Size and the City

Dec 07/Jan 08 issue

The Alternative Investment Market has its attractions, but the short-term approach of investors may be the exact opposite of what you require to achieve long-term growth.
Marc Barber reports

Part of the journey for a CEO intent on scaling a company is realising that errors occur along the way. No one, after all, is perfect and everyone is entitled to make mistakes – unless, that is, you’re in charge of a listed entity, when you’re expected to be flawless.

Ken Scott is the CEO of training group ILX, which listed on the market in 2000. Earlier this year, it missed its forecasted numbers and issued a profit warning, which saw the share price drop from a high of 95p at the beginning of the year to 57.5p.

Since Scott took over in 2003, ILX has gone from making losses of over £2 million to being profitable, and has made six acquisitions. However, it was one of these companies that caused this year’s disappointing financial results: ‘We had a difficult year in the best-practice division. We’d bought a business in November 2005 and it performed incredibly badly, making losses when it was supposed to post nearly £1 million profits,’ he says.

In effect, the reasons for this were beyond Scott’s control: ‘It was a small team of six people and the commercial director, who was essentially our route to market, left after a falling out with the managing director. It took a long time to find a suitable replacement and we couldn’t do it quickly enough.’

Although ILX missed its numbers, the financials it released for the year to March were the envy of many CEOs, with turnover surging 50 per cent to £10.3 million and pre-tax profits of £1.46 million. ‘It’s the way the market operates,’ comments Scott, stoically. ‘Our net profit was up 40 per cent. Our earnings per share were slightly down by about five per cent, which wasn’t a huge drop, and yet the share price halved at one stage.’

Gary Carter, CEO of software simulation specialist Flomerics, tells a similar tale. In July 2006 Flomerics acquired German software company Nika for an initial consideration of £8.8 million. The plan was to repeat that company’s domestic success in other markets, notably the US.

Interim results this year showed that turnover had grown by 23 per cent to £7 million, and a pre-tax loss of £805,000 was posted, compared to a profit for the comparable period in 2006 of £138,000. That’s seen the share price head south, falling from a year high of 110p down to 43.5p.

Reason versus instinct

In a rational universe, the reasons for a company missing its forecasted performance should be important or, at the very least, worth hearing. Unfortunately, the public markets are not necessarily the right place for enlightened, logical assessments.

Twice-yearly financial reporting requirements of interim and full-year results also fuel illogical market reactions. Clearly, negotiating a contract may not fit neatly into the timescale of your reporting periods, but there is often a rush to try and book big contracts or client wins before each respective set of results is released.

It’s not unusual for a company to be punished for announcing a delay in sealing a contract in its financial results, even though the deal will be signed. TEG Environmental, a composting business, saw its share price dip after a delay was announced to the signing of a contract worth £35 million to work on the biggest waste management site in Europe.

A number of companies were involved, so there was nothing specific that TEG had done wrong and it was effectively a done deal. That didn’t seem to matter to shareholders when the news was announced in July. Mick Fishwick, TEG’s CEO, says the best way to avoid such shocks is to diversify so that no single deal assumes such crucial importance.

Carter agrees, saying that when he joined Flomerics three years ago, it was clear that he had to develop new offerings and invest in research and development. If a mistake was made, it was underestimating how long it would take to integrate the new acquisition and the time required to enter another market. ‘We wanted to repeat Nika’s success beyond Germany, but it takes time to build a brand in North America,’ he says, adding that the acquisition remains a sound investment.

Like Scott and Fishwick, Carter is fully aware of how the market functions, but concedes that it’s tough to build on a strategy when the slightest error can result in millions wiped off the market cap. ‘The problem when you’re a small company is trying to grow while investing for the long term,’ he says. ‘Shareholders say they’re interested in the long term, but they want it both ways.’

Off the road
For Chris Moe, the earnest CFO of Vectrix (a US company that makes environmentally friendly electric scooters), life on AIM has, to say the least, been anything but an easy ride.

