SinnerSchrader — Update 11 February 2016

SinnerSchrader (SZZ) is Germany’s leading independent digital agency, offering a range of solutions to support its clients’ online strategies. Services include strategy consulting, e-commerce platform solutions and marketing and communication services. It has a strong technology franchise and, by offering an integrated approach to online sales and marketing, has carved out a leading position in a very competitive market, servicing high-profile clients including Allianz, BMW, Deutsche Bank, Telefonica and Unitymedia KabelBW. Until 2015, it was also investing in the development of a data management platform (Next Audience, NA). However, following disappointing commercial take-up, management is withdrawing from this activity and SZZ is now focused on its core agency business, which has been the engine of the group’s strong revenue growth over the last five years.

While the market can be volatile (net revenues grew 34% in FY14, and decreased 2% in FY15), investment in digital transformation projects continues to be prioritised by companies. SZZ is well positioned and we expect trend growth of c 7-10% over the next few years. In the past, margins have not always progressed in line with revenues. However, the closure of loss-making NA should crystallise an immediate 3pp increase in EBITA margins and, with efforts to reduce the reliance on freelancers, some encouraging interest in the higher-margin Content Marketing services and the benefit of better visibility given a stronger order book (Q1 order book was double that of the previous year), we see scope for sustained margin improvement. Evidence of this has already been seen in recent quarters’ results, and we believe that over time EBITA margins can trend back up from the 4.4% reported in FY15 to historic rates of approximately 13%. Despite final losses for NA edging up in H116 and a slightly higher assumed tax rate, given the stronger underlying margin performance in recent quarters, we are increasing our adjusted and reported EPS forecasts in FY16 and FY17 and introduce an FY18 EPS, driving a forecast EPS CAGR to FY18 of 12%.

On an annualised FY16e EV/EBITA of c 7.2x and a P/E of c 12.6x, SZZ is being priced as a low-margin business at a 30% discount to peers. However, with NA out of the frame, EBITA margins this year should be comparable to its digital agency peers, with scope for further expansion in the forecast period. The sector has also been humming with corporate activity, and as the last remaining digital agency listed in Germany, the current low valuation may attract wider interest. Using the 13x FY15 EV/EBITA multiple paid by WPP for Syzygy points to a valuation approximately 80% above the current share price.

Key sensitivities: a change in sentiment regarding the outlook for German GDP could affect forecasts. Furthermore, with a fairly concentrated client base, any significant account wins or losses could move the dial materially. As a people business, SZZ’s ability to attract and retain high-quality staff is integral to effective project management and employee productivity.

SinnerSchrader (SZZ) is a professional services agency specialising in e-commerce, digital marketing and communication services. It is one of the largest independent ‘all service’ digital agency groups in Germany and the largest in e-commerce. Clients span a range of sectors and include high-profile, blue-chip companies such as BMW, Becks, Comdirect, Deutsche Bank, Karstadt, Telefonica, TuiFly, Unitymedia KabelBW and Volkswagen. Although the group services international clients, the majority of revenues originate in Germany. It employs more than 500 people across its offices in Hamburg (headquarters), Frankfurt, Munich, Berlin, Hannover and Prague.

SZZ has a small but longstanding executive management team. Matthias Schrader co-founded SZZ with Oliver Sinner in 1996 and has been the sole CEO since 2002. He holds 21% of the shares in the company. Thomas Dyckhoff, finance director, joined in 1999 before the group’s listing in the same year.

SZZ’s roots are as an e-commerce platform development business, designing, building and managing online shops. As the e-commerce sector developed, recognising the need to offer a more integrated approach to digital sales and marketing, SZZ has leveraged its strong technology franchise and diversified into a broad-based digital agency. Driven by a combination of strong organic growth and some small bolt-on acquisitions (the most recent being the acquisition of Swipe Mobile for €0.9m in 2015), the SinnerSchrader agency now represents the majority of group revenues and earnings. Over the last few years, it was also investing in the development of its NA data management platform (DMP) for advertisers. This was launched in in August 2014, but as it failed to generate the interest the group had expected, management took the decision during 2015 to close this loss-making unit. It is anticipated that this will be completed by March 2016. Management is now focused on the agency divisions, areas where it has an established track record in servicing large customers.

