Small Cap Value Report (6 Nov 2015) - TCM
Good morning!
Extremely quiet for small cap results/trading updates today, which is handy as I have a lunch appointment with the "Sheriff of AIM", Tom Winnifrith, so that should be entertaining!
Whilst I sometimes cringe at the things he says, and the way he says them, there's no denying that he has become a huge asset to the investor community in the last year or two - single-handedly cleaning up a big section of the market, by shining a bright light on wrongdoing, dodgy companies, management & advisers. As well as the occasional misfire, when the wrong target is shot at.
Also, I think it's incredibly useful to have someone fighting for better standards who isn't frightened by the libel laws, indeed who seems to positively relish court appearances. Only this week, I became aware of a company which responded to legitimate investor concerns by firstly issuing a threat to sue them for libel! So the UK libel laws seem to be providing refuge against criticism in less than perfect situations.
We discussed this at the ShareSoc event earlier this week, with Roger Lawson briefing us on the current state of play with the law. This is the reason why shorting dossiers are issued in the US, where there is greater freedom of expression than here. Bear in mind that Tom Winnifrith was the only UK journalist who was prepared to publish the shorting dossier which brought down the Globo fraud. It's surely worrying for our freedom & democracy where the mainstream press are scared of publishing such controversial material, through fear of legal action?
Telit Communications (LON:TCM)
Share price: 232p (down 14% today)
No. shares: 115.1m
Market cap: £267.0m
Swisscom contract - this announcement reads positively, although as no financial details are given, I'm viewing it more as a marketing communication than anything else. It's not clear why the shares are down 14% today, perhaps there has been some other news which I've not spotted?
Why mention it then? Well, several readers have recently asked me to look at this company and give a view, so I've had a quick whiz through the most recent interim figures.
The balance sheet looks generally OK, although there is some debt. It seems odd to run about $36m in cash simultaneously with roughly the same amount of debt. This was a big red flag at another company recently, so that needs looking into.
My main issue however is the cashflow statement. The company is reporting profits on the P&L by capitalising costs into intangible assets. The amounts being capitalised are far higher than the amortisation charge. If you adjust the accounts to expense all development spending (which is how I like to look at things, to ascertain the real cash profits), then it pretty much wipes out profit completely.
For example, in the full year to 31 Dec 2014, the company reported $13.9m in profit before tax. However, if you look at the cashflow statement, it capitalised $26.1m of development spending, but amortised only $10.4m through the P&L, thus boosting profit by $15.7m. So the way I look at it, the company actually made a loss of $1.8m.
The company's accounting treatment is perfectly legitimate, so I'm not saying they have broken any rules. However, investors need to be aware that the profits are all coming from fairly aggressive capitalisation of costs into intangible assets.
Note that it doesn't appear to have paid any dividends in recent years either.
My opinion - I don't like it, for the reasons given above.
There's literally nothing else of interest today, which is handy as I've also run out of time!
Have a great weekend, and see you back here on Monday morning.
Regards, Paul.
(Paul has no long or short positions in the companies mentioned today.
A fund management company with which Paul is associated may hold positions in companies mentioned.
NB. These reports are just personal opinion, and never financial advice or recommendations)
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28 comments
CORRECTION: I've used 6-mth's FCF for my EV/FCF multiple, doubling the last 6-mth FCF for an approx. full-year FCF would halve the EV/FCF multiple to ~71.5x.
ORIGINAL MESSAGE NOW CORRECTED.
Apologies!
Ed Miller
Hi Paul, I like your philosophy, enjoy now. Your opinion on GVC would be helpful, I am researching it with a view to buying, my one concern is the big hike in goodwill +172% in the last 2 years. It makes me suspicious, should I be concerned? Your views will be appreciated.
KR
Charles
I always remember why Rolls Royce went bust in the early 1970's -even though they had been reporting rising profits. RB211 developments costs - being capitalised- doubled - and they simply ran out of cash!! Certainly the development of the RB211 engine did prove a success in the longer term, but capitalising the cost hid the true problems Rolls Royce was facing.
