Exit Quadnetics

To recap: Surveillance equipment supplier Quadnetics passes all the basic criteria for inclusion in the Thrifty 30 portfolio. Statistically it looks like a good business, with healthy finances, available at a cheap price.

But the Return on Equity figure I use to value the company and judge its profitability is based on the company’s accounting profit. Free Cash Flow, the actual money the company earned excluding what it spent on acquisitions and gained from disposals, was less impressive over the last decade.

In five of the last ten years, 2002, 2004, 2005, 2007, and 2009, Quadnetics produced near zero or negative FCF (green bars). The company lost money despite recording accounting profits (blue bars) in four of them. 2007, in fact, was a record year of accounting profit and a record year of FCF losses.

That year, Quadnetics used up cash buying a £2m property to expand its Synectics business in Sheffield and financing a £3.8m increase in working capital (money spent on stock and customer credit, less money owed to suppliers). It also bought equipment. In other years, it’s capitalised some of its product development costs, recording them as a depreciating asset on the balance sheet rather than deducting them from profit.

These transactions explain much of the difference between £4m net-profit and a £2.5m FCF loss and they’re not particularly alarming. A company’s cash performance can be lumpy but the accounting measure of profit is supposed to smooth it out and be a reasonable indication of the company’s underlying performance in a single year. If a company buys equipment, or spends money developing it, in one year, it depreciates the cost over many years. Increases in working capital in one year might be offset as the company collects payment from its customers in another (although a growing business will require some increase in working capital).

It’s the margin of the failure of free cash flow to match net profit on average over the last decade that may be alarming. Quadnetics’ average adjusted net profit was £1.9m (average basic net profit was £1.3m), and average free cash flow was less than £500,000. This discrepancy means I don’t think Quadnetics’ past returns are a reliable guide to future earnings. If I plug average Free Cash Flow Return on Equity of 3% into my Earnings Yield calculator I get a return of about 3% for investors instead of 12% when I use Return on Equity. It’s not enticing.

There are two kinds of business in the Thrifty 30, recovering companies like Quadnetics, and hidden champions. Recovering companies are cheap because their managements have made mistakes. I include hidden champions because their managers haven’t made mistakes, but they’re often more expensive. I’m more likely to add a hidden champion to the portfolio if the managers that had a hand in its good performance still run the company. It’s almost a pre-requisite that the managers responsible for a recovering company’s poor recent performance have gone.

John Shepherd joined Quadnetics in November 2008, and its previous ceo and founder, Russ Singleton, left the board last year to ‘focus his entrepreneurial flair on a new venture’. The lingering notion that Shepherd’s tenure might be different, less entrepreneurial perhaps, and more focused on profits and cash flows, is encouraging me to hold on to the company.

I like the rhetoric in the annual report. Shepherd immediately restructured the company and developed its focus on complex and critical surveillance markets, like mobile surveillance and systems for oil rigs, where competition from generic surveillance products would be less severe. As a more specialised firm, he expects to be able to reduce overheads, improve profit margins, and expand overseas.

Its legacy Integration and Management Services division is still responsible for over half of sales though and in the final analysis, numbers mean more than words to me.

Quadnetics may well be a success in the future, but my doubts about the quality of its earnings in previous years mean its too speculative to remain in the Thrifty 30. I’m looking for companies that only need to do as well as they did in the past to give the portfolio a good return and Quadnetics must do better.

The Thrifty 30’s done well enough out if it. At the last portfolio valuation the shares had returned 29% and the company has paid three dividend payments too.

Surveillance raises questions about Quadnetics

When I added Quadnetics (QDG) to the Thrifty 30, I could hardly contain my lack of enthusiasm. Surveillance is a necessary evil, I wrote, the company was changing its financial year, which would make subsequent analysis nightmarish, but the probability of disappointment was “low enough”.

Well, the nightmare has arrived. Quadnetics has published its annual report for the eighteen months to November 2010 and I must try and make sense of it. I added the shares at £1.53, and they currently cost £1.99, a return of 33% since November 2009, plus dividends.

