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Should income investors buy this 7% yielding small cap?

The share price of information technology services company DWS Ltd (ASX: DWS) has risen 5.34% to $1.38 following the release of its full year result on Monday. The company’s share price has rallied despite delivering an underwhelming annual result. For the period ended 30 June 2018, revenue from continuing operations fell 8.3% to $126.1 million with reported earnings before interest, tax, depreciation and amortisation (EBITDA) declining 13.1% to $22.8 million.

What happened?

The fall in operating revenue was attributed to a decline in daily chargeable rates at a major client that was partially offset by the growth in consultants from 596 to 704 at the end of June. Gross margin decreased from 33.8% to 31.9% due to the reduction in revenue being larger than the fall in operating expenses.

After adjusting for the $1.9 million write back from the Symplicit earn-out provision, the company’s underlying performance for the year was weaker with underlying EBITDA of $20.9 million.

Earnings per share decreased by 8.3% to 12.1 cents which prices the company at a valuation multiple of around 11 times trailing earnings. A fully franked final dividend of 5.0 cents per share was announced, bringing the annual dividend to 10.0 cents per share fully franked.

Foolish takeaway

Whilst the 7.25% dividend yield of DWS is attractive for income investors, it’s difficult to ignore the underperformance of the underlying business and the highly competitive trading conditions in the IT services sector. Fellow IT services company RXP Services Ltd (ASX: RXP) reported a decline in net profit for FY18 this morning and the larger Data#3 Limited (ASX: DTL) has also endured a difficult 2018.

DWS continues to acquire other IT businesses to offset the lack of organic growth in its underlying business. Subsequent to year end, DWS acquired Canberra-based Strategic Management and IT Consulting business, Projects Assured.

Effective 2 July 2018, the strategic rationale behind the purchase was to diversify DWS’s group earnings by increasing its exposure to Federal Government clients with FY19 revenue projections of approximately $35 million to $40 million. The acquisition is expected to boost earnings per share in excess of 3.5 cents after funding costs.

Despite the high yield, the lack of organic growth in the underlying business is the main reason why I am not a buyer of DWS at today’s prices. Time will also tell whether the Projects Assured acquisition can deliver a material boost to future earnings. In the meantime, income oriented investors may want to consider this dividend stock.

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Motley Fool contributor Tim Katavic has no financial interest in any company mentioned. The Motley Fool Australia has recommended Data#3 Ltd. 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 Scott Phillips.

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