Datong (DTE.L) – Inspecting Gadgets
(This is the second installment in my series of case studies on the shares that make up my portfolio. For the last piece, on Trinity Mirror, click here)
I have had many unhappy experiences when it comes to technology investing. From memory, with the exception of First Derivatives, every technology company I’ve ever bought and subsequently sold shares in has lost me money. To be fair, many of my disasters happened in my early days of investing (I’ve been actively trading since the tail end of the 1990s), at a time when the dot.com bubble was bursting. Punts on the likes of Riverdeep and Alphyra went horribly wrong back then. Since that experience I’ve been very reluctant to buy tech stocks. All that’s left in my fund are Playtech, Datalex and Datong, which collectively make up 7% of my portfolio.
Datong caught my attention when I worked as a small-cap analyst. One of the stocks I covered was an outstanding Northern Ireland technology company called Andor Technology, which I’ve long been a fan of. A prohibition on owning shares in companies that I had research responsibility for prevented me from owning shares in Andor (and forced me to dispose of First Derivatives!). However, I liked the applications that Andor’s high tech camera gadgetry could be used for and looked for similar firms that were listed on the UK or Irish markets.
With the nature of warfare evolving into a high-tech game involving extremely mobile forces, I liked the sound of Datong, which is a supplier of covert surveillance systems to Western security services. With visions of its tracking devices being used to hunt down ‘Johnny Taleban’ in mind (although more recently I’ve noticed that its equipment is also used closer to home), I decided to take a punt on its shares.
However, my experience has not been a happy one. Government budgetary pressures saw its financial performance nosedive, taking the share price down with it. A further source of pain has been a messy legal action that it is fighting over alleged patent infringement (see note 9 here). The suspension of its dividend and recent departure of its CEO have been further blows to what had once been a rather promising story.
Earlier this week the company issued full-year results which contained plenty of material for both the glass half-full brigade and the glass half-empty one. In terms of the bull points, the company announced that: (i) it was trimming £0.5m from costs (pretty chunky for a company whose FY11 revenues were only £11.75m); (ii) its own-product sales had grown 26% in the past 12 months (third-party product sales sank 65%); (iii) reading between the lines, while State security budgets are under pressure, prevention is less costly than cure, so its ‘preventative’ product lines appear less likely to be trimmed from procurement budgets than other types of security products (although lead times are undoubtedly longer).
On the bear side, however, it was revealed that net cash had halved to £1.27m at the end of FY11 relative to year earlier levels due to what to me looks like very poor working capital management (operating cashflow in FY11 was -£149k versus +£2.8m a year earlier); while the firm also disclosed that in recent times order intake has been “comparatively low”.
Leaving the outlook to one side for a moment, with a market cap of £2.7m (and hence an enterprise value of less than £1.5m), the patent infringement case clearly poses a near-term risk to the equity value of the company (to what extent it may be priced in is impossible to tell given the poor liquidity of the stock and all of the other setbacks the company has experienced in the past year), thus putting it into the ‘highly speculative’ category.
In terms of the valuation, Datong has reasonable asset backing. It has no long-term debt and boasts net assets of just under £10m. That’s 70p a share, or 3.5x its current share price. Of course, the key near-term risk is the patent infringement case, although it should be pointed out that Datong says: “the Defendants continue to have confidence in their case and, as such, continue with their defence“. A court of appeal hearing took place in late November, but the judgment has yet to be handed down.
In all, Datong to me looks like an option here. An adverse finding against it in the patent infringement case would have negative consequences – the company has made provisions of £0.3m against this for fear that it happens, but it admits that “given the open issues surrounding the case and the inherent difficulties in estimating liabilities it cannot be guaranteed that additional costs will not be incurred beyond the amounts provided”. On the other hand, a positive result would remove a major overhang and likely see a big re-rating of the stock. Given that Datong makes up only about 50bps of my portfolio, this is a punt I’m willing to run as the potential downside from here is limited to only a tiny fraction of the fund. However, due to the uncertainty and also the low possibility of a pick-up in government security budgets in the short-to-medium term, I wouldn’t be looking to add to my position at this stage.