With a low price to earnings ratio, a high trailing dividend yield, no debt, strong free cash flow and plenty of cash, it's hard to go past DWS Ltd (ASX: DWS) for a good value income proposition. The company provides IT consulting services, and saw a heavy drop in reported profit for the first half of 2014. In my head, the company is called Danny Wallis Services after the founder, former CEO and major shareholder. I've actually spoken to a number of his employees over the years, and the impression I get is that while the expansion to Sydney has not gone very well, the core business in Melbourne is still busy. One clue that things might not be as bad as they appear is the strong operating cashflow. With no debt and a cash kitty of $16 million, the company can continue to pay a fat dividend yield of 9.1%, if that's Mr Wallis' desire.
In general, the entire IT consulting industry is having a tough time at the moment. Aside from DWS, the main IT services companies in Australia are SMS Management & Technology Limited (ASX: SMX), UXC Limited (ASX: UXC), Oakton Limited (ASX: OKN) Data#3 Limited (ASX: DTL), Empired Ltd (ASX: EPD) and RXP Services Ltd (ASX: RXP). The latter two are smaller, growing companies, whereas the other four are more established companies that have seen their profits decline as work dries up and the companies struggle with an expensive workforce. The chart below shows how the IT companies' share prices have fared in the last 12 months.
Data#3 has performed the worst, because more so than the other companies, its business is dependent on sales of hardware. The continual move towards the cloud will only hurt this company, and although it may be decent value at current levels, I have no taste for riding on melting icebergs. As you can see DWS, UXC and SMS have also seen their share-prices drop by over 20%. Of these companies, DWS is about a third smaller than the other two. I think this is advantageous because the bigger an ICT firm is, the harder it suffers when there is a cyclical downturn.
Because it is semi-discretionary, IT spend is generally cyclical. This occurs because companies have to keep upgrading their systems to improve efficiencies as software and hardware options change. The move to the cloud requires the assistance of IT professionals for most big companies. Think of all the data that needs to be migrated from existing servers! However, when times are a bit tough companies and governments alike will delay IT spending because they can (if they can). Arguably, the market for IT services has been a bit soft since the GFC, with companies delaying or minimising IT spend. However, companies that haven't had a major upgrade since 2007 will already be overdue by 2014.
The main problem for DWS is that it recently lost a major contract. At the AGM last year Mr Wallis said, "Over the past four years DWS has successfully diversified in client base and currently approximately 8% of our consultants are assigned to Telstra. Whilst our preference would have been to be successful with the Telstra RFP we will work hard to continue to diversify our client base and redeploy any affected consultants." The impact of this loss is yet to be fully felt, and if the company is unable to reassign its consultants, expect profit, dividend (and probably the share price) to continue to fall. This is probably the reason the shares have plunged, and potential shareholders should meditate on this risk. My feeling is that even if the company does take a big hit, it will recover either by finding new business or letting people go (or both). While the dividend yield is likely to be lower than 9.1% in the year ahead, I think a yield of 6-7% is very achievable and quite likely.
Foolish takeaway
Morningstar has recently moved DWS from "hold" to "accumulate," and in this instance, I think they are right. I'm hesitant to even write about the company, as trading rules prohibit me from buying shares for a few days afterwards. At current levels I'm of the belief that DWS is a clear value proposition with a whopping dividend yield. While long-term growth prospects are not great (in my opinion), the company looks cheap in comparison to its peers, and on the balance of probabilities, I think it is significantly undervalued.
