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I'm always quite wary when companies make acquisitions. Growth by acquisition always suggests a lack of organic revenue generation capabilities of the top-level management. Who said Rentokil Initial (LSE: RTO)? Anybody thinking Lloyds TSB (LSE: LLOY) too?
Apart from the corporate purchases, the only other factor to really consider is the deterioration in the working capital profile. Here is the reconciliation of operating profits to net cash flow from operating profits for the last five years at MMT.
Notice how large amounts of cash suddenly start to get tied up into working capital (especially debtors) after 1996. Is that anything to do with a general loosening of trade terms, a relaxing of financial discipline, or perhaps the acquisitions at work? I think it's the acquisitions. The five years before 1997, the profile was consistent, a couple of hundred thousand or so absorbed into debtors or creditors each year.
Those are my main concerns. Is there anything to really fear from the acquisitions and the resulting affect on working capital. I don't think so, although I'm surprised at the recruitment agency purchase. IT agents are very much a commodity business in my book, although Summers does appear to be a premium player.
"It's bizarre, but when a stock price is rising, confidence in the prospects of your company increases. And the possible problems ahead become dismissed. In contrast when stock prices decline, so the doubts and fears creep in."
After the piece was published, and the Stock Exchange finally opened on that day, MMT shares fell even further to close at 515p, on the back of a 22% decline in the previous fortnight.
On the train home that night, I was thinking of the question marks over the MMT accounts that I alluded to last Wednesday. Thoughts such as "Does the stock market smell some bad news?" and "What was that phrase about falling knives?" did the rounds in my mind. As I wrote earlier "...so the doubts and fears creep in".
But, a day is a long time in the stock market.
At the time of writing (mid-morning last Friday), MMT are about 10% up from our purchase price (587p, including all costs), and around 25% up from Wednesday's close. So, all of a sudden, I'm sitting here at home thinking "What was all the fuss about" and "Do I really need to revisit the MMT decision?".
Again, as I wrote earlier "but when a stock price is rising, confidence in the prospects of your company increases. And the possible problems ahead become dismissed." How true.
But...I'm not going to sit back, put my hands behind my head, rest my feet on my desk and let the very short-term movements help dissolve the question marks that hang over the purchase decision...
As Bruce always says, there isn't such a thing as the perfect company. Although I gave MMT quite a positive write up when I proposed the company in March, there are two aspects that could unnerve investors.
MMT on the acquisition trail
(Or dare I even consider FI Group (LSE: FI.) buying Druid (LSE: DRD) and CMG (LSE: CMG) purchasing Admiral (LSE: ADC). And do both these acquisitions suggest a slowdown of organic growth in the world of IT services? I hope not.)
Of course, there are the financial risks as well with acquisitions. Why is the vendor selling his business? Is the purchased business going down the plughole and the vendor making a quick exit? In my book, there's no growth like organic growth. It just cuts out the uncertainty.
MMT had historically grown organically. As I mentioned when I put MMT forward originally, the company had, on a conservative calculation, organically grown its revenues at an average annual rate of 15% during the 1990s.
Then, all of sudden, two quite significant acquisitions were made in late 1996. And just to raise the eyebrows a little further, the corporate purchases were a slight change in direction compared to the core MMT business. Whereas the main MMT operation was primarily producing bespoke IT work for clients, the two new businesses developed and marketed their own off-the-shelf packaged software.
But both acquisitions fitted the MMT "niche" high-margin angle on the IT market. The first purchase, Cortex, was involved in derivative trading software. The other purchase, Webbins, created software that capitalises on the deregulation of world-wide electricity markets.
In the 1997 annual report, MMT Chairman Mike Tilbrook commented that "Cortex made profits comfortably ahead of management expectations. Webbins also delivered a contribution ahead of target...(and) we are increasingly presented with exciting opportunities"
Move ahead two years, and a different picture emerges: "Our derivatives operation struggled to make new sales in 1999... there have been few new traders and existing members have been reluctant to deploy new systems. The pace of deregulation of the electricity supply industry has been slower than anticipated and fewer sales had been closed by year-end than expected".
Although revenues remained flat for this "specialist solutions" division moving from 1998 to 1999, operating profits from the division slumped 30% in the same period -- from £1.66m to £1.16m. Have MMT been caught out with these purchases? Or are these temporary blips in performance? One thing I'm sure on is that MMT didn't overpay for the two operations, judging by the historical performances.
My rough calculations suggest that MMT, after purchasing the original majority stakes in both companies in 1996, valued the whole of the two operations at a total of £2.73m. After annualising the subsequent 1997 contribution of the acquired earnings, generating a figure of £0.56m, I figure that MMT purchased the two acquisitions on a price to earnings ratio of just 5.
With the subsequent purchase of the minority stakes of Cortex and Webbins valued at 8 times earnings, there appears to me to be a large margin of safety in the purchases, even if profits at the specialist solution division continue to tumble. Having said that, the division did contribute 15% of MMT's 1999 total operating profit. Any further setbacks will be material to the overall group.
