By John Ficenec , 21 January 2013
Quindell has a compelling investment story. In a little over a year it has created a platform that offers to cut costs for a motor insurance industry struggling with thin profit margins. If it can deliver on this promise business will flood in and strong growth projections will be underpinned. But like all rapid growth companies there are risks - especially when combining such diverse operations.
The problem is that investors often overpay for the promise of growth and analysts can be hopelessly over-optimistic at forecasting it. James Montier eloquently points out in his excellent book 'Value Investing' that when analysts apply discounted cash flows, such as those used in forecasts, then the 24-month forecast error is 95 per cent and the average 12-month forecast error 43 per cent. That is a pretty wide margin for error.
So what are my concerns with Quindell? First there is the claims handling operation, Ai Claims, which deals with credit hire and car repair. It is a large part of the Quindell business and it is operating in a tough market. Under the combined group structure, Quindell doesn't split out Ai Claims' performance but the company used to be listed so historic numbers are available. In its last reported full year to June 2011 revenue was £117.6m, gross margin 18.5 per cent and profit before tax £3.74m. But fast forward to March 2012 and things were deteriorating. The results for the half-year to December 2011 saw revenue fall by 21 per cent to £47.5m, as hire income fell by 25 per cent, repair income slipped 14 per cent and profit before tax fell from £1.68m to £1.2m, or by 30 per cent. Steve Broughton, chairman of Ai Claims at the time, said in the statement: "Ai Claims has delivered a creditable first-half performance in challenging market conditions. We had already flagged the likely impact on our revenues of warmer than average winter weather this year and the continuing reduction in accident frequency and repair cycle times." Mr Broughton was appointed to Quindell's strategy and integration board on 15 October 2012.
I agree much can change in a year, and Quindell chief executive Rob Terry certainly saw enough potential in Ai to take it over in 2012. But those falling accident frequency levels and shrinking repair and credit hire cycle times have proved painful for other claims handling companies. On 11 December 2012 the Drive Assist group of companies fell into administration with administrator Zolfo Cooper saying in a statement: "Unfortunately, in recent months the companies have experienced the loss of a major customer which has resulted in increasing cash flow pressures and administration was the only option available." On the same day it emerged motor claims outsourcer Elite Incident Management was to be liquidated after the decision of a major client to insource its activities. With thin profit margins and high working capital demands claims handling companies are acutely sensitive to the loss of a major customer.
On 29 October media reports said insurer RSA, one of Ai Claims' clients, had moved some of its business to Enterprise Rent-a-Car. Quindell responded by saying that Ai Claims is responsible for only a small portion of group profits and that Ai still works on other contracts with RSA. Which is all true, but when Ai Claims became a subsidiary in April 2012 it increased run rate revenues from £50m to over £150m, cash demands of this business and its importance are greater than its contribution to group profits, so it may only bring in small profits but it still brings risks.
Quindell is much more than just claims handling, though. Mr Terry says it is now the leading legal and medical supplier to the motor insurance industry as well as an award-winning technology provider. In terms of revenue, if Quindell hits analysts' forecasts for 2013 of £460m Mr Terry thinks it will be split roughly £60m from technology revenues, £200m from medical and legal, and £200m from general claims management, which is largely Ai Claims. So as Quindell grows Ai Claims becomes a smaller portion of the business.
That jump in revenue from £165m to £460m looks like a big ask, but Mr Terry assured me Quindell was well on the way. Following the demise of Drive Assist, Quindell won contracts worth £120m a year with a major UK insurer. Quindell has also won multi-year contracts with other major insurance industry providers. As these ramp up in the first quarter of 2013, Mr Terry said revenue should reach a run rate of £100m by the end of the first quarter.
The other factor I have been keeping my eye on is cash. Let's not forget revenue is vanity, profit sanity, cash reality. Quindell's most recent trading update said it expects revenue for the year ended 31 December 2012 of £165m, and adjusted earnings before interest tax and depreciation (Ebitda) of around £47m, giving adjusted EPS of 1.29p. Cash at the year end was £47m. Sounds like a resounding tick in all the boxes.
Revenue is growing fast because of the heady pace of acquisitions and contract wins in 2012, Ebitda margin of 28.4 per cent is good, but to put this in perspective Ai Claims' last reported gross margin was 21.1 per cent (six months to 31 December 2011) and profit before tax was just £1.18m in that period. True, revenue in the Ai Claims operations has since increased following new contract wins, and operational leverage combined with cost savings from slimming down management teams should help give profits a boost, but it is still instructive as a guide.