Capitalising expenses may be an important subject, and certainly worth being concerned about, but to then mention a cosmic object destroying life on this planet? Probably best to have a chilled glass of white wine...
As for the aforementioned subject, is it not a case of a man with a hammer seeing all capitalising of expenses as a nail?
Buffy
Re. Telit Communications (LON:TCM) . I think the argument whether or not one should expense software development costs will run and run as long as the accounting standards continue to give companies plenty of wriggle room.
Generally speaking I am in favour of expensing them as this is a more cautious and conservative approach. However in the case of Telit Communications (LON:TCM) I have a different view. The majority of the products that TCM sells are what are called intelligent sensors or components. These products are manufactured physical entities with embedded software. Think of your satnav as an example.
The company has I think tried to address this hybrid problem by splitting the total R&D cost into two parts (see note 5 of FY2014 accounts), $27.7m as R&D operational costs through the P&L, and $26.1m capitalised through the CFI.
I reduced my holding a few weeks back not because of this issue but because this stock is becoming just too volatile for my liking.
Regards, Ram
I warn people here. But there is a strange psychology at work - we should think about this - most people will vehemently defend something that they (deep down) know is false. You only have to look at the weird mass delusions of religion, and gun ownership.
Bottom line - mankind are just clever chimps, with a very thin veneer of civilization, which can vanish at a moment's notice (when a football match is involved, probably). We're all going to get blown up by a large cosmic object colliding with Earth at some point, so let's just enjoy the here and now, and make it as pleasant, and as civilised for each other as we can. :-D
Bottom line, if you pay 20x fake profits, more fool you!
P.
As a holder of Telit in the face of Paul Scott, Tom Winnifrith and the short position by JP Morgan I am trying to assess whether I am being really dumb or a canny contrarian.
Clearly the operational net cash flow is around breakeven but I don't feel it is alarming for a high tech company capturing a growth market. Actual product is being produced and sold in increasing amounts and (apparently) to credible customers.The Italian Ministry of Economic Development granted Telit a facility to spend $44million on this technology, if half of this is being capitalised as a long term asset for the company iy is not only legal but perhaps realistic.
Capturing cheap government loans but keeping cash at the same time is also not a bad plan for a software company.
Profitability in excess of the R&D spend must clearly be the aim, but an Amazon-like wish to command the IoT space is not a bad start.
But GBO had far more red flags than just capitalisation of R&D/development. I.e. it would be a non sequitur to conclude all companies which do so are guilty of dodgy accounting just because one company which did so WAS guilty.
However I would prefer if companies did not capitalise their development costs because, for one thing, it makes them much harder to value :)
What are we supposed to do? Avoid all tech co's who capitalize development?
Interesting that Microsoft, IBM, Intel treat R&D as an operating expense - I assume AAPL do too http://seekingalpha.com/article/2682365-apple-capitalizing-vs-expensing-r-and-d
One more thought - TCM capitalising development costs as intangibles - is this not reasonable in that they are a tech co. which creates products with IP value?
I agree that it's reasonable (& encouraged by IFRS), however, it also opens the door for dodgy accounting which is why Paul doesn't like it. It was a key factor in Globo perpetrating their (apparent) fraud. You can easily make a lossmaking operation appear profitable by capitalising R&D.
All cash costs should be expensed, in my view with tech companies - capitalising them is manufacturing false profits. You have to run to stand still these days, so development costs are not in any way long term projects that should be capitalised. They are just payroll costs. The current accounting standards are just wrong, which lead to people over-valuing companies, and opening a wide open door to fraudsters.
Listen to my interview this week with the CEO of Tracsis, and how dismissive he is of the idea of capitalising development spending! Decent, prudent mgt don't divert P&L costs onto the Bal Sheet.