And the arched eyebrows were raised even further after MMT purchased a freelance IT recruitment agency, Summers Associates, in1998. There is some logic to the acquisition, MMT now having numerous specialist contract employees "on call" for short-term "fill in" work. The aim of MMT is to move Summers to become a recruitment blend of permanent and contract IT staff.
For a freelance IT agency, operating margins are particularly high at Summers. At around 10%, it once more reflects a "niche" business MMT looks for. And again, MMT haven't really stretched themselves in terms of payment for Summers. An initial price to earnings ratio of 6 was paid to acquire a majority stake of the group, the rest being bought at 11 times Summers' future earnings.
Indeed, it was the Summers purchase in mid-1998, leading to a full contribution to MMT's revenues a year later, that allowed Mike Tilbrook to declare this in 1999: "In the circumstances (the Millennium slowdown), I believe your Company showed considerable resilience in advancing both turnover and earnings per share".
Stripping out the 3.5 months 1998 sales contribution of £2.49m from Summers, and excluding an assumed Summers annualised 1999 sales figure of £8.5m, leads revenues without the recruitment agency declining to £32.52m in 1999 from £34.21m seen in 1998. A 5% decline. So much for the "Millennium resilience".
And the acquisitions and investments continued in 2000. A small website developer, again a high-margin niche business, was bought in January, while a 24% stake in an independent electricity supplier, in exchange for computer software and services, was acquired in the same month. Both these transactions are minor compared to the MMT group as a whole.
So what can I say, other than I'm counting on one aspect with these acquisitions -- the MMT management. They've got a great operating record so far, and I'm hoping the deterioration in some of acquired trade is of a temporary nature, rather than leading to some corporate growth-by-acquisition faux pas. Comments from the company suggest it's the former, but the risks are there, nonetheless.
Working Capital
1995 1996 1997 1998 1999
(£000) (£000) (£000) (£000) (£000)
Operating
Profit 2,717 3,830 5,074 8,735 8,159
Change in
Debtors (128) (550) (1,223) (3,219) (1,733)
Creditors 69 297 (950) 249 (1,054)
Stock 27 0 12 (211) 3
Other (251) 289 488 869 382
Net cash flow
From operating
Activities 2,936 3,866 3,401 6,423 5,757
The cash profile for two of the acquisitions is very different to that of the core MMT Group. Cortex and Webbins provide big-ticket software packages to only a handful of customers. Once the sale is registered, a very chunky entry is made within the debtor ledger. But it may be a few months before payment is received.
I'm quite relaxed about this unfavourable cash profile, and the apparent deterioration. It's not particularly brilliant, but with bad debts hopefully kept at a minimum with a blue-chip clientele, the working capital aspect of Cortex and Webbins is acceptable.
One IT company that is a good example of this "nice chunky sales, shame about the cash" characteristic is London Bridge Software (LSE: LNB). Very lumpy software sales at London Bridge are usually paid by clients several months down the line. The lack of cash hasn't done that much harm for their share price. But then again, MMT doesn't quite have the same recognised growth prospects.
In Summary
Certainly, I would be thinking very differently about the purchases had we bought MMT as a highly-rated stock. A small but troublesome division can distract even the best management, leaving optimistic growth investors high and dry should overall group profits suffer.
And what about the Y2K slowdown? Was there anything more fundamental that caused the decline in underlying revenues? What about the next set of results, covering the six months ended February 2000, published next month? I'm sure the results won't be anything to write home about. It's the outlook statement that I'll be interested in. My biggest fear is that the post-Millennium work isn't on the cards. But the management expect the work to come through. And like the acquisitions, I'm trusting the management on this count.
At the end of the day, MMT Computing was bought with three deciding factors. Firstly the near 20-year record of proven and quoted growth. And that record gives credence to the ability of the long-standing management. The founder may have recently become the non-executive Chairman, but the new Managing Director, Tony Grellier has been at MMT for thirteen years and served five years in the boardroom. I'm banking on him not diverging from the historical recipe for success at MMT. With MMT, a services provider without any true "business franchise", it really is "management, management and management" that will keep shareholders content in the years to come.
Then there is the favourable industry. I'm keen to position the Qualiport into industries with a tailwind behind them, for obvious reasons. IT consulting and software is one such industry. And finally, and perhaps most importantly, the relatively cheap MMT entry price. Standing on under 10 times profits eighteen months out just can't be considered expensive. If there is a management slip up, the post-Y2K work doesn't come through or the Cortex/Webbins businesses prove problematic, I hope our undemanding purchase price will limit the downside.
The picture will become clearer with MMT's interim results in May.
Related Links
• MMT -- Qualiport Material?
• Greed, Fear and a (MMT) Buy
• MMT Music
• MMT take a stake in Imperial Power
• MMT Website