Across its three reporting divisions, SZZ offers a broad range of services:

Interactive Marketing (79% of FY16e revenues, 83% FY16e EBITDA) has been the engine of SZZ’s strong growth. It includes the activities of its largest agency – the SinnerSchrader Agency – which generates the majority of revenues, but also those of its mobile agency and the support activities in Prague. The division focuses on digital transformation projects for larger enterprises (with annual revenues above €500m) and key service offerings include:

Interactive Commerce (15% of FY16e revenues, 5% FY16e EBITDA) houses the activities of Commerce Plus, which targets smaller and medium-sized companies (with turnover between €200m and €500m) with a range of services offered by the Sinner Schrader agency but with a focus on e-commerce activities. In addition, it offers e-commerce outsourcing services, for instance establishing and managing online sales channels including logistics, payment processing, hosting and shop management.

Commerce Plus has struggled in recent years to expand, or to bring margins up to that of the larger agency. This is mainly owing to one of its largest clients incrementally moving business in house (a process that started in 2012).

Interactive Media (6% of FY16e revenues, 12% FY16e EBITDA). As outlined above, the NA platform is being wound down and, from the second half of FY16, this division will solely reflect SZZ’s content marketing activities. Content Marketing involves planning, drafting and implementing marketing strategies based on editorial content funded by brands (brand-funded content).

It is a fairly new activity for SZZ, launched in 2014 when it formed a relationship with E-Plus to develop and run a pilot project on the latter’s behalf, Curved.de, a news editorial targeted at consumers interested in getting the most out of their smartphones. Curved.de has generated good audiences for Telefonica (2.8m visits in January 2016, up from 1.2m in February 2015), and the project has been renewed and extended beyond the initial pilot. While this is a fairly nascent market, the success of Curved.de has generated considerable interest from other brands, and management plans to invest in developing this division further.

E-commerce is already a way of life in Germany. The German e-commerce sector has grown at a CAGR of 21% over the last five years and was worth €47bn in 2015 (bevh1), approximately 9% of total retail sales. While e-commerce is already at the forefront of most B2C companies’ sales strategies, the market is far from mature and investment in digital transformation projects continues to be prioritised by companies. According to an Ernst & Young study in March 2015, €41bn was invested in projects of this genre in 2014 and 85% of German companies expected digital technologies to become more important to their business models over the next five years. Having a simple shop front is no longer sufficient – to remain current, companies need to adjust their online strategies to differentiate themselves, adapt to new technologies and to capture new opportunities. A few of the trends driving investment in digital transformation projects include:

While clearly a structural growth segment, there remains a considerable cyclical influence. Companies tend only to invest in ‘transformation’ projects in periods of stable or rising business confidence (Exhibits 4 and 5). The economic outlook in Germany is somewhat mixed at the moment; while there are pressure points (exports slowing as a result of weaker demand from emerging markets), the German government is forecasting solid real GDP growth of 1.7% in 2016 – broadly similar to 2015, propped up by domestic consumption.

The digital agency market is fragmented and very competitive. The BVDW (a German organisation that ranks digital agencies) registers almost 30 companies with annual revenues over €10m in 2014. In Germany, SZZ ranks first among the independent companies in e-commerce revenues. Targeting the digital transformation budgets at larger companies, it competes predominantly with the international digital agencies, most of which are now part of the international advertising networks, for instance Sapient, Razorfish (both Publicis), AKQA and Syzygy (both WPP) and, increasingly, against the digital arms of Accenture, IBM, and Deloitte. At Commerce Plus, it competes against the mid-sized enterprises such as DMC or Planet (Hmmh).

The level of technical expertise required to launch a digital marketing strategy is increasing as companies look to harness more customer data across multiple platforms. This has, to an extent, led to a blurring of the roles of the chief marketing officer (CMO) and the chief technical officer (CTO) and, in response, of the line between traditional system integrators and agencies. This need to offer a hybrid solution has prompted a wave of consolidation over the last few years in the professional services market. The media agencies have been prolific in this area for some time (WPP via Acceleration, Salmon and Cognifide, IPG through firms like MRM, Huge and Genuine Interactive). However, the systems integrators are also increasingly active: in 2013, IBM announced its intention to hire 1,000 creative people in the US and recently announced its intention to buy digital creative agency Aperto (Berlin) and Resource/Ammirati (US); Accenture has formed Accenture Digital following the acquisitions of Acquity Group and its 2013 acquisition of the digital and services design agency Fjord; and SAP in 2014 acquired Hybris, a developer and vendor of
e-commerce platform technology, and the list goes on.