You have been warned!
Regards, Paul.
Hi Paul,
I have quite a bit if sympathy with your view, but just want to put a couple of counterarguments. You say:
"You have to run to stand still these days, so development costs are not in any way long term projects that should be capitalised."
Now that is true, of course, where a business is not growing rapidly and introducing new product families. In the case of TCM, however, revenues have been growing at a healthy 27% CAGR. Much of that growth will be as a result of new product launches (not merely replacements for existing product lines).
In that respect, development expense is directly analogous to a company having new tooling made and/or adding to factory space, in order to manufacture new products for sale. Can't recollect anyone suggesting that such costs should be expensed rather than capitalised.
It's worth checking the amortisation policies in such cases. Paul is quite right that the life of tech. products is relatively short, compared to traditional manufactures and the amortisation rate for any capitalised development expenditure should be correspondingly high. Telit's policy is as follows:
"Internally generated intangible assets are amortised on a straight-line basis over their useful lives, typically 3-5 years, from the date at which such assets are available for use. Where the internally generated intangible asset is not yet available for use, it is tested for impairment annually by comparing its carrying amount with its recoverable amount."
That doesn't seem unreasonable to me.
Finally, a number of posters have described Telit as a "software company". The vast majority of Telit's sales ($274m in 2014) are of hardware communications modules, which the company designs & manufactures for its customers. A large part of the capitalised costs will be the design, testing and obtaining regulatory approval of these modules.
Yes, accounts would be "cleaner" if such development costs weren't capitalised, but is it unreasonable to do so? It has also been argued that doing so is mandatory under IAS 38, which states:
"This Standard requires an entity to recognise an intangible asset if, and only if, specified criteria are met."
[my bold]
I did have a midsized position in Telit, but in the light of the various concerns (not just this technical issue), I halved that yesterday to reduce my risk. In contrast to Paul I feel the jury's out on this one, which is why I haven't exited altogether. If the "story" is genuine, it is becoming a leading player in an exciting and rapidly growing field. To be sure it's genuine you'd have to do a lot of due diligence on what is quite a complex operation. I would be more comfortable if there were more obvious institutional support.
Finally, it's worth pointing out that a major factor in yesterday's share price performance might have been some disappointment in US peer Sierra Wireless's Q3 results (whose shares fell by 23% yesterday): http://www.fool.com/investing/general/2015/11/06/s... Note that Sierra Wireless Inc (NSQ:SWIR) has revenues roughly double those of Telit and has a market cap. of $618m following yesterday's fall.
Cheers,
Mark
Excellent debate here. From the last interims it seems Telit did make some free cashflow: $2.935M, or 1.9% FCF yield on sales of ~$156M at a price of, by my calculations, an EV/FCF multiple of 71.5 at today's exchange rate ((1.51*£278M)/$5.87M, i.e. doubling the latest 6-mth's FCF for an approximate full-year figure)! I agree that the story sounds fantastic. The balance sheet isn't quite as good: current receivables (including Other Current Assets) amount to ~52% of the 6-mth revenues, and Receivables and Payables are running at much higher levels than the cash and debt balances. TCM might well manage to collect payments and pay its bills easily enough, but a company beginning to struggle to collect receivables and pay its bills might have a balance sheet that looked similar. I would have thought that Telit might have chosen to pay off its long-term loan of $5.595M attracting interest at significant rates. Doing so would reduce the Quick Ratio from 1.10 to ~1.05 (QR=$112.718M/$107.592M).
With capitalised R&D costs so far in excess of amortisation charges, it takes quite a leap of faith to trust that this is solely due to lag arising from rapid growth. One thing that most investors will agree is that such heavy capitalisation of R&D expenses does not amount to conservative accounting - we surely will all admit that it is very aggressive. As Paul Scott mentions, Telit pays no dividend, and doing, alongside collecting receivables, so would help start to restore confidence in Telit. It needs that because the price action after Friday's 'good news' about the Swisscom contract [no financials] given, says the market is suspicious of Telit Communications. Shorting of TCM has increased too (try this short tracker: http://shorttracker.co.uk/company/GB00B06GM726/all or get the info from the FCA's website).
