I can fully accept when a company is trading below expectations; these things happen. However, it is the duty of the board to alert the market at the earliest opportunity as and when they become aware that the company is going to miss consensus expectations by a significant margin. Otherwise, the board is being negligent in its duty as it would be creating a false market in the shares by knowingly misleading investors as to the true operational performance of the company. I discussed the obligations of directors and the rules governing market transparency rules in my article earlier this month (‘Awaiting a catalyst for a re-rating’, 11 July 2013).
The Disclosure and Transparency Rules (DTR) apply to companies with a full listing on the London Stock Exchange. The fourth of the Listing Principles ensures adherence to the spirit as well as the letter of the DTR: a listed company must communicate information to holders and potential holders of its listed equity securities in such a way as to avoid the creation or continuation of a false market. Aim companies are under a similar obligation, imposed by rule 11 of the Aim rules.
As most companies issue pre-close trading statements ahead of their final and half-year results, as well as regular trading updates at their annual meeting and during the financial year, there is no excuse whatsoever for directors failing to enlighten investors if there has been a material change in the trading performance of the business. It is commonly believed by many investors that an announcement has to be made by the board when earnings will diverge by 10 per cent or more from consensus forecasts. However, regulators are clear that there is no '10 per cent rule' and that price movements below that threshold can still be deemed 'significant' in particular cases.
And therein I have a major problem with the reporting of Indigovision. The company has just issued a trading statement two days before its financial year-end in which the board has stated that the company has been trading massively below analysts' earnings expectations. Revenues are close to those expected by analysts at brokerage N+1 Singer (£32m versus the broker's estimates of £32.4m), but pre-tax profits of £2m have missed their forecasts of £3.4m by a country mile. They have even missed the company's prior year reported pre-tax profit of £2.3m.
This all begs a question as to when the board became aware that profits would miss consensus estimates? Was it really on Monday 29 July when the company issued a profit warning, only two days before the financial year-end? Are the management controls in place that poor that the directors didn't notice their company was operating a massive £1.4m of profit shy of analysts' estimates for the 12-month period? There can be no argument at all that Indigovison has missed market estimates by a significant margin. In which case, I would request that the directors of the company issue a RNS to the London Stock Exchange immediately stating clearly when they became aware that the company was trading materially below profit estimates for the financial year to end-July 2013. I await an announcement with bated breath, but am not hopeful. Perhaps the Financial Conduct Authority would like to look into the timing of this warning and whether the directors should have issued a statement to the market earlier?
The major question marks over the credibility of the board aside, the investment case for Indigovision has crumbled with this warning. N+1 Singer has slashed profit estimates for the financial year to end-July 2014 by more than 20 per cent to £3m and this is assuming that revenues grow by £4m in the 12-month period to £36.2m. If the company achieves this then EPS would recover to 28.9p (downgraded from 35.9p). However, I have my doubts that even this lower earnings estimate will be achieved after the latest trading update. Even if the company hits these estimates, the earnings multiple I am prepared to attribute to the company is now far lower than I was previously prepared to value the company on. That is only fair considering a discount has to be applied due to the issues over the credibility of the board and the apparent lack of management controls.
To put the current valuation into some perspective, based on profits of £2m for the financial year to end-July 2013, N+1 Singer expects Indigovision to report EPS of 19.2p and end the period with only £900,000 of cash. That cash pile is only worth 12p a share and is way below the broking house's prior forecast of £2.8m. So the cash generation from the business I was looking for has failed to materialise. Moreover, even if you strip Indigovision's cash out from the current share price of 303p, the shares are still trading on a PE ratio of 14 for the 12 months to July 2014. That's expensive. And, as I said before, I have serious doubts as to whether Indigovision is going to be able to hit the July 2014 estimates.
As a result I am bailing out of my buy recommendation (‘Buy the breakouts’, 4 June 2013) even though I am sitting on a stomach-churning 25 per cent loss on the investment after the company's profit warning. The outlook may be positive and seemingly there are some large projects in the pipeline, but my advice here is simple: sell.
Please note that I will update the investment case on Inland (INL: 32p) and WH Ireland (WHI: 59p) as soon as I have completed my research and analysts have released their updated estimates.
Finally, I updated the investment case on 11 small-cap shares in three other online articles yesterday: Small-cap wonders; Deep value plays and Small-cap trading buys. I have also analysed the investment case on four more small-cap companies in three other online articles today: Undervalued and Unloved, Running profits and Capitalising on capital returns.
