced solutions to large enterprises alongside selling its own proprietary cloud based products.

Historically, IT services has been a cyclical industry with companies reducing spend on IT when the economy is weak. Whilst this is still the case today, the trend towards outsourcing organisational IT functions is providing more defensive revenues for companies like Empired.

To date the company has largely grown by acquiring other IT businesses and recent contract awards appear to validate this strategy. Only companies of sufficient scale and providing a variety of services are able to compete for major contracts with large clients. Empired now satisfies these conditions thanks to a series of sizeable takeovers, and consequently has started to win large multi-year deals.

The company is likely to achieve its revenue guidance for the 2016 financial year of $145 to $165 million, given it was recently awarded new contracts worth in excess of $32 million. Empired also has an aspirational earnings before interest, tax, depreciation and amortisation (EBITDA) margin target of 12.5%. Therefore, the company will report earnings of more than $10 million in 2016 if it reaches these goals.

The current market capitalisation of Empired is $93 million and so should everything go according to plan, the stock is trading cheaply with a forward price to earnings ratio of under 10. It should be noted that it carries around $12 million of net debt and is required to pay out $13 million over the next few years for businesses it has already acquired.

However, Empired’s financial history is poor and in the first half of 2015, it delivered operating cash outflows of $3.7 million and underlying profit of just $1.7 million on $50.5 million of revenue. EBITDA was $3.9 million and so EBITDA margin was 7.7%, well short of the company’s 12.5% long-term objective.

I think that Empired will always struggle to achieve 12.5% margins because it has powerful customers and suppliers. The likes of Microsoft, Rio Tinto and Toyota hold the balance of power in their relationships with Empired, and therefore could squeeze them on price. These multi-nationals know that there are many other willing IT consultancies in Australia that would be more than happy to work with them.

On the other hand, through providing a quality service, perhaps Empired can extend the scope of existing agreements and differentiate itself from the competition.

Foolish takeaway

I believe that Empired will meet its forecast revenue in 2016 and recent contract wins suggest that the business can continue to grow further into the future. The issue is how much of that revenue will be translated into profit and this is what is holding back the share price today. If there is any indication that the company is on track with its profit margins, then the stock will rerate significantly.

Clearly, buying shares in Empired is something of a gamble, albeit one with a favourable risk reward profile. This is the reality with most small-caps and it is the reason why they are unsuitable for those with a low tolerance for risk and volatility.

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Motley Fool contributor Matt Brazier has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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