The Quindell conundrum

What these have in common is that they were - or are - the subject of a speculative mania, or something close to it. In Quindell's case, its shares, which were admitted to London's alternative investment market (Aim) in 2011 at a consolidation-adjusted 37p, went on a roller-coaster ride that took them to a high of 262p in 2012, a low of 90p in 2013 before a crazy surge that ended at 660p this February. Quindell, like the others, is in a situation where investors are betting that behind the shares lies a great company but, at the time the money is staked, the proposition is unproven. In a way, it has to be like this. By the time it is clear that a wonderful company is emerging from its corporate pupa then, most likely, the shares will have produced their best returns. Investors must place their bets when the outcome is not just uncertain but close to glorified guesswork.

Yet the glorified guesswork must point to something special. Almost always - and specifically in Quindell's case - it points to a company that claims to bring capitalism's creative destruction to an industry or to a business process. That's always an intoxicating prospect - that investors can get in during the early days of a company that will make vast profits by spotting both the flaws in a familiar process and the potential that comes from re-arranging it.

What's so groundbreakingly innovative about Quindell? Good question because the brutal truth is it's hard to know exactly what Quindell does. Partly, that may be because it is young and fast-moving. For City analysts and financial journalists used to assessing firms with broadly-comparable business lines from one half year to the next, Quindell's pace of change presents a challenge.

Still, when Quindell reversed itself into a shell company, Mission Capital, in 2011 to get its Aim quotation, it described itself as a "re-selling and sales outsourcing company with expertise in technology, telecoms, utilities, retail and leisure". What that probably meant was that Quindell used its expertise in information technology to run sales operations for customers from the telecoms and utilities sectors. Certainly, Quindell's bosses reckoned the company had business-processing services and software that could drive growth. At that point, those services were used mainly in telecoms and utilities, but - significantly, in the light of Quindell's development - "future solutions are being developed to tackle industry-specific issues such as motor and household insurance claims", said the Aim admission document.

To what extent the solutions were developed and to what extent they were acquired is unclear. Clearly, however, in the ensuing three years, Quindell has been hugely acquisitive, doing about 30 deals; not that it ever made any secret of that intention. Yet it has changed its activities to such a degree that it now seems to be a collection of law firms pursuing compensation cases on behalf of clients and running those on its own business-processing systems.

That said, Quindell still advertises itself first and foremost as an IT company with "sector-leading expertise in software, consulting and technology-enabled outsourcing," according to its 2103 annual report. At least that is consistent with the background of its founder and boss, Robert Terry, and that's important because, as much as anything, its shares are a bet on Mr Terry's insight into the IT industry. The 45-year-old is an experienced entrepreneur who has spent most of his career in IT. He founded The Innovation Group - also a services provider in processing insurance claims - in 1997 and brought it to the London market during the dot-com boom. From there, he led the company on an acquisition binge before it almost went pear-shaped in the early 2000s.

As a result of Quindell's impact, Mr Terry now has a great following among private investors. Maybe not on a par with, say, the numbers who adored Polly Peck's Asil Nadir at his peak or, more recently, Autonomy's Mike Lynch, but at least equal to Coloroll's John Ashcroft or ARM's Robin Saxby. Ultimately, however, the test of Mr Terry's ability will be the profits that Quindell makes. There is no point in having marvellously innovate ideas if they don't generate profits. Sooner or later - in practical terms, sooner - Quindell has to deliver profits.

And there's the rub. In its short life as a quoted company Quindell has had no problems growing like crazy and producing the profits to match. Yet, while it delivers magical profits, its doubters say the numbers are just that - magical. Quindell has come up against the conceptual - almost philosophical - question: what is profit?

The flippant response is to quote the fictional finance director who is asked that very question by his rather dim chairman, to which the FD replies: "Anything you want it to be, sir." That leads to another well-known quip from the world of accounting - that profits are opinion but cash is fact.

