Stockwatch: can high valuations in tech stocks like this be trusted?

Our stock picker takes a close look at the prospects of this successful small-cap technology business. 

It is timely to compare and contrast my article last Friday on a highly rated emerging retail stock Cake Box (LSE:CBOX) with technology play D4t4 Solutions (LSE:D4T4). Does technology per se justify inherently higher valuations which you might as well ride out, or should you beware just like anything else in a mature bull market? 

From a macro perspective, US data around 2007 and 2000 shows Nasdaq stocks harder hit, and we know such trends are liable to be repeated here.

From a company specific view, however, I recall for example financial software group Fidessa enjoying price/earnings (PE) multiples often 40x or even higher at times, slumping with the market but still delivering handsome long-term gains for patient holders – especially when finally acquired as a FTSE 250 company for £1.5 billion in 2018.

• Invest with ii: Top UK Shares | Share Prices Today | Open a Trading Account

It did, however, enjoy market dominance to the extent that 70% of London securities transactions were handled by its systems. 

• Richard Beddard: nerdy but essential changes to the Decision Engine
• 10 stocks that helped AIM be a world beater

With AIM-listed Cake Box, I explained how its figures are likely to remain strong – possibly for a few years – given its franchising model front-loads group revenue, while franchisees buy keenly into the concept. But once the growth rate slows, capital growth investors are liable to sell in search of the next “roll-out” concept and a PE of around 30x is liable to drop. 

Technology has more scope to justify pockets of high valuation 

Tech can often justify high valuations. For example, a patented breakthrough can open up a substantial new market, with a robust “moat” versus competition, which also raises the chance the business ends up takeover target. Microprocessor group ARM Holdings floated as a modest-size business in the late 1990s, appeared overvalued most of the time and saw great volatility.

Yet, like Fidessa, it ended up a target - firstly for Japanese conglomerate Softbank, which bought ARM for £23 billion in 2016, then was sold on for £31 billion equivalent in 2020 to Nvidia (NASDAQ:NVDA), the US graphics chip specialist.  

Small cap tech is a potential source of grand slam gains – say over a couple decades – but mind, not even expert managers or analysts can reasonably anticipate what might emerge as a disruptor. 

• Six things you must do before buying any share
• Discover how to be a better investor here
• Check out our award-winning stocks and shares ISA

All this explains a volatile bull chart in AIM-listed data solutions group D4t4 Solutions over the last six years, as investors took profits along the way. When will its promising narrative on data management and fraud protection, deliver more exciting figures than those bumping along sideways in the table since 2014?  

The shares are up from around 50p mid-2015 to a recent high close to 400p before annual results to 31 March. But another dose of numbers reality prompted a drop to 340p from which the stock is climbing again – to 350p currently, which capitalises D4t4 around £140 million. 

Unexciting headline numbers versus a 50x forward PE

Adjusted annual pre-tax profit has eased 10% to £4.5 million on revenue up 5% to £22.8 million. A weak first-half year was partly substituted by a stronger second half, a general feature of D4t4 not just the pandemic. 

The last financial year was still “ahead of our expectations,” despite the pandemic forcing some clients to focus on internal challenges, given D4t4’s strength of product offerings and a shift of businesses online. 

Trading in the new financial year has been in line with the board’s expectations, with “strong levels of existing and new client activity” also “new product launches alongside digital transformation tailwinds”.  

But it sounds as if this will temper profit recovery given “the launch will incur additional expenditure in the current financial year as the new product will be supported by a new specialist fraud team which is being recruited, also supplementing our installed base team with new hires globally.”

This relates to the Celebrus fraud data platform, including automated behavioural biometrics to identify potentially fraudulent signals thereby prevent occurrence.   

The cash flow statement does not show material investment last year, just £195k capitalised development spend and £34k on fixed assets.   

Specific guidance is elusive in the release but published forecasts exist for £3 million net profit this year, rising to £4 million for March 2023. Look for earnings per share of 6.2p this year, then a recovery near 10p for March 2023. If you want to benchmark around a 12-month forward PE, it is a whopping 50x. 

D4t4, however, presents its sense of March 2021, adjusted fully-diluted earnings per share of 9.5p, down from 11.2p, adding back £746k foreign exchange differences and a £318k share-based payment beside the typical £279k amortisation of intangibles.

Yes, there is a case to “normalise” for the former, seeing though to underlying business performance, but they are genuine costs. 

Mind that given small caps operate from a low arithmetic base, modest changes in variables can make a significant difference to earnings per share.

Low investment needs and £14 million cash prompt pay-outs 

The total dividend has edged up 5% to 2.8p at a cost of £1.13 million, which compares with £3.3 million net cash generated from operations and a scant £204k annual investment.

The board probably wants to demonstrate proof of free cash generation and shareholder returns as priority although with the pay-out projected to rise near 3.5p by March 2023 a sub-1% prospective yield is immaterial.  

• Our five AIM tips for 2021 smashing the market at halfway point
• Stockwatch: an exciting small-cap share in a sweet spot
• Read more Stockwatch articles here

Return on capital dropped below 10% last year but has historically been in a mid-20% area, as if greater shareholder returns can be achieved by profits retention. So, investment indicated for this year is in truth welcome.  

Two insiders add modestly to their holdings 

Modes trades they are, but after results the interim chief finance officer bought £6,100 worth of shares near 350p and a senior manager £2,470 worth.

Significantly, once out the closed period, the CEO, owning just over 4% of the company, has not sought to lock in any gains – nor have institutions sold into a rise that owes plenty to investors’ exuberance for riskier plays. Since Covid vaccines altered investor mindsets last November, D4t4 has nearly doubled in value. 

Attractions of an emerging tech-stock tilt in its favour 

At a similar price of 350p last April, I tempered my stance to 'hold', having originally drawn attention as a 'buy' at 190p in December 2019. I thought the prospect of more subscription-based revenues would smooth a lumpy revenue profile, also a new CEO next year – from the US, where D4t4 derives some 40% of revenue – augured well.

The narrative also includes new products and offices such as in Australia and India. 

Yet the annual results are a reminder, D4t4 is significantly a “jam tomorrow” company in terms of delivering numbers to justify its market value.

Circa six times sales is modest however versus multiples plenty higher on Nasdaq, and a US acquirer might see D4t4 as an opportunity in due course, similarly as Americans are queuing up to buy Morrisons (MRW) which appears comparatively cheap.   

All-considered, I suggest you consider staying the course with the likes of D4t4 given data analysis and fraud detection is high-priority in the modern economy. Mind how a market sell-off can dash investors’ risk appetite and new rivals are always possible. 

Taking a 10-year view, I see it possible this and other specialist technology stocks maintain high ratings, unless warning on profits due to revenue shortfall. On current information, if challenged to tuck either Cake Box or D4t4 away for a decade, it would be this one. Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.