Shares in software provider Castleton Technology (LON:CTP) showed a huge decline in early trade today as the company warned on profits, suggesting that even a stronger H2 would result in the overall year being behind expectations. The markets did not like this one bit:
The low point of 48p was almost a 50% drop on the previous close. In the bigger picture, throughout the past couple of years this has been a strong performer with the share price doubling but today’s warning puts us back a few years. The initial thought is that this might be a bit harsh.
Castleton are a software company with a difference, providing managed software services to the social housing sector across a diverse suite of services from operations management, financial management to cloud services. In some respects, not too dissimilar to Craneware (which put out its own profit warning) although possibly without the network effect: at least in the United Kingdom, regional councils can be quite autonomous. That said, with over 600 providers signed up, we can have some confidence in their product.
What’s gone wrong at Castleton?
The bad news comes out in a trading update today. First some positive news:
The Company generated revenue of not less than £11.6 million, adjusted EBITDA* of not less than £2.9 million and cash generation in the period of not less than 79% of adjusted EBITDA*, facilitating a continued reduction in the Company’s net debt compared to the prior year. Recurring revenue has increased on an absolute basis and represented approximately 65% of total revenue in the period.
Last years revenue was £26.4m so we are some way behind this. Adjusted PBT was £5.6m so again, trailing. Cashflow sounds about the same. The recurring revenues is up from 58.3%. Onto the bad:
Trading in HY2019 has been behind expectations, primarily due to product and professional services revenue being lower than anticipated. The increase in recurring revenue has not been enough to offset the reduction in one-off revenue, and as a result of this, revenue, EBITDA and operating cash are lower than the strong comparable period last year.
The previous statement shows that there was a £3.45m hardware sale, so perhaps this may be difficult to replicate. And the demand for professional services may decline as users become more competent.
We also have a dreaded H2 weighting:
The Company is confident that revenue, EBITDA and cash generation will show a material improvement in the second half of the year. This is not expected to be sufficient to meet current market expectations. Despite this, the Board remains confident in the long-term prospects of the Group with the anticipated effects of the merging of the Company’s managed services and software divisions starting to come through.
There is a certain risk that this may not materialise and as such another profit warning may come into play.
Castleton: A Premium Valuation
One of the first things that stands out is prior to today, Castleton enjoyed an extremely high valuation respective to earnings – even on the adjusted side it was in excess of 20+. Looking at these figures from Stockopedia, we can see quite a decent turnaround:
Projecting ourselves forward to 2020/2021 we can see a business with net margins of 20%, which is exciting. On closer look, the profits are not what they seem. Net profits are bigger than operating profits thanks to a large tax credit this year which will not be a permanent feature.
Balance Sheet and Debt
The growth figures are also less impressive than what they seem as much of this has been driven by acquisitions. In fact, it is this which has led to the balance sheet becoming a bit stretched. Intangible assets and goodwill dominate this, to the extent that net tangible asset value is negative. The company is quite asset light, although arguably this may not be a problem at all, because much like a supermarket it receives monies up front for its services.
In terms of debt, there is a new £4m loan facility and £2.5m overdraft with Barclays. As of the last financial statements, only the first was drawn down. Some previous acquisitions have been financed by the issuing of convertible loan notes. Over the past couple of years the share count has expanded rapidly from 31.2m to 81.5m. The directors do not own many shares outright, but have a very large number of options outstanding, so dilution could be a factor.
A better aspect of the business is that it generates real cash and plenty of it, which is not apparent in profits due to the large amortisation charges on previous acquisitions. £6.172m was generated from operations last year, which allowed it to finance more acquisitions (almost £4m worth) and settle some deferred considerations and still have a small increase in the cash position. If the acquisition trails would stop cash could accumulate pretty quickly on the balance sheet (and hence be returned to shareholders or buyback own shares), although it seems fairly likely that any further growth would come by buying other companies.
There are quite a few pros and cons to this share. On the positive side, here we have a business that may be performing a bit better than the figures say. It has carved out a good position in its own niche, with all the big social housing providers signed up. Usually in these type of companies there may be the danger that one or two customers dominates the whole order book, but this is not the case here. At over 600 companies and £26m turnover, we can see that the charge per customer is modest, and the accounts confirm that no customer accounts for more than 10% of revenues.
Counter-party risk is also greatly reduced here, as it seems fairly unlikely that councils will default on their debt. They also are far more likely to stick around, rather than have to retrain its staff on a new system. The majority of its revenue is also now recurring, potentially giving rise to an increase in margins.
The need for social housing may actually increase depending on the political system we have in future. For sure it is one way to deal with the extremely high prices of property, although there may be vested interests in keeping them high.
Some of the downsides derive straight from this though. With so many housing providers signed up, there could be said to be a top limit to how much revenue can be generated. It seems unlikely that further revenues could be gained without providers passing on charges to their clients, which politically would be quite unpopular. A decrease in public spending could also put revenues at risk especially if the government funded an in-house solution.
Expanding abroad is a reasonable thing to do especially as social housing exists in almost every country, although trying to break these markets may be quite difficult.
The balance sheet is dominated by intangibles, and profits are massaged by a tax credit.
It was an expensive company to purchase, but not so much so now considering the price has almost halved today. In my view, this is quite nicely balanced, although still not at a price where I’d be inclined to take a risk. 3/5.