The first point to recognise is that these figures are usually produced by independently commissioned firms such as Edison Research. Remember that they are being paid for this research and are reliant on the custom of the company, so the research tends to have a bullish slant. After all, if a research firm produced research stating a company was overvalued, the company would probably cut ties and prevent future publications. When a company is unprofitable, there is a need to market positive coverage to attract investors for future placings.
This is where we can start with Clean Air Power ("CAP"), and we can start back in March 2012 to outline the background. First we can look at the technology. CAP sells a product called Dual-Fuel technology through two routes. The first is through retrofitting existing vehicles with the Genesis-EDGE system (it can be installed without engine manager assistance). The second is through partnerships with Original Equipment Manufacturers (OEMs) and is the Interfaced Dual-Fuel system. The technology is touted to reduce a truck's fuel bill by as much as 20%, thus also decreasing the environmental footprint by lower CO2 emissions.
With oil and gas prices high in 2012 and a continuous drive towards energy efficiency, the products initially found some favour with contracts being won with big names such as Sainsbury's and Eddie Stobart.
Independent Forecasts vs. Reality
Again starting at the end of March 2012, we can first look at the 2011financial results which showed revenues of £4.6m and a pre-tax loss of £1.9m. At the point of the first relevant Edison Research note, CAP was trading at 16p with a market cap of £22m. Remember that the research firm will usually try to justify the current or a higher valuation based on future numbers, because the current financials are not likely to justify the current price. Below are the first set of forecasts from Edison, in March 2012.
Edison went on to state that the "EV/Sales [was] less than 1.0x 2013 forecasts", hence "CAP's rating is very undemanding". That would be fine, except that the £16.5m of revenues forecast for 2013 were not significantly underpinned by existing contracts, and not all of the 2012 forecast was either.
If you were looking at these forecasts without prior knowledge, you might see CAP as a rapidly growing company with excellent technology that deserved a premium rating, despite only £0.5m in pre-tax profits forecast for 2013. That would be a dangerous and highly speculative conclusion to draw.
The reality was that as the year progressed, contract wins were insufficient to back even the 2012 forecasts, and there was a reduction in forecasts again in September 2012, to those below. Notice how the revenues figure had declined for 2012, as had the pre-tax profit for 2013. Yet, Edison somehow forecast an improvement (from before) in pre-tax profits to -£1.2m in 2012, and an improvement in 2013 revenues to £16.9m.
The decline in forecasts did not stop here either with Edison again reducing estimates closer to results in February 2013. In particular, the new profit forecasts for 2012 and 2013 were substantially different to those "expected" in March 2012.
Clearly, investors buying into CAP on the basis of the forecasts made in March 2012 are likely to have been left disappointed, partly down to major changes in profits expected for 2012 and 2013, as forecast by Edison.
Why is this the case?
However, inaccurate "independent" forecasts for technology companies are relatively commonplace. There is a reason for this; these forecasts are based on a certain level of market acceptance to determine the top-line growth, and a certain level of cost control to determine profitability. In reality, these two figures are hard to predict from the outside, hence are often wrong and should not be relied upon.
Looking at Clean Air Power, although margin predictions were accurate, the profit figures were wide of the mark and reflected a significantly higher level of administrative expenses (including marketing) that forecast; there was looser cost control. Similarly, revenues were revised down, probably down to slower market acceptance and interest in the product.
Perhaps more importantly we should look at the 2013 forecasts of £16.9m in revenues and pre-tax losses of £0.9m against reality.
If you had read the research note by Edison in March 2012, you may have thought that Clean Air Power was a rapid growth play at a reasonable price, with respectable financial forecasts showing the company to grow quickly and profitably in 2013. Instead, the financial forecasts for new technology plays are often wrong and based on a series of optimistic assumptions. Clean Air Power has since declined from 16p to just 3p, as a result of numerous placings funding the losses, and a loss of enthusiasm for any growth story. In fact, for 2014 CAP expects to report just £6.8m in revenues and a pre-tax loss around £5m. That paints a far bleaker picture compared to the report in 2012.
Points to Remember
- Forecasts for rapid revenue growth or rapid profit growth may be subject to downward revision, especially if the forecasts are generated by "independent commissioned" research companies. That is because the forecasts and interpretation of them will designed to paint the company in a positive light. Consequently, do not rely on these numbers and understand that any investment is highly speculative.
- It is good practice to try to work out the proportion of future revenues that are underpinned by existing contracts. In CAP's case, a significant proportion of the 2013 revenues were not underpinned.
- Technology can be leapfrogged, and may be rendered far less valuable by the advent of superior technology.
- External factors can affect market uptake. For example, CAP was planning to enter the Russian truck market in 2014, but that was delayed as a result of domestic Russian instability. Furthermore, the substantial decline in the oil price has taken the focus off energy-efficiency products in the short-term.
- New technology tends to require wide market validation by many high-calibre firms, to enable the technology becomes accepted. Although CAP partially achieved this via deals with Sainsbury's and Stobart, the lack of contracts through 2013 and 2014 did not support the step up in revenues expected.
- Marketing and R&D costs for new technology can significantly reduce forecast profitability in the initial years after launch. In particular, the technology may be tweaked several times as a result of customer feedback or customer requirements.
- If significant revenue growth (that is not underpinned by existing contracts) is forecast for the following year, keep a close eye on whether there are contract wins to back up the forecasts. A lack of contract wins may signal that the forecasts need to be reduced.