Interactive Investor

Stockwatch: the problem with small-cap growth plays

20th April 2021 17:14

Edmond Jackson from interactive investor

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Latest trading update from this data solutions stock exemplifies a current dilemma.

Yesterday’s full-year trading update from AIM-listed data solutions company D4t4 Solutions (LSE:D4T4) exemplifies the current dilemma with small-cap growth plays: is market pricing detaching from reality? But if you sell, aside from the certainty of capital gains tax (outside a tax-free wrapper) how do you know if and when to buy back in? 

An attractive business despite historic lumpy revenues   

I drew attention to this stock as a ‘buy’ at 190p in December 2019 when it appeared the market had assumed lumpy revenue timing issues implied a profit warning, hence the stock was down from 270p a year before.

Yet D4t4’s Celebrus software appeared a market leader in real-time data collection and storage, from people browsing websites and using mobile phones. It has competitive advantage by way of speed and ability to capture data from many sources, versus a ‘batched’ approach that can take many hours. It has clients in 22 countries, include Citibank, HSBC and Qantas. 

The stock plunged to 120p in the March 2020 Covid-19 crash, recovering over 240p last June. But it drifted to 180p before the November vaccines’ success rally took it up to 315p in February. After modest profit-taking, this latest update has triggered a 10% advance to 350p which capitalises D4t4 at £141 million.  

Unless recent expectations for £3.2 million net profit on £24.1 million revenue need upgrading for the current year to March 2022, it means the prospective price-to-earnings (PE) ratio tests 44x – versus a circa 1% yield – while the underlying earnings per share (EPS) trend remains lumpy.  

This compares with a forward PE of 11x and 1.8% prospective yield – or so I thought – when trusting December 2019 forecasts for about £6 million net profit in the March 2021 year. This underlines how tricky projecting software sales can be. 

Expectations beat looks chiefly due to revenue recognition policy 

An oddity I find about D4t4’s latest update and the market’s reaction to it – as if 10% greater underlying value has been “added” – is it repeating the dilemma of needing to read beyond lumpy contracts. 

Prior to the update, it appears the expectation for March 2021 had been £3 million net profit on £22 million revenue, easier than £4.5 million on £21.7 million respectively in the March 2020 year. 

Only last 1 April, D4t4 had rather cutely announced six contract wins which “will add a total £3 million revenue in the financial year to 31 March 2021”.

That casts some light on revenue recognition, given it would be remarkable to deliver this extent of value to clients and be paid if signing off the deals late on the final day of March. 

The 19 April update cites revenue and adjusted profit guided at £22.8 million and £4.2 million respectively, as if ahead of recent expectations.

Yet without booking £3 million revenue to the March 2021 year the company appears ‘behind’. My guess is they expected a majority of such deals to close in the last financial year anyway. 

Overall near-term prospects are not quantified beyond saying the order book and pipeline of opportunities “bode well for the future” – as managers typically say anyway. 

Shift to subscription-based contracts should smooth revenue/profit 

They have however said, annual recurring revenue is said up 11% year on year to £10.6 million, albeit which likely reflects composition of orders previously achieved. This, they believe, “is set to continue an upward trend as we move towards a predominantly term/annual recurring revenue model, providing more revenue visibility and ultimately better-quality earnings”.

Fair enough, but it has yet to reach half of group revenues, so does that justify expansion of the PE multiple – potentially in a 30x to 40x range if we take a respectably generous view, and could March 2022 expectations be beaten? 

Yet I recall how financial software company Royalblue – which changed its name to Fidessa and was ultimately acquired for £1.5 billion, at very good profit for long-term holders – appeared a chronically overvalued stock for at least 20 years.

AIM-listed Beeks Financial Cloud (LSE:BKS) currently enjoys a forward PE around 35x and trades on 6x sales – i.e. same as D4t4 now. 

The challenge for shareholders is figuring your risk appetite to ride with such valuations – versus what extent of greater risk that if US interest rates do have to rise to tackle inflation, bubble values on Nasdaq will pop and pull many other growth stocks down, possibly for a decade or longer. 

Good cash generation, adjusted versus reported profit   

The latest update cites it being “strong” in the second half with March-end cash up 11% to £14.2 million year-on-year. There is no debt nor has there been any resort to Covid-19 business support schemes. Again, perspective is quite a matter of timing: the interim cash flow statement had shown cash from operations halved, rebounding to a net £0.4 million generated due to an income tax refund. 

Mind how profit is highlighted pre-amortisation, re-organisation costs, foreign exchange gains/losses and share-based payment charges. While it can help to see through to how the underlying business is performing, a fair element of all this is ultimately a cost.

At the interim stage there had been a £1.3 million reported loss and a £0.8 million adjusted loss, versus a £0.7 million profit in the first-half March 2020 year.  

D4t4 Solutions: financial summary
Year ending 31 Mar

  2014 2015 2016 2017 2018 2019 2020
Turnover (£ million) 9.8 12.8 18.6 17.7 18.4 25.2 21.7
Operating margin (%) 9.8 5.3 17.7 24.3 18.2 25.1 22.7
Operating profit (£m) 1.0 0.7 3.3 4.3 3.4 6.3 4.9
Net profit (£m) 0.8 0.5 2.9 3.9 2.9 5.8 4.5
IFRS3 earnings/share (p) 3.1 1.9 7.6 10.0 7.3 14.5 11.0
Normalised earnings/share (p) 3.1 1.9 7.6 10.0 7.3 14.5 11.0
Price/earnings multiple (x)             31.8
Operating cashflow/share (p) 2.9 -0.8 16.5 6.1 1.8 22.6 5.9
Capex/share (p) 0.5 0.6 0.9 0.4 2.1 1.1 1.1
Free cashflow/share (p) 2.4 -1.4 15.6 5.7 -0.3 21.5 4.8
Dividend per share (p) 1.6 0.6 2.0 2.3 2.5 3.0 2.7
Yield (%)             0.8
Covered by earnings (x) 1.9 3.4 3.8 4.5 2.9 4.8 4.1
Net assets per share (p) 21.3 33.6 40.0 46.2 52.9 63.3 72.7

Source: historic company REFS and company accounts

New CEO, also fraud detection products to launch  

In terms of ‘something new’, various fraud products developed over the last two years are due to launch this June. A new office is due to open in Sydney, Australia, and further growth is cited at US and Indian operations. 

At the interim stage, just over 40% of revenues were US-derived. Hence it is logical for a US vice-president to replace the group CEO, who wishes to retire by end-June 2022 after 36 years with the company. The boss-to-be joined in 2018 having been CEO of Stratigent, a digital marketing analytics leader, since 2009. After a transition period he will spend at least one month every quarter in the UK. 

My view remains: D4t4 has good long-term development prospects in an attractive growth niche that may not be easy for rivals to enter. In principle, it is a stock to salt away for a few years despite looking pricey when spirits run high.

Hopefully the transition to greater subscription-based revenues will help smooth numbers. With fresh money however, you face a risk of medium-term capital loss should inflation undermine high valuations on growth stocks. Hold.   

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

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