Tonight I'm going to look at Quindell (a company I currently have a long position in) in the context of the "red flags" that investors could have found within companies like Southern Cross - a care homes operator once owned by the private equity firm Blackstone that floated in 2006 and then stopped trading in 2011.
I've picked Southern Cross for comparison, because many other commentators on the AIM currently give the impression that Quindell is destined to cease trading in the same fashion and on rare occasions even pick upon both similar and sensible points of reference.
Here are a list of some of the more major signs of weakness that could have been picked up on within the balance sheet and accounts of Southern Cross between 2006 and 2011:
- Serious cashflow issues
- Directors selling shares
- High leverages
- Customer Diversification
- Rapid expansion
- Company recommended investment metrics
- High goodwill figures
Thus, I'm effectively going to list and explaining one of the main signs of weakness within Southern Cross (mostly using their September 2008 accounts - although in any year since their floatation these statements probably would have applied) and then seeing if Quindell falls in the same category or not (using their latest set of interim accounts or the last set of full accounts - not including the update expected in a few days time):
1. Serious Cash-flow Issues:
- Now, with Southern Cross they really stumbled with their main customer being the government (via local authorities), which aren't well renowned for paying on time and this impacted heavily on Southern Cross early on. Essentially, their cash flows were not keeping pace with their profits at all.
- This is possibly the most relevant point regarding Quindell, because it certainly was an issue in the past, but with £1,000,000 being taken a day in cash in the fourth quarter of 2014, this isn't likely to be nearly as much of an issue as it used to be. Combined with the fact that in the real world mathematical analysis is non-linear (something I'm struggling with currently with the algorithmic trading platform I'm making), it likely means that if we follow Quindell's track record of exceeding their own targets and expectations it could be higher than this.
2. High Leverages:
- Looking at Southern Cross, they had a total debt of over three times the total shareholder equity - a vast amount to have relative to the shareholder equity in any company!
- With Quindell if we're being fair and taking their borrowings combined with their banking overdraft, we only get a figure of £52,900,000 which is tiny compared to a shareholder equity in the latest interim accounts of £929,000,000.
- Contextually, most people tend to get worried when borrowing levels are in excess of half of shareholder equity.
3. Customer Diversification:
- In the case of Southern Cross, around 80% of their total business came from the government with the other 20% coming from private sources. As discussed in point one, this isn't a healthy for any business and should have been a warning sign of trouble to come for the company.
- To quote their interim accounts, Quindell are "servicing directly over 600,000 consumers each year from 2014" - an undeniably thoroughly diversified customer base. Frankly, I don't think anymore information needs to be added regarding this point!
4. Rapid Expansion:
- This isn't so much a warning in itself, but in the context of points one, three and seven it makes quite a big warning sign, because it's a facilitator of these two points in particular.
- Looking at Quindell, high growth rates were certainly at risk of being dangerous to the company earlier in its history, but over the past nine months steps have been taken to reduce growth based cash-flow risks and to quote the interim accounts: "Certain contracts being restructured to ensure optimum return on cash resource". This further shows a internal interest in decreasing the overall growth rate to allow for an increase in net cash.
5. Company Recommended Metrics:
- With Southern Cross there was a clear issue with Southern Cross using and heavily quoting their adjusted EBITDA in their accounts - if your basic metrics aren't enough to represent a company then there's clearly an issue! In this case, by sticking behind their adjusted EBITDA they were able to give the impression that the company was doing much better than the other metrics stated, mostly through confabulation of the business model.
- If we take 2007 and 2008 you would have gotten a nice upwards trend, but when using any other metric you would have seen a much poorer picture. In effect,
- Through my reading of multiple editions of company accounts, Quindell have never suggested that their business should be valued using an "alternative" or non-standard investing metric - need I say anymore?
6. High Goodwill Figures:
- The problem with goodwill in the case of Southern Cross, was that it was twice the total shareholder equity (total assets - total liabilities) - a massive amount and illustrates the buying spree that Southern Cross went on post floatation. The reason this should have made people nervous was because if the value of the assets you're carrying takes a fall then the value of this shareholder equity effectively takes a huge hit.
- In the case of Quindell, goodwill at the end
of December 2013 totalled only £235,600,000, which compared to a shareholder equity figure in the latest interim accounts of £929,000,000 is a very comfortable margin to be working in.
- Generally speaking, if the goodwill figure is above about half the shareholder equity figure then you should be on edge and checking that the company still fits with your investment strategy.
To conclude, I like to think that I've taken some significant (or actually potentially relevant) "red flags" in a pretty comprehensive and understandable example and then used them to show that, in my opinion at least, Quindell is not showing any signs that investors would be (or should have been in the past) worried.
All the best,
The Masked AIM Trader
P.S.
I'm in danger of getting in trouble for this, but could this not be conceived as a slightly ironic "red flag":
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