One small-cap star I'd buy and one I'd sell today

Updated: 
Elements of the Mind

Businesses which generate a high level of recurring revenue can be extremely profitable. The attraction of making a sale and then collecting revenue for years to come is obvious.

Recurring revenue is a big part of the potential appeal of CentralNic Group (LSE: CNIC). This unusual internet company makes most of its money by selling subscriptions for domain names. Its speciality lies in so-called top-level domains (TLDs). These are the end part of a name, such as .uk or .com.

This market is changing and there are a growing number of non-geographic TLDs, such as .xyz, which is used by Google's parent company Alphabet, among others. CentralNic's growth proposition is that it has long-term contracts to manage and wholesale many of these TLDs. Today's half-year results provide a chance for us to check on the firm's progress.

Mixed results

Revenue rose by 19% to £10.6m during the first half, while adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) rose by 50% to £1.4m. However, an increase in acquisition-related charges, non-recurring costs and other non-cash charges meant that CentralNic's adjusted pre-tax profit fell by 29% to £670m.

The group's accounting is quite complex. But one positive measure from today's results is that cash generation appears to remain healthy. Net cash rose slightly, from £7.5m at the end of 2016 to £7.7m at the end of June.

Management remains confident of meeting full-year expectations. This puts the stock on a forecast P/E of 15. The company doesn't currently pay a dividend, but if cash generation remains positive, then this might change over the coming years.

I think CentralNic's full-year results will provide us with a clearer picture of the firm's progress towards being a recurring revenue business. In the meantime, I'd rate the stock as a speculative buy.

Is this setback just a blip?

Shares of marketing company System1 Group (LSE: SYS1) -- formerly known as BrainJuicer -- tripled in value between February 2016 and May this year. But they've since collapsed in spectacular fashion, falling from a 52-week high of 1,050p to just 557p at the time of writing.

This 50% drop came after the company issued a profit warning. Among the reasons cited were a 10% rise in organisational costs and deferred spending by clients. An extra worry was that competitive pressures were said to be increasing.

This concerns me, as my understanding was that the group's services were quite innovative and unusual. If competitors are starting to offer similar services at lower prices, System1's high profit margins could fall sharply.

Uncertain outlook

First-half profits are only expected to be "a little over break-even" this year. And although performance is expected to improve during the second half, the shares still look expensive to me. Broker forecasts put System1 stock on a forecast P/E of 18 for the current year, falling to 16.5 in 2018/19.

Although the company's performance could spring back rapidly, it may not.  I'd prefer to avoid the risk of further losses, even if it means missing out on a potential recovery.

Undervalued by 40%?

Our top analysts have identified a small-cap stock which they believe could be undervalued by as much as 40%. The company concerned operates in a sector that's out of favour but has continued to perform well.

This UK-focused business certainly looks cheap to me, based on recent results. If you'd like full details of our experts' analysis of this stock, download 1 Top Small-Cap Stock From The Motley Fool today.

This essential report is free and without obligation. To get your copy, just click here now.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Alphabet (A shares) and Alphabet (C shares). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.