During the previous two years, the company raised over $100 million (£48.9 million) in private equity. After assessing various markets, Nasdaq was ruled out as too large and, primarily due to the Sarbanes-Oxley legislation, too expensive. Milan and Frankfurt were considered but rejected, and a lot of investors said AIM was the natural market on which to list. In June, Vectrix raised £33.7 million through a placing with institutions at 52p, achieving a market value of £135 million.

Less than six months later, this pre-profit company’s share price toppled from 49p to 12.7p. Moe comments: ‘The thing about stock prices that are trading on a story or theme – as opposed to revenue or a price-to-earnings multiple – is that, for a while, they tend to have strong momentum. If things go up, they generally keep going in that direction, but the reverse is also true. It’s even stronger on the downside.’

Loss of control

According to the former US Marine captain, there are two main reasons for the fall in share price. Firstly, pre-IPO, there were 320 shareholders, making it impractical for Vectrix’s nominated adviser and broker, HSBC, to arrange lock-in agreements. ‘Fifteen per cent signed an orderly market agreement, which isn’t a lock-in but it’s close enough,’ says Moe.

Inevitably, a significant number of stakeholders who had bought shares at half the IPO price decided to cash in. However, the selling continued apace after a warning was issued following a mistake discovered in the assembly line. ‘We had early-stage production issues in July which were fully disclosed and swiftly resolved,’ states Moe. The spiralling share price meant that some funds had to sell, as they weren’t allowed to hold investments below a certain size. A month later, the full scale of the sub-prime crisis emerged and that, suggests Moe, led to several hedge funds having mortgage-backed assets to offload.

At present, 2,000 bikes have rolled off Vetrix’s production line and agreements have been struck with 35 dealers around the world. ‘We’re not completely beyond the inspiration phase, but we’re definitely deep into the perspiration phase,’ says Moe, who attributes the assembly line blip to exuberance. ‘We should’ve expected a hitch but we were a little overconfident. We were honest, but naïve.’

The punishment for this oversight has been extreme. With hindsight, he is sure the market reaction could have been tempered if more of the good news about the company had been released – such as the fleet deals and the star names interested in the bike, including Sir Richard Branson.

The power of PR

A former investment banker, Moe says he knows the value of law firms and banks, but had underestimated the power of public relations. ‘Most of my experience has been with private capital and not public. If someone were to ask me for advice, I’d tell them that financial PR is a lot more important than they might think.

‘If you’re a 15-year-old company with solid earnings it’s less of an issue, but if you’re more of a story stock and you need the market’s attention, a financial PR is possibly more important post-transaction than the bank.

‘You don’t want a spin master out there, as you’ll get spun up and then come right down again – but the buzz from good shareholder communication is going to do more for the stock than the haphazard attention of the institutional salesman.’

Moe, Scott and Carter head companies with market caps under or around £30 million. There’s a feeling that AIM is less forgiving than ever before for businesses operating in this area. ILX’s Scott suggests that the investment institutions and advisers aren’t interested in anything below that level: ‘The AIM market at the moment is in an awful state. I’ve spoken to some of our institutional investors – across the board, they say that the good, the bad and the ugly are being put in the same pot, so a lot of institutions aren’t investing.’

Hidden gems

This means that companies with genuine growth prospects are getting lost amidst those which, in all likelihood, should never have gone to market in the first place. If a finger of blame is to be pointed, it’s at the brokers and nominated advisers who bring substandard companies to market, plus a general lack of knowledge from investors.

Serial entrepreneur Luke Johnson, who heads venture capital firm Risk Capital Partners, argues that this needs addressing: ‘There are quite a few companies floated on AIM that I personally don’t think would pass muster with serious venture capitalists. But in my opinion, because many of the investors on AIM are not professional investors in venture capital (they tend to be quoted investors in quoted securities), the amount of due diligence, analysis and rigour that’s needed is sometimes wanting.’

For those CEOs at the more aspirational end of the market, the only course of action is to concentrate on higher turnover and profits, and assume justice will eventually be done with an appropriate market cap.

Scott says: ‘My problem is that if I focus on the share price, I’m not focusing on the business. All I can really control is the fundamentals, so presently we’re in a good position. We generate a huge amount of cash, and as the year progresses we’ll hit our numbers and people will see this coming through.’