SZZ has always differentiated itself by performing this hybrid role, bringing together both technical capabilities and creative communication excellence to offer an integrated approach to online sales and marketing. With 20 years in operation, it is regarded as a reliable partner to its clients, a number of which have been with SZZ for more than 10 years (eg Comdirect, Deutsche Bank, Görtz, Tchibo, Telefonica (Simyo), TuiFly and Unitymedia KabelBW).

Each account team has a client services director, a creative director and a technical director, each of whom is partially rewarded based on the success of client relationships. This helps to instil a results-focused attitude in what are often contradictory roles (creative vs technical). This integrated approach sets SZZ apart from other independent digital agencies, which tend to have either a communication/media focus (Syzygy, Plan.net) or a technical/platform focus (Hmmh, DMC). That said, SZZ sees itself as a technology company first and is reputed for its technological ability and innovation. This is reflected in the make-up of its employees, c 40% of whom are engineers, 30% consulting staff and 20% creative (with the remainder administrative). It supports its reputation and marketing efforts by hosting an annual JavaScript conference (JSConf EU) and a ‘digital business’ conference in Berlin, which is attended by more than 1,000 delegates (NEXT Berlin).

Examples of projects that capture the spirit of what SZZ is trying to achieve include:

While growth can be lumpy, SZZ has had a lot of success in driving its top line and, over the last five years, it has doubled its revenues to approximately €50m, most of which has been organic. However, development at the EBITA level has been less dramatic. Over the same time frame, reported EBIT margins have contracted and EBIT has increased by only 25%. This decoupling of the margin from the top line is attributable to two factors, both of which management is addressing, and we see scope for a significant expansion in EBITA margins in the coming years:

Investment in the NA platform: over the last few years, SZZ has invested approximately €1.5m a year in the development of its NA platform – an integrated ad server and DMP. The product was launched in August 2014 but, following disappointing take-up by its customers, management took the decision to wind down the business. The closure, while a clear disappointment to management, will however crystallise an immediate 3pp uplift in margins.

Resourcing in a tight labour market: projects are sold on a professional services basis (50% fixed fee, 50% time and material), meaning that staff utilisation is fundamental to managing profitability. In a tight labour market, particularly for developers, this is SZZ’s greatest challenge. Budgets can be quickly undone if a project is postponed at short notice, or if a large amount of business drops in at the same time. In these circumstances, the group turns to the freelance market to manage the ebbs and flows of demand. However, this can impact margins from one quarter to the next. This was clearly evident in 2014 when, despite a 36% increase in revenues reported by the Interactive Marketing division, EBITA margins decreased by 1.5pp, with freelancers accounting for 15% of revenues (vs 8.8% in FY15).

Exhibit 8 shows the history of EBITA margins against revenues going back to 2008. Excluding the investment in NA, over the period 2008-11, EBITA margins averaged 13.3%. In FY15, reported margin was 5.7% and the underlying margin (excluding NA) was 9.3%. In a stable growth environment, group EBIT margins should be able to return to 12-14%.

In contrast to the surge in demand seen during 2014 (revenues +34%), 2015 got off to a slow start leaving the group exposed to reduced employee productivity. However, swift action to reduce freelance capacity mitigated the impact of a weaker top line and, with a renewed focus on driving efficiencies, management was able to deliver an impressive improvement in margins. Despite the reduction in revenues during Q2 and Q315, underlying EBITA margins peaked at 18% in Q415, the highest level in several years (Exhibit 9).