Back then, Quadnetics had been crunched by delayed and cancelled orders from defence, banking and gambling companies whilst simultaneously spending more on a new generation of surveillance products. Under it’s new chief executive, John Shepherd, the company chose to cut costs and focus on selling more of its own products in its strongest markets, which were: mobile systems for buses and coaches, industrial systems deployed on oil rigs and chemical plants, network systems for banks, shops, casinos and prisons, and integration, and managed services for clients.

Plugging the numbers into a spreadsheet is tricky because of Quadnetics’ eighteen-month year. In the charts that follow and the F_Score calculation, I’ve used un-audited numbers from the annual report for the twelve months ending 30 Nov 2009 and 2010 so the company’s profitability ratios are not inflated or deflated by incorporating an extra six-months of profit/loss and cash flow figures. I’ve used the balance sheet data from Quadnetics’ first interim set of results to match the twelve month accounting period, and included all three lots of dividends in 2010 to ensure the shareholder wealth chart (orange bars) is accurate.

By changing the reporting date the company obscured a loss in the year to 30 November, from which it has bounced back reasonably well. Its F_Score, a maximum nine out of nine, suggests recovery.

Since the shares are only just trading above book value they still look cheap, if Quadnetics can regain its average level of profitability over the last ten years. Return on equity (dark green line) in 2010 was only 7% though, just over half the median. Since then, net profit margins have declined (dark blue line).

Reassuringly, the company says it can double operating profit margins within a ‘reasonable timeframe’ and credits its restructuring programme and new “single company” culture for the improvements so far. It’s relying in part on a return to “normal economic conditions” to finish the job.

Since profit margins are rising again, and my traffic light system in the summary box on the right indicates the shares are cheap, the company is profitable, and it’s financially strong, I would normally consider adding more shares.

But, I’m paying more attention to a second set of statistics that act as a check on the book values and earnings calculated by accountants, in particular intangible assets and free cash flow.

Fifty per-cent of Quadnetics’ equity is goodwill. Goodwill is the  cost of businesses Quadnetics has acquired in excess of the value of their physical assets. The price Quadnetics paid, though, must be justified by the returns it earns. If it continues to struggle, it may write-off some of the goodwill (reduce its value recorded in the accounts) because the businesses are not worth as much as the company first thought. Goodwill, therefore, adds uncertainty to Quadnetics’ book value, and consequently the price to book value and earnings yields derived from it.

Free cash flow (light green line) is a measure of the actual money the company earns in a year, as opposed to profit, which incorporates accounting judgements designed to give a truer picture. There are many examples demonstrating why such adjustments may be necessary, the classic being depreciation. A company may buy an expensive machine at great expense, reducing its cash flow dramatically, but since that machine will operate for ten years, accountants spread the cost over the whole period, reducing profit a little in each. In any year, the profit figure should more accurately measure the company’s performance, but the long-term averages of profit and cash flow should converge.

Quadnetics’ average free cash flow is only 25% of its average net profit though, which makes me wonder where the accounting profit has gone.

Although a 13% earnings yield implies there’s not much risk of paying too much for Quadnetics and its profitable past and unindebted present suggest little risk in the business, the change in the accounting year, the amount of goodwill Quadnetics carries in its accounts, and its free cash flow performance mean the statistics themselves are not as reliable as I’d like. My preferred financial ratios may not truly describe Quadnetics’ finances, performance, and value.

I’m not ready to let Quadnetics go just yet. The discrepancy between profit and free cash flow bothers and interests me most, and there is an alternative explanation. The money may have been spent on plant, equipment and product development that could earn higher returns in future.

Even so, if Blippy put a gun to my head again now, and insisted I decide based on the stats alone, I’d probably pull the trigger on Quadnetics.

Since I’m trying to minimise risk, I don’t want shares that are dependent on a better future. Thrifty 30 members should be cheap and strong now.

