When you SHOULDN’T BE investing in a free cash flow business

Introduction

Investors like investing in positive cash generation companies, a sign of competitive advantage. Even more so when free cash flow is positive.

Ideagen is a positive free cash flow business and is loved by investors.

That’s because shares in Ideagen has risen from 15 pence per share to 85 pence per share, a rise of 466%. Their market value rose by 750% because the number of shares issued increased by 76.4m to 198.1m.  The market value on Ideagen hovers at £170m.

Shareholders have done well. But….

I am a little sceptical about their “buy and build” strategy.

To provide answers to these scepticisms, here is the outline of my post: –

1). Brief introduction of what is Ideagen PLC;

2). Five reasons why shareholders are high on the business;

3). My rebuttal of the business;

4). Final thoughts.

 

What does Ideagen do?  

Ideagen PLC is a business offering management software solutions.

They offer the following services:

Safety management;

Quality management;

Document management;

ISO Standard Compliance;

CAPA Management;

Internal Audit.

 

The company saw their value rise from £1m to £170m, in less than a decade (five of those years spent listed on the stock exchange).

 

Why is this company valued at £180m when profits struggle to surpass £1m?

To answer this question, I provided a list of reasons why there are optimisms for Ideagen PLC:

1). Investor Chronicle “Buy” recommendation; – the article gave some interesting points, like:

-The global compliance market is worth $4.4bn;

-The sector is growing at 13%;

-Ideagen’s revenue grew 24%;

-Ideagen’s pre-tax profits expected to rise by £3.3m in 2018 and £4.8m in 2019;

-It has recurring sales of 57%;

-And a strong net cash position.

Yet, IC raise some bear points, which include: –

-Acquisitions could lower margins (which is Ideagen’s bread and butter);

-NHS Funding uncertainties.

 

2). One analyst forecasting the shares will rise to £1.08 from the current 85p in the next 12 months;

3). Contract wins and collaborations; – The company regularly announces contract wins with the financial details. Points won on transparency.

4). Going with the flow in a bull market; – In bull markets, investors are more liberal at their approach to owning shares. Also, they are like to invest for that momentum trade.

5). It is generating free cash flow; – The company mentioned growing free cash flow to £6.1m from £2.8m. A very positive metric investors’ seek to identify.

 

 

My Scepticisms of Ideagen

I feel investors and shareholders are misjudging this artificial optimism. Below is a list of reasons why investors should stay cautious.

 

Reason one: Unproven profits growth

The pre-tax profits forecast for £3.3m in 2018 and £4.8m by 2019 looks great.

Despite sales rising five-fold (£4m to £24m), operating profits hover around £0m to £1m.

Ideagen sales and profits

Ideagen hasn’t proven itself to consistently produce profits above £1m.

But, one analyst is optimistic about the company profit potential. He/she has forecast pre-tax profits at £3.3m in 2018 and £4.8m by 2019 looks great.

Even if this turns out to be true, at current valuation Ideagen’s PE ratio still exceed 30 times multiple in 2019.

 

Reason two: Market capitalisation based on Sales performance

And speaking of high multiples. Look at this chart below.

Ideagen Price to sales and EV to sales

Despite sales growing at 30% or more per annum for five years, investors saw Ideagen’s market value grew even faster.
That led to Ideagen’s PE and EV/EBIT multiples surpass “3-digits.” You can justify these multiples as normal in the right business cycle or their sector. Also, you could justify this by saying earnings will explode in the near future. For me, rising multiples without steady profits growth is a problem. Ideagen saw no improvement from previous five years’ earnings record.

 

So, if Ideagen fulfils their profits potential, then EV/EBIT would fall to 50 times in 2018 and 32 times by 2019.

Still, it looks rather pricey and expensive.

 

Reason three: High cash generation is a myth

Since their IPO debut back in 2012, Ideagen PLC has raised £34.2m in net proceeds so far.

I acknowledged most of this fundraising relates to acquisitions of other businesses. Yet, if one looks at their cash balance of £6.2m and compared it back in 2013, you see a decrease of £0.2m!

The idea of it generating internal cash is ludicrous, to say the least.

Ideagen cash generation table

Net cash from operations has generated a total of £18.4m since 2013. But, capital expenses came to £46.8m. How did it pay for the rest of their capital expenses? They raised £34.2m of share proceeds and some went into paying these capital expenses!

You can calculate that Ideagen raises £2 externally for every £1 generated internally. done by dividing share proceeds of £34.2m by £18.4m.

(More cash flow analysis, see reason six.)

 

Reason four: Contracts don’t mean profits

If you follow the Carillion saga, you know contracts are useless. Carillion has an order book totalling £16bn and is now in danger of going bust!

 

Reason five:  The organic growth myth

Investors’ Chronicle says Ideagen has strong organic growth. That’s laughable when it grew by 10%, whereas the sector is 13%! You can assume most of this growth came from acquisitions.

Reason six: Net cash generation coming from amortisation

What I mean by this is simple.

Profits at Ideagen is weak, but cash profit generation is strong.

So, how is this possible?

It is possible because of capital expenditure. Intangible assets rose from £7.9m to £57m in four years. When Ideagen build-up assets it increases maintenance costs, hence rising amortisation expenses.

This rose maintenance costs rose from £1.1m to £5.3m, hence why profits are suppressed and cash earnings growth.

Below is a flowchart, explaining how acquisition works. The purpose is to pay attention to the financing.

N.B.: Period covers from 2013-2017.

Ideagen Cash earnings explained

Reason seven: Disputing Free Cash Flow of £6.1m

How did it make £6.1m in free cash flow?

£8.4m in net cash earnings minus capex £2.3m equals £6.1m.

But, investors tend to ignore £18m of acquisitions. However, you justify the company’s decisions it represents real cash outflow. That’s why £10m of share proceeds was raised. Instead, people should be concerned, by asking: “Have earnings growth enough where Ideagen could fund acquisitions internally?”   

Using free cash flow as a metric where financing is external makes it an invalid indicator. Since 2013, capex totalled £6.4m, while acquisitions totalled £40.4m.

That means acquisition is six times the size of capex!

Final Thoughts

Looking at their rising share price put any investors in a trance. I admit being a tech geek. However, it acquires other tech businesses. That strategy only works if you make purchases at a reasonable value.

Take JD Sports, for example. It made many acquisitions where people questioned whether the brands have any value. Instead, JD Sports proves the doubters wrong. It increases margins every year, shareholders saw dividends growth and acquisitions are internally-funded.  

Although Ideagen is a small company and operates in a sector known for trading on ridiculous valuation, so far profits haven’t increased. It needs to raise £34M (since 2013) from investors to support business growth. If this source of finance gets cut, then Ideagen faces a minimum of 50% share price decline.

Another reason is the way the company report profits by using EBITDA (which also excludes share-option expenses and so forth to derive at higher earnings) and the inappropriate use of Free Cash Flow, as a yardstick measure.

 

This may sound like a controversial post, but it isn’t. Just an opinion piece, if you happen to enjoy the post then subscribe to my blog.

Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.

Finally, the writer does not own the company’s stock, unless stated otherwise.

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