While the Q415 EBITA margin of c 18% is unlikely to be sustainable, we believe there remains scope to deliver further improvements across the year, particularly in the current more stable trading environment. The following factors should underpin a stronger margin progression:

Given the imminent closure of NA, in our ‘adjusted’ EBITA, we now also exclude discontinued items from our calculation of ‘adjusted’ profits (along with exceptional items and amortisation of acquired intangibles). As we had assumed no further operating costs in FY16 (but included an exceptional closure cost of €400k), this has no impact on our forecasts, although we have restated historic figures.

Q116 revenues developed broadly as expected on an underlying basis (+8%). While revenue growth can be at times rather lumpy, we maintain our view that a trend growth rate of c 7-10% remains realistic over the next few years in Interactive Marketing, muted in part by our forecast for little revenue growth in the smaller Interactive Commerce division. Interactive Media, which houses the Content Marketing business, poses some challenges when it comes to forecasting; interest in this new service is reportedly strong and, with the high contract value, adding one more client would move the dial significantly. However, it remains unclear whether this interest can be converted to contracts in this nascent market. For now, we assume 10% annual growth in the forecast period, although we recognise that variance in our forecasts in this division could be considerable.

As outlined above, we see significant scope for sustained margin improvement, and have forecast on this basis for some time. Management’s full year guidance for FY16 revenues of c €50m and EBITA of €5m includes the impact of final costs at NA, and consequently implies an underlying EBITA margin of 11% (vs last year’s 9.3% excluding NA). SZZ hosts its two large marketing events in its first quarter, and as such this is typically a lower margin quarter. In light of this, the continuing 8.6% EBITA margin delivered in Q116 (vs 5.6% in Q115) is particularly encouraging and we increase our FY16 EBITA and FY17 EBITA margin assumptions from 9.7% to 10.3% in the current year. Offsetting this marginally, the final NA closure costs may be slightly higher than we had accounted for (€500k vs our previous estimate of €400k. However, overall, this still translates into a meaningful 8% upgrade to our adjusted EPS estimates and 6% upgrade to our reported EPS estimates.

In summary, we expect high single digit growth across the group, expanding operating margins and consequently strong earnings growth – 12% CAGR in reported EPS over the three years to FY18e. With the closure of NA, and a recovering margin, much of this growth will be evident in FY16, where we forecast a doubling of reported EPS.

We consider the key sensitivities to our forecasts and valuation as follows:

We consider peer group analysis as the most appropriate way to value SZZ.

Peer multiples: SZZ trades on a headline FY16 P/E of 14.2x. However, for peer comparisons, we annualise for the August year end and strip out the impact of the discontinued NA business. On this basis, the underlying annualised P/E is c 12.6x, a marked discount to its digital agency peers (c 17x) and the wider agency sector (c 15x). Exhibits 11 and 12 summarise SZZ’s share rating compared to peers across Europe. It offers excellent value in terms of both P/E (with the highest earnings growth forecast for the lowest P/E) and in terms of EV/EBITA, where its margins are now forecast to be higher than its closest peer, Syzygy, yet it is currently on a lower EV/EBITA multiple. If we were to assume a sector P/E of 16.5x for SZZ, this would imply a share value of €5.3, approximately 30% above the current share price.

However, given the wave of consolidation in the sector, it is also worth considering the possibility of trade interest – the German market is notoriously difficult to crack for non-German companies, and SZZ brings 20 years’ experience, relationships, c 500 employees and should break the €50m revenue market this year.

M&A: the recent takeover attempt for Syzygy by WPP highlights the potential value of assets of this genre to larger corporates. Syzygy, like SZZ, is one of Germany’s largest independent digital agencies. WPP offered €9 per Syzygy share, implying an FY15 P/E of 24x and an EV/EBITA multiple of 14x, which compares to SZZ’s current annualised FY16 EV/EBITA rating of c 7.2x. Applying a similar rating to SZZ would imply a value per share of approximately €7.3 – c 80% above the current share price.

Together, these methods point to 30-80% upside to the shares which, despite strong trading and a growing margin profile, continue to trade at a marked discount to peers and recent transaction values. 2016 is an important year for SZZ as it puts the NA restructuring behind it and focuses on driving growth and margins in its agency business. If management can deliver on its 2016 guidance, this points to a doubling in EPS and should help crystallise a significant re-rating. In a cyclical industry with a mixed economic outlook, the c 3% dividend yield should support the downside.