Cash is king and many highly profitable companies have got into trouble because of cash demands. In the final quarter of 2012 Mr Terry said Quindell had generated Ebitda of £18m and operating cash of £12m, so 67 per cent cash conversion. The reason for that conversion rate, as Mr Terry explained, was that Quindell makes payments to insurers up front and on average has to wait five to six months until claims finalise and they receive all the cash. So I will also be looking closely at the balance sheet to see what is going on with cash. In Quindell's interim results to June 2012 revenue and Ebitda increased sharply, but there were warning signs of working capital outflows on the balance sheet as trade and receivables had increased by 193 per cent from the year-end, to £92.87m, while trade and payables increased 158 per cent, to £53.96m. When revenue races ahead and debtors expand faster than creditors you have to fund the difference somehow.
Mr Terry was absolutely clear that Quindell now has more than enough cash to fund expansion. He said that cash reserves of around £40m and credit facilities of around £40m, give Quindell £80m to fund the organic expansion of revenues in 2013. Quindell raised £63.5m net of expenses through the placing of 454.8m shares in November and December for these funds. In its last trading update the company had cash of £47.5m and net cash of £15m, with Mr Terry telling Investors Chronicle that "no more fundraising was required in 2013 to hit the 3p EPS targets".
That brings me neatly on to dilution. Investors don't get diluted if acquisitions deliver quality earnings growth. Mr Terry said in the trading update: "material acquisitions are only being considered where they are significantly earnings enhancing and any resultant equity issue is at a significant premium to current share price". He also mentioned organic growth no fewer than four times in the update.
Time will tell on the quality of Quindell's earnings, but what we do know is that to fund Quindell's rapid 2012 expansion plans shares in issue went from 2bn to 3.6bn by the end of the year, an 81 per cent increase. Detail in the Ai Claims deal documents on the 2 April stated that the Quindell Board has the authority to issue 3.37bn new Quindell shares representing 128 per cent of Quindell's then issued share capital of 2.63bn. Updating those numbers to today means Quindell is still able to issue another 2.4bn shares, or around 66 per cent of the current issued shares.
Quindell shares could also come under pressure from issuance if the deal to buy Abstract Legal Holdings (ALH), announced on 2 December closes as anticipated in early April. On completion this deal will require the issue of 267.8m shares, or 8 per cent of Quindell's current issued shares. A large number of shares issued to fund deals in 2012 will also exit lock-up periods this year (see table).
|Significant Quindell acquisitions subject to lock up|
|Ai Claims||25 Jan 12||58m|
|360GlobalNet||28 Feb 12||16m|
|Ai Claims||2 Apr 12||50m|
|IT Freedom||24 May 12||50m*|
|ICM||15 Aug 12||27m*|
|Quintica||18 Sep 12||48.4m*|
|Overland Health||26 Sep 12||140m*|
|Metaskil||10 Oct 12||40m*|
|ALH||3 Dec 12||28m*|
|SilverBeck Rymer||21 Dec 12||98m*|
|Pinto Potts||31 Dec 12||87m*|
|*Lock up of 12-36 months roughly a third per year|
Turning to the valuation of Quindell the shares at 15.25p are trading on a fairly conservative 11.8 times adjusted 2012 EPS, or 6.2 times House broker Cenkos' forecast for 2013 of 2.45p EPS. Some investors think the valuation multiple for Quindell should be in line with other high growth technology companies on around 20 times adjusted EPS. Applying this to Cenkos forecasts gets to a target price of 50p, and to Mr Terry's own 3p EPS target you get 60p.
But lets not forget what Quindell has to do to hit 2.45p, or Mr Terry's 3p target. Revenue has to almost triple to £442m and adjusted pre-tax profits have to more than triple to £126m. Quindell is well placed, but this kind of growth brings with it high risks. Also I think a lot of that growth will come through from the Ai Claims business, this company when listed had a five year average PE of 8 times, and when Quindell paid just over 24p per share for the business in 2012 this equated to a PE ratio of 6.6 times GECR forecast of 3.64p EPS for 2012.
I'll be watching Quindell with interest in the year ahead as it has provided the junior markets with a fantastic success story so far. Just as a matter of housekeeping I tipped Quindell on 19 July 2012 at 7.25p, and then advised taking profits at 13p on 2 November 2012. I am not permitted to invest in any company I write about and have never had a holding in Quindell shares.