I have no position in TCM, but for the sakes of all those who are long on TCM I hope the story comes true - you're braver than me.
Regards,
Ed Miller
Paul,
Thank you for your comments. I have learnt a valuable lesson here. Are your comments on capitalising R&D costs equally applicable to all industries? Eg Pharmaceutical companies spend very large amounts on R & D.
A thing is worth what it can be sold for on the open market. AstraZeneca spent £Billions on Exanta, https://en.wikipedia.org/wiki/Ximelagatran, which could be worse than nothing (legal costs).
Capitalising development costs seems like the usual perversitity of demanding quantification of the intangible and unquantifiable.
Hi Paul, I mostly agree with you on capitalisation of development costs (I am nearly but not quite as hardline about it as you are).
However, my main concern is why do Telit have more than $10m working capital loans when they claim to have $36m cash. That doesn't make sense at all. Working capital loans are only used when you have poor cashflow. But their working capital loans increased from $10m to $10.4m between December 2014 to June 2015, and how does that add up when they claim cash has increased from $26m to $36m in the same timeframe. I wouldn't touch this stock with a bargepole until that question is answered.
cig, Mark, thanks for your replies.
Hi Paul – you seemed to miss Inlands end of year results on Wednesday. Will you be looking into them again? A lot seemed to have happened there and its Stock-ranks have rocketed up too since the result to 96!
Also yesterday’s OPG Power Ltd’s Q3 results seem interesting too (and again are ranked highly).
Regards
Something I tweeted earlier on Telit about its capex
https://twitter.com/MaynardPaton/status/6281162877...yep - don't like the look of that. My thoughts are that TCM can just print whatever profit they want on this basis. equity/debt/capital raises to repeat-prime the machine.
Hi Paul,
Interesting acquisition from a company that I saw present @ Mello 2014 Acal (LON:ACL) - market seems to like it.
Regards,
Sully.
TCM - interesting re booking expenses as intangibles.
Am I right in saying although this would boost profit it would not boost free cash flow? And prior years of FCF at TCM have been largely lackluster.
However in the TTM figures on Stocko, free cash flow per share has been boosted to 14 cents versus 12 cents EPS indicating that aggressive treatment of expenses or not, the company is now generating cash?
If you look at the detailed cash flow page the cash flow is about +1m a year, so not much more than break even for the size. The June interims show +11m but that matches almost exactly debt/equity issuance so still net flat from operations.
It can be okay as a way to a run a growth business, though then you need to guess whether it will mature nicely and if so how they will distribute the proceeds. Guilt by association and non-UK management will probably impair in the short term (whether it's justified or not). For me it goes in the "too hard" pile at this price.
Hi Cig,
I think you're looking at the wrong line in the June figures. +$11m is net from financing (mostly Italian govt. nominal interest rate loans). I make FCF at June +$2.9m, after $17.8m in CAPEX & capitalised development. So, positive cash generation but only marginally so, relative to turnover & profits.
Cheers,
Mark
The OP (post #5) was asking about the cash flow per share number in the main stock report page ("free cashflow ps" row, "TTM" column) which has gone markedly up. My hypothesis is that it is explained by the interim net figure, including financing. It is real cash, just not real profit.
BTW if it's subsidised loans that's a good thing and goes some way to explain having both loans and cash.
I had a Twitter legal threat merely for linking a controversial article about our esteemed Tory Kurdish MP! Even though I sent it to Conservative Head Office so they had it brought to their attention / could check it's veracity.
So screw them going forward.
I had a a veiled thread of libel action from the chmn of a company after I'd questioned him on how a share buy back had resulted in directors getting bought out at surprisingly good prices.