Data analytics technology supplier First Derivatives (FDP:AIM) has come under fire from short-sellers, people betting that the share price will fall. The stock is down 15% in trading on Friday (5 October) at £29.90 with the attackers raising concerns over the company’s growth, profits, cash flows and accounting.
That compounds a big sell-off yesterday, meaning that the stock has slumped 27% in two days. Clearly the market has been spooked by the claims regarding the previously £1bn valued business, but how worried should investors really be?
ROBUST DEFENCE
Analysts at Liberum Capital have immediately launched a robust defence, reiterating their firm ‘buy’ case for the shares.
‘While some accounting policies could be more transparent, we believe many of the claims that arose over the past hours are unfounded and speculative,’ says the broker in a note headed ‘Short attack overdone’.
‘In our view, First Derivatives’ strategy of disciplined growth provides a path for consolidating the Kx technology as a global leader in big data applications and our investment case remains unaffected by such claims.'
It’s worth saying that Liberum is an independent commentator and is not one of the company’s paid advisers. Liberum also maintains its £53.00 target price for the stock.
Without getting bogged down in the details, we believe two things are worth saying. First, if the recent past has taught investors anything, it is that such short attacks should not be lightly dismissed.
Effective frauds have been uncovered in recent years, highlighted by similar attacks. First questions were raised over practises at insurance software supplier Quindell, then enterprise mobile applications designer Globo came under fire, and both companies have collapsed since.
That said, shorting attackers don’t always hit their mark. Cardiff-based compound wafers technology firm IQE (IQE) has also been targeted in the past (it also remains one of the UK market’s most shorted stocks), yet that has so far come to nought.
PROFITS INTO CASH = ?
A second point about First Derivatives is its poor cash conversion track record. The rate of converting earnings before interest, tax, depreciation and amortisation (EBITDA) - one of the technology arena’s favourite growth and profitability benchmarks - is the ‘main measure of earnings quality,’ according to Ian Spence, the astute founder of the Megabuyte technology company analysis boutique.
So I scanned back over the past six years of First Derivatives’ financial data today, and was left unimpressed by its cash conversion data, which you can see below.
First Derivatives' Cash conversion
| (FY 31 March, £m) | 2018 | 2017 | 2016 | 2015 | 2014 | 2013 |
| EBITDA (adjusted) | £34.1 | £28.8 | £23.3 | £15.5 | £12.5 | £11.6 |
| Operating cash | £25.3 | £30.3 | £17.0 | £11.5 | £10.3 | £8.7 |
| Conversion rate | 74% | 105% | 73% | 74% | 82% | 75% |
Source: Company accounts
This is not to damn the company, it is merely illustrative of one part of the operating model that is now under fire.
There may be legitimate reasons why operating profit should be poorly converted into cash, as Megabuyte’s Ian Spence has previously alluded to. Some business models require cash investment, either above or below the operating cash flow line, to feed growth.
Adverse working capital patterns, the need to invest in fixed assets, and other factors may be quite reasonable justifications of low cash conversion.
‘But in my view the argument that growth requires cash investment is vastly over-used in the tech sector,’ says Ian Spence.
