Adapt-ing to accounting standard issues
- South Africa
- Accounting standards, Adapt IT, HEPS, IFRS 16, IT, Software, Trading Statement
- October 26, 2020
Adapt IT is a JSE small cap operating in the IT industry. The company is worth around R390m which is unremarkable. The remarkable news is that it was worth only R160m at the end of September.
This is the thing with smaller companies on the JSE: they trade sideways for extended periods and experience significant jumps or drops based on newsflow. This is because liquidity is typically low and institutional investor interest is limited, so high volume traders rather play in more liquid shares over the course of any given year.
Remember, liquidity is a measure of the amount of trade in a specific share.
When there is a catalyst for a share price move (like a trading statement), strong investor interest flows into the stock and you see mouthwatering (or soul-destroying) moves.
The share price jump on October 1st was because of a trading statement released late on September 30th where the company confirmed that “Normalised” HEPS (Headline Earnings Per Share) would change by -1.4% to 3.6%.
Hang on a second. That’s not good news, so why did the share price jump? Also, isn’t a trading statement only released when earnings will change by more than 20%?
Learning to deal with accounting issues
From time to time, new accounting rules are introduced that have a significant impact on listed company results. IFRS 16 is one such standard.
IFRS stands for International Financial Reporting Standard and IFRS 16 is the standard that governs the accounting for leases. It sounds simple enough, but the complexity is the treatment of leases where the substance of the lease is that the company is the owner of the asset by all economic measures, even if not by legal measures.
This is estimated based on the specific terms of the lease and becomes intensely complicated for large companies with numerous leases in place. The effect of the standard is that most leases are brought “on balance sheet” and accounted for as though the company owns the asset (even though it doesn’t).
The standard is there to avoid companies manipulating balance sheets through having significant lease obligations that are invisible to shareholders, hidden away as a simple rental charge in the income statement.
This may all sound crazy to you, but commercial contracts become unbelievable complex in practice.
When a new accounting standard is introduced, companies are usually compelled to report the effects of that standard separately.
If the effect of IFRS 16 is stripped out, Adapt IT announced an expected change to Normalised HEPS of 6.1% to 11.1%.
That’s still not a change of more than 20%?
No, it isn’t.
Normalised HEPS isn’t a thing though. The JSE recognises no such concept. Companies use it to try and give shareholders a better idea of what the sustainable performance was.
HEPS is what the JSE cares about. Excluding the effect of IFRS 16, HEPS was expected to change by 24.2% – 29.2%.
Finally, we’ve identified why a trading statement was issued in the first place and why the share price skyrocketed. Or have we?
To be technically correct, the JSE would’ve measured the trading statement applicability based on HEPS including the effect of IFRS 16, which was well below 20%.
Adapt IT was conservative and transparent in its reporting to shareholders, issuing a trading statement which wasn’t strictly necessary – this always helps endear a company to the broader investor community.
Enough accounting lessons for today – what does Adapt IT do?
Adapt IT is a software group that provides software to a variety of industries. Some of the industries were real winners over the lockdown period, like education and telecoms.
Others aren’t so great, like manufacturing and especially hospitality.
The mixed effect is that revenue grew over 3% in the 12 months to June 2020. The revenue growth was primarily driven by acquisitions (5%) rather than organic growth (-2%), but it’s still an ok result over this period.
However, one must note that this result was for the year ended June, so lockdown only impacted the last 3.5 months of the reporting period.
Annuity revenue comprising 62% of total revenue gives the group a defensive position from which to compete in the South African market. In the tech world, annuitized revenue is all the rage. Investors hate lumpy revenue.
Operating profit looks exciting at first blush (up 21%) but IFRS 16 is causing havoc here again. Splitting out the accounting standard reflects only 9% growth in operating profit.
EBITDA margin moved in the right direction but not by much, increasing from 15.96% to 16.82% (ignoring IFRS 16). With IFRS 16, the margin suddenly leaps to 20.04%.
The point I’m trying to make is that you have to be extremely careful in interpreting financial results of a company. Don’t just rely on the headlines – open the result and have a look at whether there are major reconciling or explanatory items (like a new accounting standard).
Adapt IT has put in a decent performance here but nothing particularly special in my view. It’s an IT company and they generally did ok over lockdown. In any event, lockdown only hit the last few months of the financial year. In that context, the revenue growth is not strong and the improvement in operating margin is negligible.
With just over R70m in attributable profit, Adapt IT is now trading on a price/earnings ratio of around 5.5x. The share price has run hard to get to this level, particularly over the past 30 days with a 137% return, but over 5 years the company is down -74%.
I fear the opportunity for attractive share price returns from Adapt IT has run its course. I also fear that the market didn’t take the time to look through the IFRS 16 noise, driving the share price based on margin expansion that was mostly attributable to a change in accounting rules.