Fool's Eye View

[ February 15, 2000 ]

Not So Compelling Compel

By Maynard Paton (TMFMayn)

Carburton Street, London -- IT companies fell into two categories last year. The first group consisted of the likes of Sage (LSE: SGE), Logica (LSE: LOG) and CMG (LSE: CMG). This bunch sailed through into the new Millennium without any noticeable downturn in their financial performance. Their customers, it appeared, had no intention of holding back orders in the run up to the much-vaunted date change.

The second group, consisting of mainly smaller players, fared less well. Shareholders in Gresham Computing (LSE: GHT), Triad Group (LSE: TRD) and MMT Computing (LSE: MMT) all suffered a poor 1999 as their investments warned of a slowdown in business in the run up to the New Year. Unfortunately for Compel Group (LSE: CGR), the company fell squarely into this second category.

Compel, an IT consultancy and outsourcing specialist, left it rather late in the day to warn shareholders of a material shortfall in "Millennium" profits. An AGM statement at the end of October confirmed investors' worst fears. But at first glance, Compel does appear to be back on track with the release of its interim results this morning. But a deeper look at the accounts gives a much less impressive picture.

Compel is quick to remark on the post-Y2K upturn in business, with the underlying market that Compel addresses "remaining strong". The group also highlights that a robust flow of substantial new contracts from FTSE 100 companies is expected, and that customers' expenditure will increase materially during the first six months of the year. It's all positive turnaround stuff.

Talk of the financial performance, though, is limited. Chairman Neville Davis only mentions the numbers once in the press release -- "The Group's pre-tax profit of £3m (1999: £5m) was in line with expectations at the time of the AGM".

For the record, here are the figures presented by Compel.

                     Six months to        Year to
                  31/12/99    31/12/98   30/06/99
                    (£000)     (£000)      (£000)
                  
Turnover            135,698   121,590     293,750
Operating profit      3,241     5,438      13,829
Earnings per share       9.9p      11.6p       36.2p

However, all is not what it seems, in the profit and loss account.

Back in January 1999, Compel acquired Info'Products, a loss-making IT service firm, for just £1. The net asset value of the newly acquired company was £16m. The purchase brings into play an unusual accounting concept -- the concept of "negative goodwill".

In the more familiar situation, where one company pays a premium to another's net asset value during an acquisition, the familiar "positive goodwill" is created. Under FRS10, this goodwill is capitalised in the balance sheet and amortised over several years. The amortisation is charged through the profit and loss account, and reduces reported profits.

But when companies generate negative goodwill, the whole situation is effectively reversed. "Negative amortisation" is then credited to the profit and loss account, artificially boosting profits.

Thus for the year to June 1999, £7.2m of negative goodwill was released through to the profit and loss account, doubling the reported accounting operating profits. No wonder Mr Davis commented in his 1999 annual statement that the new loss-making division had actually been "earnings-enhancing".

Again, in the interim period ending last December, a further £3m of negative goodwill was released in a similar manner. Without the goodwill interference, Compel actually made a trading profit of only £241,000. After interest and tax, Compel just broke even.

Although Compel are following accounting guidelines, it is far from obvious as to how much of the Compel reported profits are actually genuine profits and how much is generated from an accounting convention.

It's strange, but not surprising, that Compel don't actually report any "adjusted for goodwill" profit and earnings figures. On the other hand, most companies saddled with large goodwill write-offs take great steps to inform shareholders of their more realistic, and larger, profit figures.

As Compel reported interim earnings of 9.9p, when a more accurate figure would be have been 0p, their shareholders really ought to be concentrating on the financial presentation first and foremost, rather more than contemplating the bullish outlook statements.

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