Globo Plc – Value superstar or too good to be true ?
At a first glance, Globo PlC looks like a highly profitable, strong growing and incredible cheap software company suffering only from overall bad sentiment against anything which is related to Greece. A second short look however shows clearly that there are a lot of issues in their accounts (capitalization of expenses, revenue recognition) which in my opinion already raises a couple of red flags.
Additionally, some of their behaviour like taking on expensive loans despite a comfortable cash position does make no sense at all.
As for me, value investing is foremost about protecting the downside, Globe PlC is not something I am interested in as a potential investment and not worth additional analysis.
Among value investors, Globo PlC, a UK listed mobile phone software company is no stranger. Almost any screener will have Globo as one of the top investments.
Here are the current ratios which clearly look attractive:
Market cap 186 mn GBP
Operating margin 35%
yoy revenue growth +49%
yoy EPS growth +27%
Net cash 40 mn EUR
For some strange reason, whenever I see something like this my first reaction is “This can’t be true”. There has to be an explanation for this apparent under valuation. Especially in a market environment like now there are no “undetected value pearls” anymore.
In Globo’s case, one part of the explanation is pretty easy: Globo started out as a Greek company, is run and owned by Greeks and still does (some) business in Greece. So the recent mayhem in Greece has clearly taken its toll on Globo’s stock price as we can see in the stock price chart:
If this would be the only explanation, then Globo would be very interesting. Getting a stock for cheap because sentiment is bad, I mean that’s what value investing is all about.
Usually for me the next step is to look into the last annual report in order to get an “unprejudiced” view of the company. Globo’s 2014 report came out 4 weeks ago.
The first strange thing already appears on page 25 of the annual report:
Profit before tax of €35.7 million, an increase of 30% (2013: €27.4 million) and ahead of market expectations. This reflects the combination of strong top-line demand and the allocation of resources to increased marketing and direct sales processes combined with the cost efficiencies that the Group has achieved.
Increased Free Cash Flow generation to €7.3 million (2013: €5.2 million), excluding the impact of the Sourcebits acquisition. This is the third consecutive year in which Globo has generated positive Free Cash Flow whilst maintaining strong revenue growth. Cash conversion of profits remained healthy at 72%, supporting organic investment and working capital needs.
Despite the fact that 7,3 mn is not even close to 72% cash conversion, for a Software Company, Free cash flow generation looks really really bad. Usually for most software companie cashflow is even higher than stated profits, so this is clearly something to look at.
On page 34 then the “UH OH” moment arrives with the following statement:
Investments in intangible assets of €23.5 million (2103: €14.6 million), amounting to 22.1% of Group revenue (2013: 20.4%). This resulted from the balance between an ongoing commitment to product development and innovation and the significant economies arising from R&D centres located in Ohio US, Greece and Bangalore
If we translate this bullshit sentence into plain English it actually means “We capitalize a large part of our cost to make our earnings look better”. Capitalizing costs is not illegal but it is aggressive accounting. A software company like IGE&XAO for instance does not capitalize at all R&D. So in order to compare Globo’s numbers to other software companies, one should expense most of this which is roughly 2/3 of the shown profit.
Looking at the balance sheet and the P&L of Globo, we can see additonal “odd things”:
1. Receivables are relatively high and growing quicker than sales
In 2014, receivables jumped from 28,6 mn EUR to 50,8 mn EUR or from around 0.4 years to 0.5 years of sales. The receivables disclosure is actually not very good. On page 37 they mention the following:
The Group has billed and unbilled trade receivables together with customer specific work in progress totaling €45.7 million.
However in the notes to the receivables (nr. 23) there is no further information on what has actually been billed or is work in progress. For software companies, revenue recognition is always a critical issue, Just ask HP why they had to write down 9 bn od their 11 bn purchase price at Autonomy. The 22 mn EUR jump in receivables also “eats up” much of the growth shown in the income statement If you adjust for the acqusition (~5 mn sales) and receivables (22mn) only ~10 mn “real” grwoth remain. Not bad but pretty far from the 50% shown in the head line numbers.
2. They pay almost no taxes
According to people more familiar with Globo, this is due to the fact that they get “research tax credits” in Cyprus. WHich I find strange as they talk about R&D “in Ohio US, Greece and Bangalore”. No wonder that the Greek and Cyprus governemnt has revenue problems….Anyway, I would find it quite aggressive to assume that Globo will continue not to pay any taxes in the future. One should also take into account the possibility that the tax collectors at some point in time actually do not aggree with Globo and then Globo will have to pay past taxes. I don’t know about other countires, but in Germany for instance this can hit you until 10 years after a business year if they do a special audit.
3. Their funding strategy makes no sense
Globo claims to have 83 mn gross cash and 40 mn debt so ~43 mn net cash. Nevertheless they increased borrowings by almost 20 mn EUR in 2014 without any obvious reason. As a result they paid around 4,1 mn EUR of interest and only received 0,3 mn interest income on their cash. Why would anyone pay 4 mn EUR net fincance cost a year just to increase a non-required cash position ?