In which case, Quindell's accounts are long on opinion and short on facts. This leads to the major issue surrounding Quindell, which has played a big part in the spectacular drop in its share price from 660p in February - where the stock market value of its equity topped £2.8bn - to today's 208p. It's to do with what accountants call 'revenue recognition'.

That Quindell is growing its revenues at a fantastic pace isn't in doubt. Table 1, Testing for efficiency makes that clear. From just £14m in 2011, revenues accelerated to £163m in 2012, £380m in 2013 and, according to the company, are on track to be well over £800m in 2014. Profits are following a similar course. Operating profit - net profits before a few bits and bobs, but chiefly interest and tax - went from £4m in 2011, to £36m, then £109m and, if City analysts are to be believed, will easily clear £300m this year.

However, operating cash flows tell a different story. In 2011, they were £3.1m, which meant that Quindell converted almost three-quarters of its operating profit into cash. In 2012, operating cash flow surged to £14.1m; even so, less than 40 per cent of operating profit was turned into cash. In 2013, the picture was completely different. Profits and cash flow went in opposite directions. Quindell converted none of its accounting profit into cash and, indeed, saw a £21m loss of cash at the operating level.

Quindell may be suffering from a severe case of what we could label 'extreme growth syndrome'. It's what can happen when a company grows very quickly - profits surge far ahead of its ability to generate cash. Several reasons lie behind that, but, for Quindell, the chief one is this concept of revenue recognition.

Quindell books in its accounts income due for work done long before it receives the cash payment. In other words, it 'recognises' the revenue even though it hasn't got the cash. This is understandable since much of Quindell's work is in processing insurance claims. The work is done up front and the cash disbursements from the insurer follow on (eventually). Besides, Quindell will book revenues according to familiar accountancy rules which demand that revenue cannot be recognised until:

■ The risks and rewards within a contract have been transferred from seller to buyer, which means Quindell should have done most of what it was expected to do.

■ The collection of payment is reasonably certain

■ The amount due can be measured with equal certainty

■ The cost of earning the revenues can also be measured reasonably accurately

If these criteria are satisfied - and Quindell's auditor needs to be confident they are - then the revenue can be recognised. Arguably, it should be recognised because costs will have been incurred and a fundamental concept of accounting says that, where possible, costs and their corresponding revenues should be recognised in the same accounting period.

Fine. However, the consequence is that the faster a company grows, the more that cash generation lags profit creation - and Quindell is growing very fast, indeed. As a result, Quindell is owed increasing amounts, which is quantified in the row for 'receivables' in Table 1. These grew from £32m in 2011 to £178m and £328m last year. More specifically, Quindell separates out its 'accrued income', which is the amount of revenue it has recognised before it has collected the cash. From just over £1m in 2011, this grew to £48m, then to £152m.

More on accrued income in a moment. Meanwhile, Table 2: Accounting profits to cash loss shows how that expansion sucks up cash. Take the schedule for 2013. Quindell's income statement showed almost £109m of accounting profits, but that was after various non-cash debits and credits. Add back almost £10m of depreciation and a £16m assortment of other charges, and operating cash flow - according to the company's definition, but not ours - was almost £135m.

Then, however, all the work that Quindell had booked but not been paid for meant that effectively it needed a gigantic loan to tidy itself over. That is quantified by the £124m increase in working capital, which was funded by the equity Quindell raised from investors during the year. Most of the increase relates to the £104m rise in accrued income during the year. The result is that £109m of accounting profit falls to £10m of cash profit. Then there are further adjustments; in particular, £24m for the cost of capital spending, which is the cash-flow counter weight to the £10m write-back of depreciation. All told, in 2013, £109m of operating profits swung to a £33m loss of free cash, an enormous movement for a business that recorded £380m of revenue.

