S4 Capital: When Knights Cry

Rules are made to be broken. While I have generally followed a practice of backing away slowly from any company mentioning AI or TAM in recent times, this week I bought shares in a “tech-led, new age/new era digital advertising, marketing and technology services company” at a highly depressed valuation.

While the tech sector and its tie-ins haven’t been the place to find value lately, S4 Capital has declined to an attractive price through a combination of industry cyclicality, operational mis-steps and a UK listing.

The stock is down an astonishing 95% from its heady, post-covid days to the point of trading for less than a quarter of the capital invested since its founding. Put another way, the funds needed to replicate the business today would be far greater than S4’s current enterprise value, without ascribing any value to the company’s reasonable future prospects.

Brief Background

The company was founded in 2018 by Sir Martin Sorrell, who built up WPP in the eighties and was the longest serving FTSE 100 CEO at its helm, until his acrimonious exit under allegations of bullying and misuse of company funds. Nothing was proven, but Sorrell wasn’t one to fade quietly into the sunset, saying he wasn’t ready to retire and “had a point to prove” over the founding of S4.

The comeback tour had been going nicely, as IT marketing capex ramped in the covid aftermath. His new company seemed perfectly positioned to reap the rewards, but 2022 saw big tech embrace a new religion of frugality and unleashed an unexpected cyclical trough in digital marketing, despite what should remain an excellent long-term story.

The company has grown largely by a string of acquisitions over its lifetime. Some of these were likely too expensive, but by positioning itself as a digital-only firm, S4 can remain nimble and target the growing segments of the ad market. Accordingly, S4 and WPP both achieved around £130k revenue per employee in 2023, despite WPP having nearly 15x the scale.

It is also of benefit that S4 doesn’t need to manage a traditional marketing division facing genuine headwinds, as many of its larger competitors must. Further, the company can offer data analytics and AI transformation services as specialities in its suite.

As can be seen below, the tech sector is very meaningful but industry diversification does exist. Similarly, operations are broadening to the point where S4’s six largest clients now make up 39% of revenues and should continue to spread. These major clients being the large tech platforms, although some are protected from confirmation by NDAs.

Source: S4 Filings

The global digital ad market is currently estimated at $700b annually and although this is dominated by these mega platforms, there is still ample room for a smaller niche business to grow.

It’s cheap

To really get a handle on how far S4 has fallen, consider that at its peak 2021 market cap of £5b the business was trading at 14.5x its 2020 sales of £343m. Today that valuation is .23x 2023’s £1b. It’s a humbling game when your revenues triple and the market rewards you by re-rating your multiple down 98%.

I have made an effort to avoid levered EBITDA stories after their inducing numerous heart palpitations over the years, but there is a simple case to be made here. Sorrell himself put the case forward in a recent interview which I would encourage anyone doing background on the company to take in.

His back-of-the-envelope method assumes S4 should be a 10x EBITDA business in normal times, so multiplies this by their £100m of EBITDA for an EV of £1b, then subtracts £200m* of debt for an £800 market cap.

He further expands that the company should rightly be a 20% EBITDA margin business and the company is working steadfastly towards this as a goal- which would potentially give £200m of EBITDA, multiplied by 10x for a £2b EV and subtract debt again for a £1.8b market cap. Obviously these numbers are tantalising- a 3.5-8x on re-rating alone. Imagine if the company could return to growth.

Of course, this is far from assured and the market is passing judgement that S4 is a failed experiment, now in structural decline and without any terminal value. This future can’t be ruled out, although I judge it as relatively unlikely. While the company is expected to reach profitability next year, it is still consuming cash and very vulnerable to further industry challenges. Debt is currently at the high end of management’s goal band and it will be telling to see if they can halt its rise without issuing shares.

The company is working overtime to cut costs and is guiding to match 2023’s EBITDA despite lower revenues, reflecting this lower cost base. Additionally, head count has been reduced by 13% over the last year.

Psychologically, the share register has also seen a multi-year turnover from blue-sky, growth investors towards value-oriented owners- a process that is hopefully closer to its end than start.

Insurance

Despite the current distaste for S4 shares, the private markets still see the company for the bargain it likely is. Against the current share price of 37p, global marketing firm Stagwell made a takeover offer of 95p per share in March. Despite being a 150% premium, Sorrell later referred to the offer as “nothing credible”- either a huge vote of confidence in the company or an enormous act of stubborness… possibly both.

So on the one hand you have the knowledge that private buyers would pay a multi-bagger premium for your shares tomorrow if allowed. But on the other, a controlling shareholder with a significant sunk cost, who would only be interested at a much higher price. Personally, I’m quite a patient owner of most companies so am happy to let it play out and know the value is there.

As mentioned above, it wasn’t the leveraged shitco angle that got me over the line in the end. It was a lot of thought about whether a deep discount to book value means anything with such an asset-light, goodwill-heavy company.

Could you recreate S4 Capital and its £1b in annual revenue if you had £230m in cash to burn and were prepared to borrow a further £200m? I believe the answer is clearly no. Not even close, which ties back in to why acquirers will likely remain very interested around current prices.

Conclusion

For the rationales listed above, I have opened a position in S4 Capital close to all time lows.

The market has been wetting the bed in anticipation of a trading update to be released tomorrow. This is probably reasonable as they have been consistently bad in recent times, but I’m hopeful that the worst is long priced in.

While the downside is a possible zero or major dilution, the potential multi-bagger upside and likely cyclical recovery make the company a highly mispriced bet at current levels.

If you found this idea interesting, please pass it on. I’m always keen for feedback, especially when I’m outside my comfort zone.

Thanks for reading,

Guy

*Net debt is actually only £183m as of H1 2024

As always, this isn't investment advice. Please do your own due diligence and seek professional advice if you're unsure about your finances.