How Quindell PLC Could Disappoint Investors

quindellQuindell (LSE: QPP) unveiled a significant shift in strategy at an ‘Investor Teach-In’ on 17 June. The company announced it was going into the market for ‘noise-induced hearing loss’ (NIHL) claims in a big way.

Up until this point Quindell’s services division (responsible for 80% of group revenue over the last two years) had been focused largely on claims related to road traffic accidents (RTAs). Management had only ever mentioned in passing the company’s employer liability and public liability work (a whole gamut of things, including NIHL).

Reading off a chart from the investor teach-in materials, I calculate that Quindell’s targets going forward imply NIHL claims will make up a whopping 75% of the services division’s revenue.

Quindell’s shares opened at 270p on the morning after the teach-in. Now, four weeks and a bullish trading update later, the price is 230p — down 15%. So, what’s going on?

On the face of it, Quindell is an absolute bargain, trading at less than four times forecast earnings. This super-low earnings rating suggests the market is currently listening to sceptics, while bullish noises coming from the company and its brokers are falling on deaf ears.

What are the sceptics saying? Let’s have a look at their broad hypothesis.

It’s well known within the insurance industry that until recently Quindell had been aggressively buying up huge volumes of work in the RTA claims management market, bidding well above competitors for claims produced by claims management companies (CMCs), or ambulance-chasers in popular parlance.

Industry veterans are sceptical about the exceptional profit margins Quindell is reporting. They believe that not all of the accrued income that is building up rapidly on the company’s balance sheet — and which feeds into the ‘paper profits’ in the income statement — will subsequently come through as hard cash in the cash flow statement.

Now, investors have been waiting patiently for Quindell to prove that its paper profits translate into positive cash flow. And management had promised that operating cash flow this year would move to breakeven in Q3, followed by an inflow of £30m+ in Q4.

The sceptics suggest that if Quindell had continued with its existing RTA-claims-dominated model, management would have been unable to deliver on its cash-flow promises. Therefore, it was essential that Quindell found some way to meet (or exceed) cash-flow guidance, and the guidance on its other key performance indicators (KPIs); namely, profitability and EBITDA margin.

This, the sceptics suggest, explains the sudden and aggressive move into NIHL work. Moreover, the sceptics speculate that while Quindell’s volume and success-rate predictions for NIHL claims conveniently enable the company to meet or exceed 2014 KPIs, the predictions are wildly optimistic, and will ultimately lead to cash-flow disappointments further down the line.

It takes around 18 months for NIHL claims to play out. As the sceptics see it, this week’s bullish trading update changes nothing, and Quindell still has it all to prove.

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G A Chester has no position in any shares mentioned. The Motley Fool has no position in any of the shares mentioned.