Meanwhile, Quindell's £152m of accrued income - or 40 per cent of the turnover logged in 2013 - is also an issue because this is unusual for a software company. Typically, such companies generate a lot of income by selling licences. As a result, they get cash in upfront and gradually 'earn' the money over the period of a contract. This is illustrated in Table 3: Quindell compared. Business software developer Micro Focus (MCRO) has no accrued income in its latest balance sheet, which means that in the previous 12 months there was no revenue it recognised before the cash came in. However, waiting to be earned was £97m of 'deferred income' - equivalent to 38 per cent of 2013's turnover - which is cash received for work under some sort of deal that was still to be done. In contrast, Quindell's end 2013 deferred income equated to just 1 per cent of its turnover.

True, a comparison with a long-established software developer such as Micro Focus may be tough. Perhaps, a better comparison is with Mr Terry's previous quoted company, Innovation, which is in a similar line. Like Quindell, Innovation has only nominal deferred income, implying that much of the software income these two generate is via a payment-per-usage 'software as a service' model. Yet Innovation's accrued income of just 12 per cent of turnover is less than a third the size of Quindell's.

It's the major worry about Quindell, though all will be well if Quindell turns its receivables into cash. Chairman Rob Terry is adamant not just that the company can, but that it will start doing so imminently. Earlier this month, Quindell's board promised that there would be a significant operating cash inflow from 2014's fourth quarter.

Clearly, if Quindell fails to achieve that, Mr Terry will be in big trouble. The trouble will be almost as bad if 2014's final quarter inflow turns out to be a one-off as careering growth sucks up more cash in 2015 and beyond. Then the fear would grow that the profits were fictional; that the profitability of Quindell's business model was more theoretical than real and that growth was being maintained at almost any price to disguise that ugly truth.

Quindell would hardly be the first company to get itself into that bind. Nor has it helped its cause in three ways. First, its corporate communications are long on spin, jargon and sloppy writing. Sure, that's a problem with too many companies, especially in the IT industry, but Quindell is a big sinner. For example, take the following paragraph from an investors' teach-in in June where Quindell discussed developments in its insurance claims services: "There are still a number of infill earnings enhancing vertical opportunities available to the group, which provide us with a unique offering in both our core markets but this is not a current focus for the board. However, this would drive significant organic growth during a period of market share grab that only comes along once in a decade and with our unique combined offering and market leading technology it is quite clear that we are in pole position to capitalise on this opportunity." Make sense of that, if you can.

Second, earlier this year, it seemed in an indecent haste to get a full listing, almost enticing investors with the prospect of a place in the FTSE 100 index. As it happened, the company could not satisfy the listing rules. Third - and most important - the company comes with corporate governance issues. Mr Terry, who controls over 10 per cent of the equity, appears to be the dominant figure on the board where he is the executive chairman and where two of the five non-executive directors - including the senior independent director, Anthony Bowers - have a sufficiently long business relationship with him for their independence to be questioned.

Still, no ugly truths have yet to emerge from Quindell and the hope is that they won't simply because corporate success stories are so much nicer than corporate failures. Besides, there is one significant indicator that at least a good chunk of Quindell's profits are real - Quindell pays a lot of corporation tax.

Sure, just like any quoted company, Quindell charges lots of tax in its income statement. But, then, companies want to impress investors by declaring big profits and one consequence of doing that is having to charge taxes, too. But the key question is: how much of the tax charged is actually paid? Little tax paid though much charged implies the profits leaned heavily on creative accounting. Tax both charged and paid - though usually in succeeding accounting periods - implies that the Revenue & Customs, which has better access to a company's books than any investor, reckoned the profits were real. In Quindell's case, profits were real enough for it to pay £2.5m tax in 2012, shooting up to £10.4m in 2013.

It's a promising sign, yet with Quindell it's hard to avoid the old but incisive investment aphorism that, if something looks too good to be true, it probably is. For those investors who have already made big money from Quindell's shares and exited, that does not matter. Meanwhile, those who are still in the stock or have yet to buy - assuming that significant sums are being wagered - must be confident they have the constitution to cope with lots of worry. If they are not, they should get out now or forget about Quindell altogether.