As a software company, they shouldn’t have any specific intra-year working capital spikes so there is no economical reason for this at all. If you need a buffer for potential M&A transactions you would just sign a credit line at a fraction of the cost and draw it down when needed.
Another interestign aspect however is that the UK parent company is actually net cash negative. If we look at the Company balance sheets (page 57) we can see that the parent has -29 mn net debt.
The parent company cash flow statement looks even more bizarre. There are only operating cash outflows and the cash inflows are either new loans or capital increases (2013). Even more strange was their (failed) attempt to issue a high yield bond in June. According to Bloomberg, they wanted to raise 180 mn USD. This was the official reason given:
Upon successful completion of the offer the net proceeds from the sale of the Notes will primarily be used to fund further acquisitions that support the Group’s international expansion strategy in its key growth markets. Additionally, proceeds will be used to repay existing indebtedness and for general corporate purposes.
Honestly this is quite an idiotic reason to issue a bond at an indicative pricing of 8% p.a.. In order to repay existing indebtedness, they could just use their existing cash (if it exists). Also, the normal way to do this is to actually sign the acquisition first with a potential bridge financing and issue the bonds afterwards. Bond investors would then know what they would get and banks are happy to extend loans when they get the High Yield bond business.
If I would be in a friendly mood, I would rate their financing startegy as “amateurish”, I don’t want to say here how I would call this in a less friendly mood.
4. For such a small company they have a surprisingly complex structure
In the list of the subsidiaries one can see a lot of strange subsidiaries “holding intellectual property” in interesting jusrisdictions like Jersey or Cyprus. This might be part of the genius tax structuring but overall looks quite intransparent and hard to understand. Taken together with the strange account of the parent company (very little participation values, huge receivables position), this would not give me a lot of confidence what I actually would own if I buy a stock of the parent company.
I know that not many investors care about such things but for instance with the “Chinese-German” companies this was one of the features where it there was a clear indication that most of those companies were actually empty shells used to funnel funds from investors to “insiders”.
5. My favourite strange item: classification of bank counterparts
This is something I only recognized when I read it a third time. Let’s look at the table how they present their cash balance:
|31 December 2014|
|A+, A, AA-, Aa3||9.977.272|
|B3, B, B-,Baa3||72.774.361|
At first I would say: This is a normal table sorted “descending” by rating. But a second looks shows us an “interesting” feature: The majority of the cash is held in banks which are either low investment grade (Baa3) or deep junk (B3, B, B-). So one could ask now: How much is actually held in the “still investment grade accounts” and what is held at junk banks. They way they present it, even if only a single EUR is held at the Baa3 account would be enough.
Compare this with what they write earlier in the annual report:
At the end of the period the Group had cash resources held by counterparties (“Banks”) of €82.8 million. Our counterparty risk management is focused on the protection and availability of cash deposits for the benefit of the Group. Actions have been taken to reduce counterparty limits with certain financial institutions and to hold a significant proportion of our euro denominated holdings in highly rated banks outside of the Eurozone.
One thing is clear here despite their rather obscure disclosure: Most of the money (if it exists) IS NOT held by highly rated banks but rather at pretty weak institutions.
TOO MANY RED FLAGS
For me, despite having had already quite some entertainment while reading the report, this is now the place to stop. In such a case, the possibility to loose all your money is definitely not zero. To be honest, in one other case where I did the same (Reply Spa) the stock made around 400% after I had rejected it for some “creative cash flow reporting”.
For any one who is maybe less risk averse I would however recommend to adjust the profits with regard to capitalised expenses and normalized taxes. Roughly speaking, “true earnings” are maybe only 1/2 of stated earnings if you would assume more conseravtive assumptions.
If Globo turns out to be a actual great company and continues to grow like crazy then the upside is of course there. On the other hand, for me value investing is mostly about protecting the downside. And in a case like Globo, the downside case for Globo is clearly there. I do not want to own companies where the chance of a total loss is relatively high. My “style” of investing works better with very boring companies where in the worst case I don’t loose much. There is a sometimes invisible line between investing and speculating, but for my this line is crossed if I cannot trust the accounts of a company.
For me there is no need to dig deeper into the business itself as I never would be sure that the whole thing doesn’t turn out to be “another Autonomy” but without the take-over….
Ennismore & would I short this stock ?
It is no secret that fundamental small cap investor Ennismore is short the stock (-4,4% of the outstanding shares). They had issued a 5 page research piece on Globe more than a year ago which includes some more stuff like the questionable background of one of the board members.
For the time being I would not short the stock. Why ? First of all, I do not know enough about the company. I have only looked at the most recent annual report for maybe 2 hours. Secondly, as in the Autonomy case, especially in the software sector there might always be another cash rich software company with a bad Due Dilligence team who might actually buy them. Or if they actually manage to issue a 180 mn USD high yield bond with few covenants, they could actually buy themselves out of trouble if they are lucky.