Surveillance reveals Quadnetic

Intruder in the Thrifty 30.

This week I’m adding Quadnetics (QDG) to the Thrifty 30 model portfolio. It makes surveillance technology and sells integrated surveillance systems.

There’s plenty of hype about the need to control terrorism and loutish behaviour so, just to reassure you that I’m not being suckered in to paying too much. I’m not enthused by the surveillance story.

It’s a bit like the defence industry it serves – in an ideal world you wouldn’t need surveillance, but this isn’t an ideal world. I hope we don’t need too much of it, and don’t have a strong conviction that its a growth market.

Some surveillance, is, however necessary and I’m interested in Quadnetics because it looks like a good old fashioned value share.

Quadnetics also sells, maintains, manages and runs systems for retailers, heavy industry, casinos, and local authorities. It installs mobile systems in buses and trains and lorries. The Look DriveSmart system monitors drivers (for safety and training purposes, not anti social behaviour).

it was a struggling conglomerate, part security and part aerospace and engineering company, but by 2002 it had sold off all but Quadrant Video Systems, an ‘integrator’, designing, installing and maintaining security systems made from components, CCTV cameras, control software, hardware, and video recorders made by its sister company, Synectics, and third party manufacturers.

Since 2002, it has been a good deal more profitable, although growth has been pretty flat since 2004, and in the year to May 2009 reported in its recent annual report, profits and profitability fell sharply.

It looks as though John Shepherd was appointed a year ago to grow a company that had reached its limits under its former chief executive, Russ Singleton, now in charge of product development. But as delayed and cancelled orders, especially from defence, banking, and gaming customers coincided with the cost of developing its next generation of products, Shepherd has to manage a turnaround too. This month’s trading update emphasises cost cutting opportunities on top of the restructuring Shepherd conceived to focus on selling more of its own products in Quadnetics strongest markets:

1. Mobile systems
2. Industrial systems (deployed on oil rigs, in oil terminals, and chemical plants for example)
3. Network systems (large scale systems commonly found in banks, shops, casinos and prisons)
4. Integration, and managed services (where SSS, a Quadnetics company takes responsibility for procuring and running security services for a client)

Ignoring the costs of redundancies and reorganisation, the company’s profitability halved last year. Including exceptional costs it was barely profitable. But in other respects Quadnetics looks strong. It has no debt and in cash terms, as opposed to accounting terms, it’s more profitable. For investors who gain confidence from dividends (I’m not one of them) it also maintained its dividend.

At 151p, the shares cost twelve times its average earnings over ten years, not quite in bargain territory but then the company isn’t in dire trouble.

A Twitter friend tells me Quadnetics has a history of disappointing. It probably does, but your level of delight or disappointment depends on your expectations in the first place. Since Quadnetics doesn’t need to grow much to justify the current price, it just needs to recover, my expectations aren’t too high.

I think the probability of disappointment is low enough to add it to the Thrifty 30 portfolio, which you can find in the usual place. Quadnetic’s mid price is 151p, but the spread is quite wide and since my broker’s only offering 153p, that’s the price I’ve recorded.

There’s no mention of it in the annual report, but I am concerned that Quadnetics must benefit from a booming construction industry, and suffer when, like now, building projects are being delayed or cancelled. While the effects are likely to be temporary, the Thrifty 30 already has four holdings that are more dependent on construction:

1. Alumasc, which makes building materials,
2. Dewhurst, which makes buttons for lifts
3. T Clarke, an electrical contractor, and…
4. …engineer Waterman.

It’s a dilemma for value investors. The numbers lead us into unfavoured sectors when others would diversify. On the other hand, we’re not going to beat the stockmarket by owning a spread of stocks that resemble it. To win, you have to be different, the question is, how different.

Another irritation, Quadnetics is changing its year end. The next one is November 2010, a year and a half after 2009’s. At best, that will make comparisons with next year and this year more tricky, at worst it’s an opportunity to conceal a bad year by extending it.

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